#3 Revolve, and should I buy Tesla?
Plus: our updated watchlist, trusting Buffett, and keeping it cool.
In this edition, I talk about Revolve, Tesla, Berkshire, and keeping your dry powder.
Hey folks,
Revolve is an e-commerce fashion retailer that’s growing +20% per year. It’s a business with a high return on capital, low capital requirements, and an excellent management team. Curious? You cand find my write-up at the bottom of this e-mail.
Before you read that, some updates:
I might initiate a position in Tesla over the next weeks
Tesla’s price now implies a 3-year annual return of >40%. The economic downturn doesn’t change my investment thesis. In fact, a recession might leave Tesla relatively better. Traditional OEMs’ sales will fall from a much higher base and their investments in EVs will be delayed. Just some weeks ago GM announced it would plow $20bn in EVs. Can GM invest that much? Maybe it could, but now it can’t. Tesla has $8bn in cash, enough to navigate this storm. With all that’s going on, Tesla just gained more headway over competitors.
I’ve bought some Berkshire @ $180
At this point, it’s a small tracking position. I couldn’t resist. Warren Buffet has been hoarding +$120bn cash for the last ten years. Now it’s time to use it. The more the market falls, the more Berkshire will benefit.
“My reaction is that I like to buy stocks, so I don’t wish ill on anybody else. But if they want to sell them to me cheaper, I prefer it.” - Warren Buffet
I’m looking forward to analyzing Berkshire in a future edition. For now, it’s a no-brainer.
Stay cool. Breathe in, breathe out
Amid the market turmoil, looms the temptation to buy whatever is falling. Even airlines (argh). But I’m keeping a high cash balance and waiting for excellent opportunities to pull the trigger. My focus: keep the dry powder, find strong balance sheets and good businesses, and invest in no-brainers.
You can find our most recently updated watchlist here.
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Let me know your thoughts.
Stay safe,
Fred
Revolve (RVLV)
5-Bullet Summary:
Revolve is a premium and luxury fashion e-commerce retailer that targets (mainly) young women through social media and influencers.
The company is profitable since inception and reached +$600mm in sales with almost no outside capital.
What I like about Revolve: strong sales and expanding margins, high return on capital, low capital needs, strong balance sheet (high cash, no debt), and management with skin in the game.
There’s a credible path for continued growth: a large addressable market, untapped international expansion opportunities, and a secular trend towards fashion e-commerce.
But there are many competitors and I don’t see what’s Revolve’s competitive moat. So I’m extra conservative in my assumptions.
I calculate Revolve has a fair value of $10.80/share.
Revolve doesn’t meet my investment return criteria (>25% 3-year annual return). I may initiate a position if the stock falls below $8. Anything below $7 is a screaming bargain.
Revolve: An Attractive Business, But What’s The Moat?
Revolve is an e-commerce fashion retailer. To advertise its platform, Revolve promotes social media campaigns through paid posts by influencers (#Revolve) and special events like the Revolve Awards (which prizes influencers). The company targets (mainly) women that are millennials (born between 1982 and 2000) or generation Zs (born after 2000).
Millennials posing for other Millenials #revolvesumer (shouldn’t it be “summer”?)
Revolve has two segments: REVOLVE (revolve.com) and FORWARD (fwrd.com). REVOLVE sells premium apparel, footwear, accessories, and beauty products. FORWARD sells those same products, but at a luxury level. You can see a breakdown here:
Most products sold in the REVOLVE and FORWARD websites are from third-party brands. For example, FORWARD lists products from the likes of Givenchy and Burberry.
However, Revolve also sells its own branded products, a segment which it calls “owned brands”. Owned brands are designed by Revolve and manufactured by contracted suppliers (this is called private label in business jargon). Owned brands command similar pricing as third-party brands but at a higher gross margin. Revolve has 24 owned brands which in 2019 represented eight out of its ten top-selling brands.
Revolve was profitable in 16 out of 17 years since it was founded and has grown with only $15mm of outside capital (the company’s 2019 IPO's main purpose wasn’t to raise capital, but to provide an exit to investors).
Here’s what I like about Revolve:
1) Strong sales growth and expanding margins
Revolve had a 24% CAGR in sales from 2016 to 2019 while being profitable, generating cash, and expanding gross margins. A large chunk of Revolve’s margin expansion flows to Revolve’s operating income and free cash flow. See below:
2) Asset-light business model
Revolve produced $38mm NOPAT in 2019 over average invested capital of $88mm. That’s a 43% ROIC. Excluding the cash balance, it’s an even more impressive 81% ROIC. No matter how you slice it, Revolve’s profitability metrics are outstanding.
3) Strong balance sheet
Revolve has no debt, a cash balance of $65mm, and a business that requires no material capital expenditures. Revolve is ready to sail over the most troubled waters.
"It's very hard to go bankrupt when you don't have any debt" - Peter Lynch.
4) Growth opportunities
Revolve has barely penetrated international markets (only 16% of sales in 2019, mainly the UK and Australia) and has only reached ~3% of its target market in North America. There’s plenty of room for expansion. The company could also target more men and continue increasing the mix of owned brands vs. third-party brands in both REVOLVE and FORWARD, which would further expand margins.
5) Skin in the game
Revolve is led by its two founders and co-CEOs, Michael Mente and Mike Karanikolas. These guys have been leading Revolve from scratch as a profitable company, and accepted almost no outside capital, keeping their controlling stake. These are long-term people playing a long-term game.
There’s much to like about Revolve. The combination of high returns on capital, low capital needs, many opportunities for growth, strong capital position, and good management is highly compelling.
What about Revolve’s technology?
Revolve has advertised itself not only as a fashion e-commerce retailer but as a data-driven e-commerce retailer. From Revolve’s S-1:
To improve on the merchandise offerings from traditional retail, we have built a custom, proprietary technology platform to manage nearly all aspects of our business, with a particular focus on developing sophisticated and highly automated inventory management, pricing, and trend-forecasting algorithms. Our proprietary technology leverages data from a vast net of hundreds of thousands of styles, up to 60 attributes per style, and millions of customer interactions, creating a strategic asset of hundreds of millions of data points. We have complemented these efforts with an organization built from the ground-up to make decisions in a data-first, customer centric way. Together, this enables a “read and react” merchandise approach; we make shallow initial buys, then use our proprietary technology to identify and re-order strong sellers, turning the fashion cycle from a predictive art to a data-driven science.
All companies want to be tech because they want a tech valuation (remember WeWork). But this doesn’t make sense for Revolve. I think (1) Revolve’s technology platform has problems, (2) technology is a requirement, not a differentiator, and (3) Revolve’s core value proposition is about fashion, not technology.
To the first point: Revolve’s discourse and reality are disconnected. The discourse is that Revolve’s technology helps predict fashion trends and optimize inventory so the company can purchase products that will sell fast, at high volumes and good prices (no discounts). The reality is that Revolve had problems with inventory management for both REVOLVE and FORWARD over the last years. The company had to discount products to sell through old inventory, which lowered Revolve’s AOV from $304 in 2017 to $275 in 2019. Revolve’s technology needs some work.
To the second point: A sustainable competitive advantage is something hard to imitate. Revolve’s technology doesn’t qualify. Using data-driven technology platforms in e-commerce is not innovative. You need data to optimize product selection, manage what’s in front of customers, what should be discounted, and how much to buy. It’s a requirement to compete. Any fashion e-commerce retailer, like Stitch Fix or ASOS, has similar technology.
To the third point: Revolve is a fashion retailer. Sure, there’s quality and service, but ultimately fashion is subjective. Revolve’s core value proposition is to sell a broad assortment of fashion products that are desirable to customers because they are desirable to other people. The company invests in social media and influencers to create the buzz that makes young ladies want to buy products on its platform. Why do they buy Revolve? Because their friends and favorite influencers like and use them, and because Revolve sponsors cool and exclusive events, which makes Revolve’s products special and stylish.
Industry and Competitors
According to Statista, fashion is the largest e-commerce market segment, with a global size of $620bn, estimated to grow at 12% per year over the next years. I know, it’s hard to trust this kind of forecast. However, we can rely on this: the e-commerce share of fashion sales has almost doubled from 14% in 2014 to 27% in 2018.
It’s a growing industry and Revolve benefits from that opportunity. Competitors also do. There are many players in the fashion industry: The RealReal, Stitch Fix, Urban Outfitters, L Brands, GAP, Farfetch, Nordstrom, ASOS, Next Plc, Boohoo. Let’s focus on the ones that compete more directly with Revolve.
Stitch Fix (SFIX)
“Stitch Fix is the world’s leading online personal styling service. We combine data science and human judgment to deliver apparel, shoes, and accessories personalized to our clients’ unique tastes, lifestyles, and budgets. Our service is available for women, men, and kids.”
The main differences between SFIX and Revolve are that SFIX provides personal style services from +5,000 stylists and targets not only women but also men and kids. The personal style service makes it a different business model. That aside, there are similarities. SFIX has a presence in the US and the UK; sells third-party and owned-brands; and uses data and algorithms for inventory management, product selection, and customer service.
ASOS.com (ASC)
“Our mission is to become the world's number-one online shopping destination for fashion-loving 20-somethings.”
ASOS is similar to Revolve. ASOS sells third-party and owned-brands, has a broad assortment and constant update of products and styles, uses technology and recommendation algorithms, has an easy product return policy, and targets a similar age group. However, there are some important differences. Revolve focuses on higher price point products (premium and luxury) and on women. ASOS has a much lower average order value and is not especially focused on women.
Boohoo (BOO)
“Our vision is to be the leading e-commerce fashion market for 16 to 40 year-olds”
A key difference between Boohoo and all other competitors is that it sells only owned brands (no third-party). Boohoo has a brand called prettylittlething which is very similar to Revolve: targets women in the same age group using a similar marketing strategy through influencers. Apart from that, the main difference between Boohoo and Revolve is that Boohoo is not focused on the premium and luxury segments.
Revolve vs. Competitors
Here’s a comparison with some relevant metrics, followed by my observations:
All competitors are growing fast, reflecting the growth in the overall industry.
Revolve has a more select public, focusing mainly on women and higher price points. Maybe that’s a reason why it’s growing slower than competitors.
Revolve has relatively high gross margins. Boohoo has the highest gross margin because it doesn’t sell third-party brands.
Revolve has low inventory turnover. A possible reason: Revolve has more product returns as part of its customer service strategy. Regardless, there’s much room for improvement there. Revolve has problems with inventory management and I think the company doesn’t have the best technology.
Revolve is smaller than competitors. That’s good because it has room to grow. It also has one of the best margins at a lower scale. That’s a sign of differentiation. As Revolve grows, it could leverage size to expand margins.
Valuation
Revolve has characteristics of a quality business: low capital requirements, high return on capital, growth opportunities, management with skin in the game, and no debt. There’s a credible path for Revolve to continue growing its top-line at 10% to 20% a year over the next, say, five years, and to expand margins through economies of scale and a better segment and product mix. There’s a large addressable market, international expansion opportunities, and a secular trend towards fashion e-commerce. Revolve is executing well.
Yet, it’s not clear to me what Revolve’s competitive moat is (if it has one). I don’t fully grasp it. Maybe Revolve’s brand is a competitive advantage, supported by its social media/influencer marketing strategy and targeted focus on a niche market (millennials and gen Zs, women, higher price point). Even so, is that defensible (i.e. hard for competitors to imitate)?
I’m not sure. The e-commerce fashion retail industry has many players and barriers to entry are low. That adds uncertainty to my assessment of Revolve’s value. My solution is to play on the safe side, with conservative assumptions.
Revolve is growing top-line by +20% a year. It trades at ~$9/share excluding net cash and generates ~$0.50/share in free cash flow (5.5% free cash flow yield).
Say Revolve grows by an average of 10% per year over the next five years and doesn’t expand margins. Revolve would generate ~$970mm in net sales and ~$65mm in earnings in 2024. I’m forecasting Revolve will lose market share (the industry is supposed to grow faster) and many of its expansion initiatives won’t work. In 2024 Revolve would have lower sales than its main competitors have today. From 2024 onwards Revolve would grow like a mature company in a mature industry. In addition, because I’m keeping operating margins constant and lowering Revolve’s growth I’m implying that Revolve’s customer acquisition costs (baked into operating expenses) will increase.
I think those are conservative assumptions. As I said, I’m playing on the safe side.
Assuming historical working capital and CapEx requirements (the Company wouldn’t have to expand filling and distribution capacity because what it has is sufficient until 2023 if it grows at 20% per year), a 10% discount rate, and a 3% terminal growth rate, my DCF yields a fair value of $10.80/share.
Sanity check: at $9.50/share, Revolve trades at a trailing P/E of ~18x, or ~16x excluding cash. My valuation implies an exit 2024 P/E multiple of ~15x, excluding cash. Historically, Revolve and competitors traded at a much higher P/E. Note I exclude SFIX because it’s an outlier (trading at ~140x P/E).
You might wonder: what about Covid-19? I can’t predict what the impact will be. I lower my downside by adopting conservative assumptions and a significant margin of safety (minimum 25% 3-y annual return). When I say 10% annual sales growth over the next five years, it’s an average. Maybe this growth won’t materialize this year but could be much higher two years from now as global economic growth accelerates. By holding a longer-term view and observing a large margin of safety I compensate for short-term fluctuations and inaccuracies in my forecast.
Risks
In the short-term, the biggest risk is a global recession due to Covid-19. Given Revolve’s cash balance and low capital requirements, two years of recession or slow growth don’t impose material bankruptcy risk for Revolve. In the long-term, the major risk stems from competitive pressures. Revolve has many competitors. Price compression hasn’t hit the e-commerce fashion industry because the market is expanding. Once it matures, competitive pressures will loom.
Conclusion
Revolve is a business with many attractive features. However, the fashion industry is competitive and I’m not sure if Revolve has sustainable competitive advantages. These two factors add uncertainty over my understanding of the business and its future prospects.
I’ve decided not to buy the stock because it doesn’t meet my return criteria (that is, my margin of safety). With the recent Covid-19 panic, I wouldn’t be surprised if the stock falls to a more attractive price over the next weeks. I may initiate a small tracking position if it reaches <$8/share because of the low downside risk and high business quality. Anything below $7/share is a screaming bargain.
Given Revolve’s cash position, it could be a good time for the company to initiate buybacks. I don’t see better use of the company’s cash at this point.
Next Steps
Here’s what I’ll watch out for:
Covid-19 effects: how will Revolve be affected by this crisis and how will management behave.
Growth in the international segment (UK, EU, and Australia)
Growth in owned brands.
Improvements in inventory management.
Tracking of key metrics: the main ones are average order value and number of active users.
Sales mix between REVOLVE and FORWARD.