AKA - Revolve Group: Headwinds Will Be Difficult To Overcome

2023-09-09 23:26:26 ET

Summary

• Retail stocks are down across the board due to lower earnings and caution from investors. This is creating opportunities to invest in high-quality businesses at discounts.
• However, some retail stocks may not bounce back pandemic-level earnings power.
• I think demand headwinds will hurt Revolve's FY2024 earnings more than investors are expecting as higher oil prices and resuming student loan payments hurt discretionary spending across the board.
• My $13 price target is based on my FY2024 estimate of $0.60 and a 20x multiple.

Most retailers are going through a difficult period as consumers are cutting back discretionary spending on goods and competitors are increasing promotional activity to reduce their inventories. In response to this environment, retail stocks are down due to lower earnings and general caution from investors in this sector.

I believe that this is creating opportunities for investors to invest in high-quality businesses at discounts to their intrinsic values, but determining the diamonds in the rough is a difficult task. Not all of these stocks are cheap based on 2024 earnings expectations so it may be some time before they bounce back, if they bounce back at all.

The SPDR S&P Retail ETF ( XRT ) in the price chart above illustrates how retail stocks have fallen significantly from their peak in 2021.

The best retailers are the ones with competitive advantages that will allow them to maintain high returns on invested capital over the long term. These competitive advantages are difficult to determine by examining results from the last few years as the strong demand environment for goods created a rising tide that lifted all retailers. This allowed many to generate an artificially high ROIC. Now that the tide has gone out, investors must determine which retailers have competitive advantages that will bring them to return to previous earnings strength sooner than later.

It is difficult to determine if Revolve Group, Inc. ( RVLV ) truly has a competitive advantage that will allow the company to outperform over time. If there is not a competitive advantage, operating margins may not return to where they were in 2021 and 2022, and forward earnings expectations would drop.

While Revolve’s stock has dropped substantially year to date, it’s still not cheap based on most estimates of 2023 and 2024 EPS. Along with this, the online retail space is much more competitive than investors think and brand equity will be difficult to maintain as more and more competition emerges.

There are positives with the company, however, namely, its strong balance sheet and its owner-operators that own large stakes in the business and care deeply about brand equity.

These positives are not enough to ease my concerns about industry competition, continued economic weakness in its target demographics, its lack of a clear competitive advantage, and the fact that the stock is not cheap based on 2024 earnings. I am initiating coverage with a sell rating and a $13 price target based on 20x my 2024 EPS estimate of $0.60.

Business Overview

Revolve is an online-only premium retailer that targets Gen-z and Millennial shoppers. While the company started out as an apparel-focused retailer, it now carries footwear, accessories, home products, and beauty products. The company has two reportable segments, REVOLVE and FWRD. Both of these segments sell similar products but FWRD is focused on luxury products whereas REVOLVE is more focused on premium but everyday products.

The company has been innovative in its use of social media to market its site and products as they have a network of thousands of influencers that they partner with to promote Revolve and its products. This is a win-win for all parties involved as the influencers get free products and enhance their image due to their association with Revolve, and Revolve gets millions of eyeballs on its brand. This type of marketing has led to high growth but an important question for investors is to understand whether this growth is due mainly to a general increase in online shopping that occurred over the past few years, or due mainly to business-specific aspects about Revolve.

Past Financial Results

As I mentioned above, Revolve has grown tremendously over the past few years. Growth in active customers and total orders placed show this best.

This growth in active customers and total orders placed has led to growth in sales and earnings. Revolve’s ROIC has climbed in this period in part because of this rise in earnings, but also due to its online-only business model which requires little capex and utilizes a small asset base.

I could argue that much of the company’s marketing spending should be capitalized because it is going towards building brand equity, an intangible asset. This is why Revolve’s operating expenses are so high despite the fact that it has no store footprint that requires paying for labor, rent, and general occupancy costs. Making adjustments for capitalized marketing spending would change ROIC slightly but would not change the big picture of the company’s operating model.

The market has previously assigned the stock a high earnings multiple due to this high ROIC and growth. At peak ROIC and growth in 2021, Revolve’s stock traded at around 50x trailing earnings. This looks expensive in hindsight but it was reasonable if those growth and ROIC trends, along with the low discount rate at the time held up. While ROIC in 2022 was still relatively high at 25%, it will be much lower for FY2023 and FY2024 with earnings likely to drop substantially in those years.

It's difficult to determine if Revolve’s past high ROIC was due to business-specific factors or due to the fact that the industry it operates in had strong tailwinds. Other online-only retailers such as Shein, while much bigger than Revolve, grew tremendously fast in the pandemic years only to see growth slow and valuations drop. Shein recently raised $2 billion but at a valuation 33% lower than in 2022.

a.k.a. Brands Holding Corp. ( AKA ) which owns various online retailers such as Princess Polly and Petal and Pup, also saw triple-digit growth during the pandemic but has since seen revenue decline substantially. This led to a reversal in operating leverage and a decline in profitability.

The macro question for these online-only retailers is whether Gen-z and Millennial discretionary spending will improve over the course of the next 12-18 months. The business-specific question for long-term shareholders is whether each one has a competitive advantage that will allow it to gain market share and return to earnings strength after this downturn.

Price Target

While management’s 2023 guidance takes expected weakness in millennial and gen-z discretionary spending into account through the end of the year, what will 2024 hold for these consumers? I am betting on continued weakness in 2024 as student loan repayments continue in October. Oil prices have also started to rise and I don’t think many are considering the effect that this will have on retail spending as more of the consumer’s wallet share goes towards paying for gas. Oil prices remaining in this $80-$90 range for some time may hurt discretionary in 2024.

High oil prices will also lead to higher freight expenses for companies like Revolve that have to deal with high rates of returned items. With oil prices already 25% higher than they were at the end of Q1, sales could decline and expenses could rise more than analysts are expecting in the coming quarters.

I estimate that FY2024 EPS will come in at around $0.60, which is about 10% less than what analysts are currently expecting. My estimate for this underperformance relative to expectations stems mainly from my beliefs that Millennial and Gen-z consumers will continue to spend cautiously in 2024 and that selling and distribution expenses will remain elevated as a percentage of revenue due to high return rates and higher than expected oil prices. With this in mind, I am assigning a $13 price target to the stock based on a 20x multiple of my FY2024 EPS estimate.

This is just about where the stock is currently trading but I believe the probability for further downside is higher than the probability for upside. If higher oil prices negatively affect discretionary spending across the board I believe analysts will lower earnings expectations for the upcoming quarters. A drop in Q3 and Q4 earnings expectations would cause the stock to decline to a trough multiple of earnings of around 17-18x, putting the stock at around $10.

Investors with longer-term holding periods can take some comfort in the fact that the founders/CEOs running the business clearly care deeply about long-term brand equity and take proper action to promote long-term value creation as they together own 45% of the business. The company's strong balance sheet with $270 million of net cash also gives it the ability to invest aggressively during this downturn. If these investments generate high returns on invested capital, they will emerge on the other side of this downturn in a stronger position.

Final Thoughts

I believe the retail sector is presenting plenty of opportunities to invest in businesses at discounts to their intrinsic value. This task is easier said than done, however. Investors must correctly pick which ones are underearning and poised to rebound to previous strength as opposed to the ones that may never return to earnings power that was achieved during the pandemic.

I am not convinced that Revolve will return to its pandemic-level earnings anytime soon. The company faces stiff competition from other online retailers, demand headwinds as student loan payments begin again and oil prices rise, and industry supply headwinds due to overstocked inventory that is causing increased promotional activity.

My $13 price target is based on my FY2024 EPS estimate of $0.60 and a 20x multiple. This EPS target is below what analysts are currently expecting as I don't think investors are considering the effects of higher oil prices on consumer demand and freight costs.

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