RVLV - Revolve: Short-Term Pain For Long-Term Gains

Summary

• Revolve's business is under pressure due to poor consumer sentiment, high inflation that is impacting operating margins and a potential recession on the horizon.
• Nevertheless, the business is still successfully growing and has effectively zero debt on the balance sheet.
• The company has managed new trends effectively in the past and is adding many new customers, mostly young people, which might grow together with the business for years to come.
• The current price can be an interesting entry point for a very good business.

As many other growth stories, Revolve ( NYSE: RVLV ) has seen its share price beaten down over the last year and a half. However, the company recently posted an overall positive quarter in my opinion and has grown over the past few years consistently and profitably. I like the business model as it boasts very high margins and is not only retaining the customers but also achieving higher average order values year after year, which is a testimony of customer loyalty.

Despite all the good news, the macro headwinds are definitely impacting its operation as it belongs to the delicate sector of consumer discretionary. There is a potential for the shares to slide more if the economy falls into a recession, but overall Revolve is a good business and I believe it is well positioned to potentially gain market share even during hard times. Let’s see what makes Revolve so special.

What makes Revolve unique

Revolve markets itself as a fashion retailer with a specific target in Millennial and Gen Z customers. The company markets its offerings as high value and as such, they offer generally medium-to-high ticket value items with over 70,000 curated articles for its community of consumers. Since its inception in 2003, the company was created around the concept of leveraging new technologies and channels in order to offer a model that is more targeted than department stores or generic online retailers. The company developed internally a technology that relies on algorithms for managing inventory, pricing and for forecasting new fashion trends. In the last annual report , the company proudly detailed how 87% of everything sold on the platform in 2021 was at full price. Thanks to this, Revolve operates at a very healthy gross margin of 55% which is quite high as a fashion retailer.

Revolve’s attitude towards utilizing new digital channels did not stop to evolve since the company was created. In the past few years, the company has doubled down on a marketing strategy heavily reliant upon partnering with social media influencers, in a further attempt to reach its targeted demographic customers. The company has noted how in 2021 over 50% of traffic for Revolve came in through the use of free and low-cost sources (directly on Revolve website or by using its app, via e-mail marketing, organic search results etc.) which further demonstrates brand loyalty.

Another avenue taken by Revolve in order to boost its impressive margins is creating in-house brands. The company is managing 30 owned brands, each operated independently from a marketing perspective and targeting different types of customers. Overall, in FY2021 5 of the top 10 brands sold on the platform were owned by Revolve and represented 20.1% of net sales.

The company is also riding important macro trends that could ultimately help fuel its growth. I already talked about how Revolve is leveraging new digital trends in order to boost its reach, which not only helps targeting the desired customer demographic today but is also a play on the future of communication. Social media platforms are on the rise among young people, albeit in an ever-changing form. The same customers are also more reliant on their mobile devices for their online purchases and see less favorably legacy brick-and-mortar generalist retailers. Revolve fully embraced the trend and the mobile-only nature of such channels: In 2021 over 64% of total orders processed by Revolve were placed by its customers from a mobile device.

I believe that Revolve positions itself to gather market share from legacy retailers that are generally much slower to adapt to new trends. Today’s Millennials and Gen Z customers might become loyal customers of Revolve for many years to come if the company will also be able to slightly adapt in the future based on their needs.

Recent performance and short-term headwinds

In the second quarter 2022 , Revolve reached 27% YoY growth in revenue compared to the same quarter the previous year and added 124,000 active customers during the quarter, the best result for any Q2 (39% growth). The company was consistently profitable in every second quarter since 2019, with net income generally growing in a steady and consistent way until this year. The $16 million of net income registered this quarter came in much lower than last year, when the company managed to bring in $31.5 million of GAAP net income; however, management highlighted in the report how this comparison is naturally unfair due to a one-time event that occurred last year in the second quarter when Revolve had only 3% tax rate compared to the current 23%. On this topic, the company expects long term to have a tax rate around 25% thus this effect will normalize in the future.

Great news on the margins side, as Revolve has consistently established itself around 55% gross margin pretty much since 2019, with the exception of 2020 obviously due to the COVID impact to the economy. This margin represents best in class compared to other online marketplaces such as Stitch Fix ( SFIX - 43%) or Farfetch ( FTCH - 43%). In addition, customers are generally spending more with average order value for the quarter growing to $303, an increase of 19% YoY.

Despite growing consistently and adding a healthy amount of new customers, the company is navigating a complicated environment from an operational point of view. In the past quarter, the company has experienced a higher than normal return rate from its customers for multiple reasons. First and foremost, Revolve is expanding internationally and in order to grow faster in new geographies and entice new customers, it is offering perks such as hassle-free returns, which naturally drives up the return rate overall. Management has offered as an example the expansion in Canada, which saw a quadrupling in net sales over the past 6 quarters but also a 2x in return rate.

The strategy seems however sound as Revolve might retain these customers long term and as such some short-term pain now might translate into more success in the future. In addition to this strategy, a higher return rate might also be an indication of a more problematic souring of customer sentiment in general, which wouldn’t be that surprising considering the generationally high inflation we are experiencing now. The problem is that a higher return rate is also adding pain to another short-term headwind which is fuel surcharges and higher shipping costs. Although clearly an exogenous factor outside of management control, inflation is clearly taking a toll on operating margin (6.6% this year vs. 14.4% in 2021).

A bit more worrying is the inventory trend, up 73% YoY and 15% sequentially from Q1 to $222 million. As stated by management during the latest earnings call, this is a higher level than expected and will need to be addressed:

Our inventory investments are reflective of our efforts to keep pace with the robust consumer demand we had experienced over the past several quarters. However, with the demand trends shifting during the second quarter as discussed, our inventory balance ended the quarter in a place that is higher than we would like. While we feel good about the quality of inventory, the overall balance is elevated and we are working diligently to bring it back in balance.

The high inventory level might force the company to lower the value of some of the merchandise and offer more discounts than it normally would.

Guidance, valuation, and key takeaways

Going forward, management still sees some pain and actually openly invited investors to have low expectations:

[The economic macro] pressures mounted as the quarter progressed, negatively impacting consumer demand and our top line, particularly in June and continuing into the third quarter, with net sales growth of approximately 10% year-over-year for the month of July. [...] Given the uncertain macro environment and considering that our comparisons are more difficult in the second half, we encourage investors to model further moderation in our year-over-year net sales comparisons for the balance of the third quarter from the approximately 10% growth in July. And since our net sales growth rate accelerated throughout 2021 and with the economy looking uncertain at best, we continue to expect the fourth quarter to be the most difficult comparison of the year.

It makes sense to tamper expectations considering that the second half or 2021 coincided with the great reopening from the COVID pandemic and as such will be very tough comps to beat, while at the same time the current economy soured very quickly and discretionary spending might be under pressure for a while.

All in all, I believe the headwinds described above are temporary although it is not clear how long they will last. Moreover, an actual recession might be in the cards and this will further dampen investor mood and customer sentiment. However, the share price today appears to have priced in at least partially these worries: for a company that is growing fast, has high margins, is adding many new customers and appears well positioned to further gain market share the stock is trading for a very reasonable valuation. Even considering the slowdown in top-line growth for the second part of 2022 (and potentially further), the company is still projected by Wall Street as growing 20% this year and 11.7% next year (Yahoo Finance data) while trading at just 1.5 Price / Sales ('TTM'). As far as earnings, a P/E of 19 is very attractive but with the earnings under pressure due to the headwinds described above the value might increase; nevertheless, both multiples are way below historical average for the stock and are still valued at market average which makes it interesting considering that Revolve is a growth story.

I believe that the headwinds the company is experiencing are temporary in nature and the growth story might just experience a pause. The current price point seems to have discounted a lot of troubles already and might be an interesting entry point. However, I think that placing a small order for now might be the correct strategy as the possibility the stock might slide more is very real given the state of the economy. Further dips in the stock price will be a good opportunity to add more for the quarters to come.

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