I have been keeping a close eye on the recent IPO activity of online retail businesses in the UK.
AO World is the most recent example, an online retail business selling a range of white good brands which listed on March 3rd 2014 and achieved a market capitalisation in excess of £1.5B (close to 6x historic revenues), joining ASOS and Ocado in what seems to be an uncontrollable euforia amongst retail investors for anything that involves selling and online.
Having looked at ecommerce businesses in the private market as an investor over the past four years, what caught my interest is that such valuations are nowhere to be seen in private equity land. Some of the most recent deals in the private markets (interestingly one has to go back to December 2011 to find the first relevant one), such as Wiggle, Moonpig or MyProtein, were done at 2-3x revenue and 10-13x EBITDA. This is a world apart from what the listed markets are valuing online retails businesses at the moment: Ocado (70x EBITDA), ASOS (80x EBITDA), AO (147x EBITDA).
So why are private equity investors not paying such high multiples for online retail businesses, while listed market investors pile in?
A few charts should help shed some light. Red dots represent listed online retail companies (including the ones rumoured to be listing in the next few months e.g. Boohoo, Photobox), blue dots represent privately owned online retail companies. Three things appear quite evident:
1) Listed market investors are happy to pay a premium for revenue growth, unlike private equity investors;
2) Private equity investors value margins, while the listed market investors don’t seem to care that much;
3) There is a slight premium for scale in the listed markets, not in the private markets;
Three things could be explaining this data:
1 – The level of sophistication amongst private equity investors is higher than that of listed market investors (listed equity fund managers, pension funds, retail investors). This would explain private equity’s obsession with margin (a rough proxy for the quality of the business model) rather than topline growth (which could come at the expense of margins). In a nutshell this is Amazon’s equity story of how they won the heart of Wall Street: a business carefully run at zero margin to keep topline growing at >20% pa to win market share of all retail. More equity analysts covering UK ecommerce stocks could be a good thing as the market capitalisation of online retail businesses in the UK now tops £10B.
2- There is a scarcity of growth stocks for UK fund managers to take exposure to and the offline to online shift is still one of the few attractive growth stories remaining out there. So anything that simply smells ecommerce, regardless of the actual underlying business model, will attract a premium valuation. This is actually causing severe headaches amongst some of the best IPO candidates (and their bankers) that, despite operating at 30-40% margins, will inevitably be thrown in the “online retail” bucket by the listed markets and possibly get an Ocado (5% margin) or an AO.com (3% margin) multiple on their revenue (c. 4x). I am sure they won’t be un-happy about those multiples, but in theory they should trade at a premium to less attractive business models.
3 – Listed markets seem to believe that with size come economies of scale in ecommerce, and therefore they are happy to ascribe a premium for larger businesses. But is that actually the case? The same data set suggests the opposite, the larger the business the lower the margins (a proxy for its efficiency) i.e. it’s either growth/scale or margin in ecommerce. This brings us back to point 1: how sophisticated are the listed market investors?
Every year, 40 million people walk in and out of Piccadilly Circus underground station in London. That’s 770 thousand a week, 110 thousand a day, every day. That’s a lot of footfall, but also potential eyeballs.
You can actually rent a retail shop in Piccadilly Circus station for £1,500 / week. To keep it simple, you could just hang a large billboard in front of the shop unit, so you don’t have to bother about fitting it, staffing it, stocking it etc.
Now, assuming that all 770 thousand people walking in and out of the station on a weekly basis look at your billboard, that’s costing you just shy of £2.0 CPM (£2 for every 1,000 impressions).
Let’s say you wanted to buy 770 thousand impressions online from an audience that is similar to the people that pass through Piccadilly Circus every day (i.e. 50/50 men/women, ABC1, shoppers, tourists, 18-40, professionals). That’s likely to cost you a lot more than £2.0 CPM. For example, the Mail Online, world’s largest online news site (with close to 200 million monthly UVs and an audience somewhat comparable to the Piccadilly crowd) charges anywhere between £20-50 CPM for ad space on its web property.
I’ve made the assumption that all people walking through the station would look at the billboard, which is obviously optimistic. However to achieve a CPM comparable to the online CPM only 4-10% of the people would have to look at the billboard, which feels quite conservative given people have to walk by it to get in an out (I for example always look at ads in the tube and at stations, I suspect I am not the only one).
I have also assumed for simplicity that one would just hang a billboard in front of the shop, which would not attract higher than average attention from the crowd. In reality, with a little investment, the unit can become an interactive billboard where potential customers can walk, touch and feel the products, talk to staff and buy.
Overall it feels like there is an opportunity for online businesses to leverage flexible offline retail presence to drive impressions at attractive CPM rates, with the upside of the human interaction.
I have been thinking at the off-price retail market recently, both offline and online. Businesses playing into this market rely on accessing surplus stock from brands, and then selling it down to the end customers at a markup (but still at heavy discounts to RRP). Surplus stock fundamentally exists because of structural inefficiencies in the retail industry which make it difficult for brands to accurately forecast demand (and therefore production): production cycles are long, so brands don’t know if it will be a good season until it’s too late to react. In categories like fashion, where trends are volatile and their lifespan difficult to predict, this factor is even more important: fear of missing out forces brands to deliberately over-produce.
One key question from the investor’s perspective is whether these structural imperfections will at some point go away, as brands become increasingly good at forecasting demand. That would obviously reduce the economic need for off-price retailers, as in a perfect retail marketplace brands should be able to sell 100% of their inventory at full price.
So I looked at the US market, where more data is available on listed off-price retailers. I specifically looked for evidence of low / decreasing importance of off-price retailers in the retail value chain (in my mind low was <5% of the entire market, a completely arbitrary low number). I was therefore surprised to find that the basket of six off-price retailers I used in my analysis contributed to 16.3% of the US Clothing & Clothing Accessories market in 2012, up from 12.9% in 2005. I looked at the clothing and accessories market as off-price retailers tend to mainly sell that.
Note: off-price include TJX, Ross Stores, Big Lots, Stein Mart, Overstock, Bluefly.
Source: companies accounts, US Census
This is even more impressive if one thinks that those off-price sales occurred at c. 50% discount to full retail price, so in terms of volumes the importance of off-price retailers in this category is enormous.
My analysis is deliberately conservative as it is excluding all privately-owned off-price retailers which I could not easily get revenue data for. These include large online off-price retailers such as Gilt, RueLaLa, HauteLook etc which experienced very high growth over the period I looked at and certainly would add % points to the 16.3% number I got to and steepness to the red curve.
What this is suggesting is that surplus stock is unlikely to go away from the industry any time soon and, if anything, brands should be feeling more comfortable in their over-production decision because of the efficiency of these channels in clearing up their unsold stock.
What this is not showing though is the impact on margins that this channel has for the brands…
As I think it is a good practice for investors to make investment thesis publicly available, this post will be about the investment thesis that led Forward Investment Partners to invest in Appear Here back in November 2012.
As a backgrounder on the company, Appear Here aims to be THE online marketplace where commercial property is rented out, irrespective of lease length. The investment thesis can be summarised as backing a compelling entrepreneur to disrupt a large, ripe market via a proven and attractive business model.
Commercial property is a large sector (between retail and office rentals, the UK market is worth well in excess of £30B a year), currently undergoing rapid and significant structural changes:
1) Landlords are under pressure as an ever larger portion of their portfolio becomes vacant and occupied lease lengths keep falling year after year.
- Vacancy rates up. This is driven by the weak economy, and online sales growing as a portion of total retail sales. This has meant UK retail vacancy rate (i.e. readily available retail units as a % of total available retail units) has surpassed 16% towards the end of 2012. This is likely to grow even further, possibly double, driven by ongoing growth of e-commerce and the large number of long-term leases coming up for renewal in the next 2-3 years which are unlikely to be renewed. It is also worth noting that vacancies have a double-whammy impact on landlords: not only do they generate no rental income (opportunity cost), they still incur in business rates which the landlords have to front (actual cost). This cost UK landlords £1.1B in 2011/12;
- Lease lengths down: the average length of new signed leases continues to shorten, from over 20 years in 1991 to c. 9 years in 1999 to below 5 years now, with terms now often including long rent-free periods and short break clauses. There is no sign of this trend inverting any time soon;
- Conclusion: landlords know they need to adapt to a new environment where their inventory gets rented out on extremely flexible and standardized terms (e.g. rolling weekly/monthly leases). What they are looking for is a platform that will help them to optimize this inventory so the total net value of the yield is the same.
2) Secondly, on the demand side, brands are increasingly trying to build direct relationships with their customers, cutting the intermediaries out of the equation as Paul Fisher has elegantly illustrated in one of his recent blog post.
- In the long-term the dis-intermediation of the retail world is inevitable and brands will establish more direct relationships with their customers;
- Retailers, particularly online ones, are starting to value bricks & mortar as an extension of their brand: much more about the touchy-feely customer experience rather than product revenue. What companies like Rapha, Warby Parker, Moo, Etsy etc. have done offline are good examples;
- As online cost of customer acquisition keeps increasing month on month and return from online marketing dollars is maxed out, offline becomes an attractive complement as another touch point in the customer purchase cycle. This requires a shift to viewing a square foot of space as media rather than as potential revenue generator;
- Conclusion: brands need flexible and easily accessible physical retail.
3) Last, dis-intermediation in the property marketplace is inevitable: timing is not clear, but the web WILL disrupt as it has done already in other sectors:
- the transparency brought by the internet makes it increasingly difficult for middle-men to justify their share of the value created along the entire value chain, leaving buyers and sellers to retain the margin that would otherwise go to the market intermediaries;
- the compensation model under which commercial property agents are remunerated is still the same as it was when lease length averaged > 10 years, with short-term leases not generating enough commission to be worth their while;
- Conclusion: the web will enable dis-intermediation in the commercial property market.
An online transactional marketplace is a proven business model that is very attractive because of its economics and its defensibility, at scale.
- Attractive economics: marketplaces generates a fee without taking the cost of inventory and incurring in the risk of not being able to shift it; in the case of Appear Here, the inventory is owned and held by the landlords, and Appear Here valuably facilitates the transaction via its website;
- Defensibility: marketplaces also tend to be highly defensible, once they reach a certain level of liquidity; this is because buyers/sellers tend to naturally gravitate (and stick) to highly liquid marketplaces where they have the highest chance of being able to find a large number of seller/buyers.
Ross Bailey is a charismatic and energetic entrepreneur with a grand vision and the courage to go after it. We, at Forward Investment Partners, love backing entrepreneurs like Ross.