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It may be too early to buy Farfetch (FTCH) stock just yet. Shares are down 88% from February 2021 highs, and the company isn’t profitable yet — or all that close. That’s not a profile which the market seems to like at the moment.

Meanwhile, earnings loom next week. Traditionally, big declines into earnings offered the potential for a “relief rally” off a report often referred to as “better than feared.” Those relief rallies have been few and far between this earnings season. Online retail platforms haven’t done well, either, with Amazon.com (AMZN), Shopify (SHOP) and Etsy (ETSY) among the stocks selling off.

Adding to the short-term worries, FTCH gained 16% in trading Friday amid a burst of buying in the most beaten-down and most speculative names. The big gainers during that session offer a who’s who’s of sh—cos1; it’s not particularly comforting that Farfetch was grouped in with those names. That aside, were an investor willing to time the bottom, she’d likely prefer to own the stock ~14% cheaper at Thursday’s close instead of Friday’s.

That said, to some degree similar caveats plague pretty much every stock in this volatile market. In this environment, we continue to advise caution, and continue to exercise that caution in our personal accounts. Taking the long view, however, there are going to be opportunities created by this sell-off. At some point, Farfetch seems likely to be one of those opportunities.

Introducing Farfetch

London-based Farfetch operates a global marketplace for luxury brands. The core of the business is the company’s third-party Digital Platform (including fulfillment, almost three-quarters of 2021 Gross Merchandise Value). Farfetch offers merchandise from more than 1,400 brands based in over 50 countries in categories including clothing, bags, watches, and accessories, with a blended take rate just over 30% last year.

Over time, Farfetch has added to this core business. The 2015 acquisition of UK retailer Browns underpins first-party distribution revenue (~13% of 2021 GMV). Its 2019 purchase of New Guards Group, a “brand platform” that incubates labels (Off-White and Palm Angels among the most successful), drives 1P revenue as well as the “Brand Platform” (11% of GMV). In-store operations add about 2% of GMV and almost 3% of total revenue.

The business has grown nicely over time. GMV has risen from $382 million in 2015 to $4.3 billion last year, a 50% annualized growth rate. Farfetch still believes it can drive ~30% annual growth going forward. Active consumers were 416 million in 2015, and 3.69 billion six years later.

That growth underpinned an initially successful IPO back in 2018. Farfetch stock priced at $20 and closed its first day above $28. A soft Q3 report a year later, which included the announcement of the New Guards acquisition (a deal the market did not initially appreciate, though the $675 million purchase price in retrospect looks like a winner), sent the stock down 60% in a matter of weeks to the single digits.

The novel coronavirus pandemic led to a huge rally. Like many e-commerce plays, Farfetch was seen as a beneficiary of stay-at-home orders. Spending on travel and dining was redirected into merchandise (Farfetch posted 49% GMV growth in 2020). Thanks to strong performance on a roaring market, FTCH rose almost 10x from its 2019 low to a February 2021 high.

As noted, from that point, the stock has fallen 88%, as the same factors that drove FTCH stock up have unwound in a spectacular manner.

Fundamentals In The Eye Of The Beholder

Admittedly, near the bottom (the stock touched an all-time low on Wednesday before rallying 23.5% across the Thursday and Friday sessions), the fundamentals are not necessarily compelling on their face.

Relative to FY22E revenue, FTCH trades at about 1.3x EV/sales.2 That’s certainly seems reasonable in context; ETSY, for example, is about 5x on the same metric. But ETSY already is driving high-20s Adjusted EBITDA margins, about where Farfetch currently is targeting (Farfetch’s first-party revenue depresses the figure somewhat), and investors at the moment no doubt are skeptical of (or scarred by) valuing solely on an EV/sales basis.

Profitability metrics, meanwhile, don’t quite work. After Q4, Farfetch guided for 1-2% Adjusted EBITDA margins this year, after generating $2 million on that basis in full-year 2021. But stock-based compensation remains significant, coming in at almost 9% of revenue last year. Assuming the company can get to its 30% long-term margin target, or the mid-20s figure analysts have forecast for later this decade, the current ~$3.3B market cap is probably a steal: continued GMV growth at a 20%+ CAGR plus 20%+ margins gets EBITDA over $1 billion. In that scenario, FTCH stock is a multi-bagger.

As we shall see, however, that’s a huge assumption.

Short-Term Worries

In the meantime, there’s a lot that can go wrong.

The luxury space, historically, has shown some resilience against macroeconomic pressures. But the key phrase there is “some resilience”. The UK alone accounted for 10% of revenue in 2021 (the US about 21%), and lingering effects of Brexit combined with the impact of the Ukraine war in Europe pose a threat to revenue this year.

More importantly, Farfetch is making a big bet on China. A joint venture with Alibaba (BABA) and Rochemont (CFRUY) underpins its strategy in a country that already is the second-largest on the Farfetch platform by GMV. Both the current impact of the novel coronavirus pandemic and a central government increasingly (and, to Western eyes, erratically) clamping down on the private sector suggest risk to 2022 performance in that hugely important market.

Shipping cost inflation is a risk as well. Farfetch already has negotiated increased commissions per the Q4 call, but those commissions may well get passed along to more cost-sensitive end customers. On the same call, an analyst noted the potential for Farfetch’s “multipoint architecture” to amplify cost inflation, owing to the lack of major distribution centers. Chief executive officer Jose Neves replied that the company’s distribution model offered better speed and greater inventory — but didn’t necessarily dispute the thesis underpinning the question.

Earnings arrive a week from Thursday after the close. They will be delivered in a market that (last two sessions notwithstanding) shows no apparent tolerance for any growth stock showing any kind of disappointment. For Farfetch in particular, the guidance for 1-2% EBITDA margins offers a potentially significant pressure point; a post-pandemic return to negative EBITDA may be seen as a huge problem, even if profits were positive in 2021 by only the narrowest of margins (and on an adjusted basis).

Straddle pricing in the options market suggests a move of almost 20% between now and Jun. 17. It wouldn’t be stunning to see Farfetch stock make that kind of move downward — particularly since such a move would only get shares back to about where they closed on Wednesday.

The ‘Feel’ Case for FTCH Stock

So there are roadblocks here. There doesn’t seem to be a huge case for stepping in big ahead of earnings. Nor is it easy to pound the table on a fundamental basis. Again, FTCH is a multi-bagger if it hits its management targets — but there is no shortage of stocks for which the same is true.

That said, we do have some data points to suggest that the sell-off has gone too far. Let’s go back to the IPO: FTCH now is down 69% from its first-day close, despite the fact that it’s performed reasonably well against expectations. Adjusted EBITDA does seem to be a modest disappointment — margins are a few hundred basis points below hopes — but given the upheaval of the last two years that’s hardly a fatal hit to the bull case.

Farfetch’s revenue growth has benefited from acquisitions. But even using only third-party GMV in 2021 (and excluding fulfillment revenue, which is generally pass-through), Farfetch posted growth of nearly 40% annualized from 2015 to 2021, and 100%-plus between 2018 and 2021.

This is not a business that has been a massive disappointment. Yet FTCH not only is well below its IPO price, but is down 14% since the beginning of 2020. Zoom Video Communications (ZM), perhaps the biggest of the pandemic winners, still has rallied 39% over that same period despite a far more direct boost from stay-at-home orders and the like.

We can also look around the space. MyTheresa (MYTE), a far smaller competitor, had a $3 billion valuation immediately after its IPO (admittedly in January 2021, near the top for growth names). Its GMV is about one-fifth that of Farfetch. In January 2018, Richemont paid roughly the same amount for Yoox Net-A-Porter. That deal didn’t work — Richemont in fact is looking to sell a stake in YNAP to Farfetch — but in large part because Richemont tried to make YNAP more like Farfetch — and failed.

Even the joint venture with Alibaba and Richemont seems to value the Chinese operations at $2 billion, and Farfetch’s stake at $1.5 billion.3

These comparative data points are imperfect, to say the least. But they add to a common sense argument that a $3.3 billion valuation for this kind of business is far from onerous. The luxury market is a huge, attractive industry. It’s been slow to move online — but it’s catching up. Farfetch at least has a chance to be a huge part of that shift — and it’s clear that investors have been willing to assign a similar valuation to businesses in weaker positions.

At the very least, the risk/reward here, at least mathematically, is skewed in favor of a long position. FTCH can’t fall more than 100%. It can pretty easily double: shares in fact closed at $17.24 (94% upside) just six weeks ago. Five years of 20% annualized growth, 10% EBITDA margins, and a 15x EBITDA multiple get FTCH close to $20, suggesting annualized returns in the high teens. Performance absolutely does not have to be perfect for investors here to win over the long haul.

And in the short term, while next week’s earnings look dangerous, FTCH stock actually soared after the Q4 release in March, rising 23% and gaining in the weeks followed before the broader market sell-off reversed the rally.

The Mono-Brand Question

If Farfetch can keep this year’s expectations reasonably intact after Q1, FTCH stock probably can find a bid after next week’s earnings report. (Again, it’s dangerous to hope for a relief rally in this market, but one would think the market could find room to forgive EBITDA margin pressure, in particular.) But as far as the longer-term outlook goes, it’s really a matter of keeping reasonably close to multi-year targets.

The biggest hinge there seems to be on the competitive front. As far as multi-brand retailers go, Farfetch appears to have a big edge on MyTheresa, Yoox, and others. Amazon and Alibaba have on occasion made moves toward the space, but neither has been a huge winner yet (and Amazon, in particular, doesn’t seem to have the brand to move that far up the ladder.) But the long-running worry here has been that multi-brand retailers will get shoved out by so-called monobrand offerings.

Indeed, monobrand websites (websites who only sell one luxury brand) have steadily taken share: per Bain’s 2021 Luxury Report, they accounted for 40% of the online segment, up from 30% two years earlier. There’s some logic here. Luxury retailers, in particular, simply have to control supply and distribution because brand perception is so key. Those retailers are not trying to sell everything they can; in many cases, they’re not necessarily even trying to sell more.

Many of the biggest luxury brands are housed in businesses large enough to afford the investments required. The smallest, most successful brands can get large enough to do the same. So the worry is that Farfetch is not going to have a wide enough breadth in terms of the most popular high-end names, whether in terms of enduring appeal or current buzz. That in turn means that growth quickly decelerates; profitability doesn’t arrive; and a $3.3 billion valuation falls even further.

It’s a legitimate concern. But it’s a concern that, at least to this point, doesn’t have a ton of evidence behind it. Farfetch has grown from zero to a guided $5 billion-plus in 2022 GMV in fifteen years. Even the largest companies running monobrand websites (like, say, Rolex) still are going to offer product in multiple channels, like any other retailer. And it’s not as if there are going to be successful non-marketplace multi-brand competitors; luxury brands won’t cede pricing to a third party.

Upheaval in the online ad market, caused by privacy changes from Apple (AAPL), offer another potential mid- to long-term tailwind. Farfetch has done well driving app downloads, which generally drive higher-quality customers and can get around some of the privacy changes. But weakened targeting capabilities in online advertising also upend a key part of the strategy for growing smaller brands — adding to the value of a multi-brand offering like that of Farfetch.

And, again, some of the best companies in the world have added credibility to the model, either by selling through Farfetch, mimicking it, or investing in it. So have some of the best customers in the world: the top 1% of Farfetch consumers in 2021 drove 27.5% of revenue, or over $500 million. That’s ~$14K/consumer, proving the value of Farfetch’s Private Client offering.

In addition, Farfetch’s expansion is offering a wider variety of services. Most notable is Farfetch Platform Solutions, or FPS. FPS encompasses pretty much all of the back-end services required for luxury retailers of all sizes. Neves noted after Q3 that there are multiple companies worth $10 billion-plus simply by offering that model. He said after Q4 that 2022 “will be a transformational year for FPS.” A $200 million investment in US high-end retailer Neiman Marcus should add another client; FPS already had a big contract (and an apparently successful launch) with esteemed UK retailer Harrods.

There’s a lot of work left to do, certainly. Farfetch needs to drive better margins, and probably should drive better margins given the luxury nature of its products (and a ~$600 average order value). Volatility is likely around earnings and potentially for the rest of the year.

But this still is an awfully good business in a seemingly solid position. Revenue growth will drive at least some kind of margin expansion. There’s little reason to expect a deceleration in the luxury market more broadly. And between FPS, the growing first-party business, marketing campaigns, and other efforts, there are catalysts beyond the core platform.

There was enough here to get investors excited even outside of the roaring bull market in growth in 2020-2021. When some semblance of normalcy returns, there should be enough here to get them excited again.

As of this writing, Vince Martin has no positions in any securities mentioned. He may take a position, either equity or options, in FTCH ahead of next week’s earnings report.

Tickers mentioned: FTCH

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