Farfetch Well Placed as Online Luxury Takes Off

Farfetch FTCH is an online platform connecting sellers and buyers of luxury goods. The company partners with around 1,000 luxury goods sellers, including over 600 retailers and 375 brands, to offer their inventory on the platform. For making retailers’ stock available to a million active customers, the company charges a 30%-plus cut (third-party take rate). The business model is capital-light--the company carries only inventory associated with its physical Browns store ownership--so it can offer a significant number of products without incurring risk of excess inventory write-downs. Farfetch offered 3.9 million stock-keeping units at the end of 2017 and 5.7 million currently. The platform carries around 10 times more SKUs than the next-biggest player, according to Farfetch’s initial public offering prospectus.

Although Farfetch generates most sales through its marketplace platform, it has invested in retail operations, such as the Browns acquisition in 2015, and is working toward solutions for an integrated online and in-store experience through its “connected retail project.” It also provides white-label website services for luxury brands through its Black & White division.

The idea for Farfetch materialized when founder Jose Neves noticed that the stand-alone website for his SIX physical store had growth limitations needing significant human resource and marketing investments, which are hard to justify for a small business. Farfetch’s platform aimed to facilitate and lower the costs of physical retailer access to the online space while providing customers with the opportunity to browse stores’ assortments without having to visit each store’s website, saving time and effort. Without inventory, Farfetch could be bolder with new designers and more extravagant styles, providing a wide merchandise selection. Unlike other marketplace players, such as eBay EBAY, Farfetch does product curation at a retailer level, besides just finding a store to partner with.

Farfetch managed to overcome the initial resistance of luxury retailers to online channels through personal contacts with fragmented, family-owned businesses. The timing may have been right as well; the company started in 2008 amid the financial crisis, with retailers looking for opportunities to increase revenue in a tougher environment. As a result, the platform managed to extend its network of suppliers from 35 boutiques in 2009 to almost 1,000 branded and retail suppliers currently. The number of brands on the platform increased from 49 in 2015 to 375 by mid-2018. In 2017, Farfetch partnered with Gucci to offer a 90-minute store-to-door delivery service in 10 global cities. In 2018, it signed a deal with Burberry in which all the brand’s inventory would be available through the e-commerce platform, including some capsule collections exclusive to Farfetch.

Business Model Could Have a Moat Down the Road We lack confidence that Farfetch will be able to enjoy sustainable economic profits over the long term, given its currently limited customer reach (its active customers are less than half a percent of the luxury purchasing population, by our estimates) and lack of monetization, even at elevated third-party take rates. There is the potential for intensifying competitive pressures, given the industry's early stage of development.

Nonetheless, we believe Farfetch’s business model displays traces of a network advantage, as it is currently one of just a few early aggregators in the luxury industry. We look at Farfetch’s network advantage from the perspective of its main stakeholders: brands, retailers, and end consumers.

Wide-moat-rated marketplaces under our coverage, such as Amazon AMZN, MercadoLibre MELI, and Alibaba BABA, have around 10%-15% of each target population as their active customers. Once this threshold is achieved, we believe it becomes very difficult for competitors to unseat the incumbent and can lead to an extended period of excess economic returns. As a comparison, no-moat Zalando reaches around 10% of the population in its core Germany, Austria, and Switzerland region but only 4% in the newer European markets. We believe that with its 1 million active consumers, Farfetch reaches less than half of a percent of 350 million luxury consumers globally (according to a Bain 2017 luxury goods report). In fact, no participant in Farfetch’s fragmented industry is near a critical customer scale, as YNAP, the biggest luxury online retailer, reaches only around 1% of the luxury-purchasing population through its platforms Net-a-Porter, Yoox, Outnet, and Mr Porter, leaving an opportunity for leaders to form over the coming years.

Finally, although Farfetch’s third-party take rate is among the highest in the industry, suggesting an ability to monetize the network, the company has yet to show profits and positive cash flows, given the elevated technology investment levels and lack of leverage on general and administrative expenses and fulfillment costs. Also, we aren’t certain whether such high third-party take rates can be sustained in the context of increasing competitive pressures.

We believe the brands and their content associated with Farfetch help us define the purpose and advantages of the company’s platform. We see several benefits a brand stands to gain from a presence on Farfetch’s platform, such as credibility and positive halo effects from a growing platform, favorable economics, and distribution that reaches important demographics.

That said, we believe luxury brands are more difficult to onboard to online platforms compared with midpriced and low-cost brands, which protects the incumbent luxury online sellers (including Farfetch). Through our talks with luxury companies, we gauge that their concerns when picking online partners are: the right brand representation (which includes appropriate user interface with a “luxurious” feel), appropriate peer group (no luxury brand wants to be the priciest player in the retail channel, or the first one to come on board, creating a chicken-and-egg problem), no counterfeited goods, and control over pricing. Farfetch overcame these hurdles over 10 years, first addressing luxury retailers and building credibility with the brands over time through personal contacts.

Although new brand additions lead to higher competition, we believe they also add to the credibility and luxury feel of the platform and attract the right target audience, benefiting the existing branded players. For example, a brand like Prada would not be willing to be the only luxury brand on the platform of cheaper or lesser-known peers, as such a platform wouldn’t attract the right target audience, or worse, have a damaging, “cheapening” effect on the brand.

The presence of established luxury brands also provides a positive halo effect to the younger high-end brands, which are only looking to establish themselves as luxury, supporting the case for suppliers to use Farfetch. While purely direct-to-consumer distribution may be preferred by certain brands (several of the most prominent luxury brands, such as Louis Vuitton, Hermes, and Chanel, are currently shunning third-party online distribution), the majority of brands don’t have enough brand equity and resources to make it on their own. We argue that smaller brands benefit from the additional consumer reach that selling wholesale or being on platforms such as Farfetch allow. Own website and retail infrastructure development requires financial resources and may not attract enough customers to justify it if the brand is relatively small or immature. As the market for online direct-to-consumer brands gets increasingly crowded, it is getting harder for new brands to emerge without help from a strong wholesale partner. Partnering with Farfetch allows them to be displayed next to established luxury brands such as Gucci, Prada, Dolce & Gabbana, Valentino, Saint Laurent, and others for credibility.

Furthermore, brands are likely to favor platforms over wholesale online partners as the control over product pricing is retained and a higher share of profits is captured, even after Farfetch’s margin, compared with traditional wholesale. Finally, most obviously, brands benefit from new customer additions through an expanding target audience. Farfetch can help brands establish themselves with younger luxury consumers; luxury company executives are concerned about appealing to the millennial demographic, given their rising purchasing power. Farfetch’s average customer age is 36, and almost 70% of its clients are younger than 40, versus 58% for luxury industry, according to the company. We attribute this to the higher propensity of the younger population to shop online.

Despite growing slower than brands’ own retail channels, wholesale still accounts for over 60% of luxury goods sales, according to the Bain 2017 luxury goods report, with around 22% market share of specialty stores (Farfetch’s key partners), 23% department stores (largely untapped territory for Farfetch, with its first partnership with Harvey Nichols sealed in 2018) and airport stores (8%).

This provides a wide array of potential retailer partners to tap into. Although partnering with Farfetch reduces wholesaler margin through a hefty 30%-plus third-party take, a store’s existing inventory is made available to a wider audience than a stand-alone boutique could have (1 million active customers and over 2 million customers in total). Further, increasing the probability of full-price sell-through may offset the charge applied by Farfetch as existing stock is made available to a wider audience. We believe that exposure to a wider audience than a store itself offsets the negative impact of increased competition, as more stores/brands join the network. According to the company, some retail partners also experience a positive spillover effect on their retail store performance, as they can be less risk-averse with stock purchases. Finally, Farfetch’s retail partners should benefit from the growth of active customers and website visitors, as it creates a higher chance of purchase. We note, however, that the growth of SKUs has outstripped growth in gross merchandise value over the past three years, thanks to an increased contribution of brands (from 46 in 2015 to over 300 by 2018, according to the company). Should this pace continue, more competition may outweigh the benefits of additional customer eyeballs on existing retailers, damaging any potential network effect.

The value of the network to retailers and brands can be seen through a 30%-plus third-party take rate, which outstrips even that of established marketplace peers, such as 8.4% for narrow-moat eBay, 15%-20% for wide-moat Amazon, and 10%-20% for no-moat Zalando’s Partner Program. Although contracts with Farfetch are renewed on an annual basis, the company retained all its top 100 retailers over the past three years and all but one top 100 brand (one was discontinued due to poor performance), according to the company’s IPO prospectus.

We believe the primary client benefit of the Farfetch platform is the wide choice of products available. With 5.7 million SKUs included as part of its summer 2018 collection, Farfetch offers 10 times more SKUs than the next-biggest competitor, according to its IPO filing. Since products are selected from boutiques all over the world (currently in 45 countries), there is more of a chance to find merchandise not available elsewhere, especially since 98% of retailers work with Farfetch on an exclusive basis, an attractive proposition for fashion-conscious consumers. Farfetch also addresses the modern luxury consumer’s quest for newness with its daily assortment additions. Around 70-80 SKUs were added daily and over 550 SKUs were added weekly, according to our observations in September-October 2018. Based on discussions with luxury industry players, we gauge that consumer desire for product newness is strong and is addressed by the industry through frequent product “drops,” shopping directly from the runway, and changes of creative directors at prominent brands. We believe that Farfetch’s vast SKUs offer daily product additions and the ability to offer new designer items and more extravagant pieces without inventory risks, helping it cater to this customer need for newness.

The tricky part is product curation, as leafing through the variety of merchandise can be a daunting task. We believe that thanks to learning algorithms about consumer purchases over time (online as well as potentially offline through connected stores), the merchandising and consumer interface can be increasingly personalized, which could lead to better sales conversion. In this case, consumers would be able to benefit from additional merchandise that is specifically tailored to their preferences without having to leaf through millions of pages. Personalized merchandise should in turn benefit retailers and brands, since their products are displayed to an audience with higher buying probability.

Currently, the growth of the platform is primarily driven by attracting new customers, as the number of active customers more than doubled from 2015 to 2017, from 416,000 to 936,000, and stood at 1.1 million in the first half of 2018. Consumer engagement is also slowly increasing, as seen through increasing orders per active customer (from 1.9 in 2015 to 2 in 2017, still below YNAP’s 3, which increased from 2.8 orders per active customer in 2015). Gross merchandise value per active customer has increased recently as well, to 956 in 2017 from 902 in 2015, and experienced further 15% growth in the first half of 2018. As a result of this consumer demand, Farfetch outperformed the online luxury market, as its market share grew from 2% in 2015 to 3.2% in 2017.

We believe the data that online platforms gather through client interactions cannot be easily replicated and over time can be transformed into an intangible asset advantage. This data can be shared with branded or retail partners to better inform their design and merchandising decisions, and it can be used to customize products for a certain client type, increasing the chance of conversion and benefiting customers (offering products they want) and partners (offering products to the customer who is more likely to buy them). Purchase conversion rates are an indicator to watch for in the emergence of this moat source.

We also see potential drivers of switching costs. First, providing white-label website solutions to brands and retailers can increase switching costs with Farfetch’s partners over time. For example, Shopify SHOP, a peer providing a cloud-based e-commerce platform for small and medium enterprises, has garnered a narrow moat rating. We believe there are switching costs in changing e-commerce platform providers that include time, effort, and monetary expenses, and those usually outweigh the realized savings from the switch.

Second, augmented retail could also increase switching costs for the physical store partners of Farfetch. Chanel is an important heavy hitter that came on board the project last February, along with its investment in Farfetch of an undisclosed amount, despite not selling any goods on the platform. Under the project, Farfetch provides stores with an “operating system” that aggregates data from online sales and from physical stores, obtained through RFID-enabled racks, which allow it to auto-populate consumers’ wish lists, or smart mirrors. We believe this would increase the stickiness of its retail partnerships and would make the transition to another partner more complicated for the retailer.

The development of augmented retail is currently in the very early stages, as the operating system was only introduced in April 2017; hence, its future success is very hard to assess. We believe the value for consumers must be tangible for the system to really work. It may be more difficult to convince customers to share data offline than online, given that they are much more accustomed to online data sharing. Further on the downside, overtargeted marketing may be considered by some customers as intrusive.

We will monitor the share of augmented retail and white-label solutions as percentage of revenue for this moat source development.

Luxury Goods Industry Continues to Buy Into Online Sales Online luxury sales have been growing at a 25% pace over the past decade, increasing penetration of total luxury sales from 2% in 2007 to 9% in 2017, according to the Bain 2017 luxury goods report. We expect online luxury sales to continue growing at over 20% annually over the next five years, driven by demographics and brand willingness to focus on the channel. This compares with our forecast for low-single-digit growth in brick-and-mortar luxury sales.

First, we believe the generational shift is set to contribute positively to this trend. Younger generations are more tech-savvy and interested in online shopping. Among the fastest-growing and digitally advanced Chinese luxury consumers, 42% of millennials make luxury purchases online, versus 34% for Generation X and 28% for baby boomers, according to Deloitte’s 2017 white paper on China luxury goods. Also, according to the Bain 2017 luxury goods report, as cited by Farfetch, millennials and Generation Z across geographies will account for 45% of total global luxury spending by 2025, up from 32% in 2017. Advancements in convenience of delivery and exchanges as well as ease of sizing and fit should also convert more luxury consumers into online buyers, while frequency is making people more at ease with making big-ticket purchases online (52% of U.S.-based daily online shoppers are likely to prefer buying a big-ticket item online, versus only 22% of those who shop online a few times a year, according to a FuturePay 2017 report).

Additionally, after years of reluctance, luxury brands are finally embracing online through their own branded websites and partnerships with online platforms. Most of the luxury companies we cover are prioritizing online as a distribution and marketing channel. They are revamping their own online platforms, expanding partnerships with third-party distribution luxury online platforms, and entering the multibrand wholesale business. An online offering helps brands reach new, younger audiences (for example, over 75% of Hermes’ online customers are new to the brand), increase visibility of the brand (60% of luxury purchasing decisions are digitally influenced, according to BCG’s 2016 report), and expand its presence into new geographical locations without the need to invest in retail infrastructure.

Negotiating Power Sits With the Big Brands Smaller multibrand retailers remain the pillar of Farfetch's growth and where the negotiating power of the platform is the highest (98% contracts with retailers are exclusive, while contracts with brands are not). Despite the growing importance of retail channels in luxury goods distribution, wholesale remains a predominant industry distribution channel. According to the Bain 2017 luxury goods report, wholesale accounted for 64% of industry's sales in 2017, down from 77% in 2008. The shift to retail distribution has been driven by the brands' desire to increase control over brand representation and pricing and build-out of retail infrastructure in new markets, such as China. Nonetheless, despite industry and channel fragmentation, we believe the ultimate bargaining power sits with the big brands. Big, listed luxury companies together account for over 50% of the industry's sales, according to our estimates. Moreover, the industry is further consolidating.

The impact of brand consolidation is offset by the lowering of entry barriers for emerging luxury brands through online wholesale platforms, such as Farfetch and others. Online platforms can offer consumers more extravagant clothing and newer designers versus the brick-and-mortar wholesalers, as they don’t need to commit valuable shelf space, and in the case of Farfetch, don’t even risk inventory write-downs thanks to its consignment business model. Taking these offsetting trends together, we expect the bargaining power of big, branded players to remain largely stable.

New Entrants Could Shake Up Competitive Landscape We see the fragmentation and growth potential of the online luxury market providing an opportunity for the existing players while also inviting potential competition. (YNAP is the largest player with around 10% market share, versus around 3% market share for Farfetch.)

While the American online luxury market remains the largest, Asian and European online markets are growing fast and increasing their share. Compared with total luxury buying, Asia and rest of the world remain underpenetrated in terms of online luxury buying, contributing 28% of online luxury buying in 2017, although 60% of luxury buying globally came from Asian and rest-of-the-world consumers. Chinese luxury consumers are getting younger and, according to the companies under our coverage, are very digitally savvy and connected as well as more comfortable shopping online for luxury items.

We believe this growth opportunity is likely to attract incremental competition; for example, in Asian luxury e-commerce we have seen new market entrants Toplife by JD.com JD and Luxury Pavilion from Alibaba, catering specifically to full-price luxury sales in China. Although European players may have the advantage of greater authenticity perception, we believe they will encounter increasing competition from local players. Farfetch enjoys some advantage in China through its partnership with a strong local player. Farfetch generates 35% of revenue in Asia and partners with JD.com on logistics, payment and technology. JD.com is also an investor in Farfetch with around a 16%-17% stake.

We think these newly established Chinese platforms stand to become formidable competitors over time, given their access to the fast-growing population of Chinese luxury consumers. We note that these platforms started dealing with brands directly rather than with retailers. If they choose to engage independent retailers into their supply chain, we believe that thanks to fragmentation and size of the addressable luxury wholesale market ($196 billion versus currently less than $1 billion gross merchandise value for Farfetch), it may take some time before online players/platforms start courting the same independent retailers and competing actively on price.

We see opportunity and competitive risk in the online luxury market eventually leading to a handful of winners. We believe brands are cautious about adding new e-commerce platforms to their distribution channels. Nonetheless, some of the new players are well equipped to overcome the entry barriers, in our view. For example, Luxury Pavilion gives access to the most affluent of the 600 million-plus TMall users, while 24 Sevres offers exposure alongside LVMH’s powerful brands like Fendi and Celine. We believe that ultimately the industry’s power will stay with the big brands. We don’t think that any platform will gain a dominant position because the brands would be reluctant to depend just on one player for third-party online distribution. We also don’t think the online luxury market will be very fragmented in the future, because brands are wary of overrepresentation in too many channels and running the risk of brand trivialization, excess inventory, and discounting. Rather, we believe the market will consist of a limited number of strong global players. Farfetch could be one of them, given its value proposition to the brands, retailers, and customers. Nonetheless, significant risks remain, as smaller competitors with strong financial backing could leapfrog Farfetch through more aggressive rollouts and better economics for suppliers.

There may be some inertia for retailers to change their online platform partners, given the exclusive nature of platform contracts (duration of the contracts is one year). Case in point: the retention rate among Farfetch’s top 100 retailers was 100% over the past three years, and all but one of the top 100 brands have been retained. A potential new platform competitor should be able to provide better customer reach and/or charge a smaller take rate. So far, Farfetch remains the largest marketplace for luxury goods, with other bigger peers predominantly wholesale (competitors, rather than sales channels for brick-and-mortar retailers). Some follow niche strategies such as flash sales, resale, or runway preorders. Seattle-based Garmentory, founded in 2014, could be regarded as a closer peer, although it focuses mostly on young, lesser-known designers and sells items in the $75-$600 range versus Farfetch’s $620 average purchase value.

Farfetch Could Enjoy Strong Margins as It Scales We believe that Farfetch's platform of forgoing warehouse infrastructure investment and working capital requirements is highly scalable, which along with market share gains in a growing industry should lead to operating margins in the mid- to high teens by 2027 versus negative 24.5% in 2017. We expect fulfilment economics to be strong, given the high purchase value to delivery costs, and we expect administrative costs to scale as revenue grows. As a comparison, other bigger marketplaces under our coverage, such as Alibaba, eBay, or MercadoLibre, enjoy operating margins of 15%-30%, and we expect them to earn around 20% margins midcycle.

We don’t think Farfetch will gain the dominant position among the aforementioned marketplaces, but we expect its market share of online luxury sales to increase from 3.2% currently to 8.7% in 10 years, versus YNAP’s current 9%-10% share. This would bring Farfetch’s average annual revenue growth rate to around 27% over the next 10 years. This forecast is based on our expectations for double-digit growth in the online luxury market and rising online penetration from 9% in 2017 to 19% by 2022 and 25% by 2027.

Although we don’t see any platform dominating the luxury market, given the strong negotiating power of the big brands, we believe that the market will consist of a limited number of strong global players. This is in contrast to the fragmentation of global luxury brick-and-mortar wholesale, where presence in a specific geographic area is more important.

We believe increased purchases from existing consumers and attracting new consumers will drive Farfetch’s further market share gains. The company can increase orders per active consumer through more personalized product merchandising, increasing breadth of product offering, and a higher share of consumers’ luxury fashion budgets spent online. Further, there is growth in consumer numbers; Farfetch currently counts less than 1% of the luxury purchasing population among its active clients. We believe that the pool of vendors can be significantly expanded too, given that Farfetch’s gross merchandise value was just short of $1 billion while global luxury wholesale sales are around $196 billion, with around $68 billion in specialty store sales, according to the Bain 2017 luxury goods report.

As new competition enters the market, we expect Farfetch’s third-party take rate to come under pressure. We expect this to occur gradually as fragmentation and size of the luxury wholesale market could allow multiple players to grow without competing for the same retailers on price for some time. We model its third-party take rate to decline to 29%-30% over the next 5-10 years versus 33% in 2017.

We expect significant operating leverage to kick in as revenue grows because the marketplace business model is scalable and capital-light. We expect Farfetch’s fulfillment costs to be leveraged to 12% of gross merchandise value from 20% currently, versus YNAP’s 10% of revenue, benefiting from improving route densities as more stores close to consumers are added to the network. We believe luxury online businesses enjoy more favorable fulfillment economics compared with players with more moderate prices such as Zalando or Asos, given the high value of the product in relation to delivery costs. The average order at Farfetch stands at $620 versus $380 at YNAP and $76 at Zalando; thus we believe fulfillment economics should be very attractive as the business scales. Further, because shipments are done from the retailer, there is no need for warehousing, so warehousing costs are also removed from the equation; these costs contribute around a third of fulfillment costs at Zalando. However, we assume some inefficiencies in terms of shipping costs because of no central warehouse, the sometimes less-than-optimal shipping routes, and higher costs of product photo shooting to offset this.

We expect demand generation expense to stay elevated to fuel further new customer acquisition in an intensifying competitive landscape (demand generation expense as a percentage of gross merchandise value is already 8%, versus 12% at YNAP and 8% at the bigger Zalando).

We believe that Farfetch has a cost base to support higher revenue, providing an opportunity for positive operating leverage as revenue grows. As an example, YNAP’s gross merchandise value is over 2.5 times that of Farfetch, but head count is only 1.6 times bigger. Hence, we expect general and administrative expense, including depreciation, share-based payments, and technology expense, to scale from around 25% of gross merchandise value currently to 12% in 10 years’ time. This compares with 14% at YNAP and 5.4% at Zalando currently. All together, we expect Farfetch’s operating margins to reach 17.5% over our 10-year explicit forecast horizon.

Given the early stage of development of this business model and fast industry growth and change in competitive landscape, we believe investors should demand a wider margin of safety before building a position in Farfetch’s shares, which are currently trading above our fair value estimate.