Farfetch's Farfetched Valuation

(Bloomberg) -- Who wears it best in online luxury? Investors are about to decide.

Just as Cie Financiere Richemont is taking control of Yoox Net-A-Porter Group, rival Farfetch U.K. Ltd may be eyeing a $6 billion initial public offering.

Though YNAP is a digital pioneer, it apes a traditional department store. It buys stock and holds it until it is sold to customers. In contrast, the majority of Farfetch's business is selling products on behalf of boutiques, which pay it a commission on every item it shifts.

Farfetch looks like a capital-light way of tapping into the fast-growing online luxury market. It’s not the first to try this approach. Just Eat Plc has achieved surprisingly decent margins from connecting hungry customers with fast-food outlets.

Farfetch's Farfetched Valuation

But an online platform for top-end fashion is very different from one for pizzas. Investors need to make sure they’re compensated for the risk of Farfetch’s spending creeping up from size zero.

At a possible valuation of up to 5 billion euros ($6 billion), investors would certainly be betting on it being capital light. Gross merchandise value, orders and services including tax and shipping, was 550 million pounds ($757.7 million) in 2016, the most recent accounts available. If that rose to 1 billion pounds in 2017 -- not an unreasonable assumption given that GMV increased 82 percent in 2016 -- that implies an enterprise value to trailing sales of 4.3 times. That’s well above YNAP's 2.4 times.

Farfetch's Farfetched Valuation

Internet-based fashion retail is becoming increasingly capital hungry. YNAP is set to invest 1 billion euros through to 2020, and while much of that will be spent on warehousing and distribution, it is by no means all.

It’s an issue for the masses as well. At downmarket rival Asos Plc, about a third of this year's capital expenditure will be on fulfillment centers. But a similar proportion will be spent on technology.

Farfetch shouldn't need to spend so much on infrastructure. But it's hard to see it escaping the need to maintain a strong pace of investment in IT, particularly if it wants to stay at the cutting edge.

When it comes to online luxury, it is the most upmarket shoppers who count. They demand the best service and the most seamless delivery, and competition to get them to crack open their Gucci wallets is rising. YNAP already knows this -- roughly 40 percent of sales at Net-a-Porter and Mr. Porter come from just 2 percent of its highest-spending customers.

Farfetch's Farfetched Valuation

So while the likes of Just Eat can get away with a rather more pared-back customer experience – with spending to match – that’s not so for luxury retailers. On top of this, Farfetch is also responsible for returns to its boutique partners. You don't get that with fast food.

The company's geographical ambitions are another call on its purse. It is currently building its operations in the Middle East and China. Though partnerships with the Chalhoub Group and JD.com should help, global domination isn’t cheap. The company has already raised $677 million since 2012, including a $397 million stake from JD.com.

Farfetch had a 35 million-pound loss in 2016, which it blames on heavy spending as it expands geographically and into new areas, such as building online flagship stores for brands.

Indeed, the business model is evolving. Farfetch bought London boutique Browns in 2015 to create a test bed for a division that helps physical retailers use its technology. But this gives it the same old problem of getting stuck with inventory.

There are no plans to hold any more stock right now. But business models can change. Take Just Eat. It wasn't initially responsible for deliveries, but will now invest in its own courier service. 

If Farfetch really is able to crack online luxury retail without becoming a big spender itself, then it deserves a premium. But given that it is hard to see how its investment needs will wind up being as slim as the cigarette pants on its site, its prospective valuation might prove to be quite farfetched.

To contact the author of this story: Andrea Felsted in London at afelsted@bloomberg.net.

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