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Aritzia (ATZ.TO) – Investment Memo
Aritzia (“ATZ” or the “Company”) is a premium women’s apparel fashion house with multiple in-house brands focused on different clothing styles. The Company describes itself as an “Everyday Luxury” brand, with a focus on quality items at an aspirational (but not necessarily affordable) price point. It was founded in Vancouver in 1984 but exploded in 2020/2021 due to TikTok virality and expansion into the U.S. The Company has a reliable growth algorithm driven by store expansion into the U.S. and healthy HSD / LDD % same-store sales growth from its virality and increasing brand awareness. During the last quarter, a step-function increase in inventory in the face of a tougher macro backdrop has dampened sentiment around the stock, and the stock has declined ~22% from its 52-week high. The opportunity today is to acquire a compounder with a long growth runway at ~10x fwd. non-GAAP EBITDA, and we underwrite a ~2x MoM over three years driven by a >25% EBITDA CAGR.
Sentiment & Setup
ATZ traded up considerably post-Covid as the Company had its moment in the U.S. driven by significant virality on TikTok, with the stock ~2.5x from year-end 2019 through year-end 2021. Since then, it has been highly volatile as Aritzia, along with other retailers, faced a challenging retail environment with higher wage inflation, FX headwinds, and elevated freight & supply chain costs. This culminated in the recent earnings print (Q3 ’23 – quarter ended 11/27/2022), when Aritzia saw ~300bps of gross margin compression due to a ~187% increase in inventory as the Company’s Spring/Summer collection arrived earlier than anticipated. Especially in the face of a consumer spending slowdown, the stock has traded off (~22%) from its 52-week high, de-rating from ~16x fwd. non-GAAP EBITDA to ~10x today. Our view is that these issues are transitory and offer an attractive entry point into a compelling store expansion story over the next three years.
Investment Thesis I: Best-in-Class Retail Brand Driven by Flawless Execution
Consumers are obsessed with Aritzia, with lack of brand awareness the key unlock to continued market share capture.
Consumers love Aritzia. While there are concerns about the difficult growth comparison against 2021 given TikTok virality, our view is that the Company belongs in rarefied air with Lululemon or Yeti. At a high level, our customer survey (n = 153) indicates that Aritzia is the best of related brands in terms of both quality and trendiness.
This customer love translates into dollar spend at Aritzia. On average, Aritzia makes up ~26% of total dollar value of the wardrobes of women who have purchased at least one item from Aritzia before. This contrasts considerably against the Company’s meager LSD % share in women’s apparel in North America. In fact, the former Director of eCommerce Operations & Product Catalogue at Aritzia highlighted that ~80% of in-store revenue comes from a cohort of “best customers” who, on average, spend ~$5k/year at Aritzia. This level of customer loyalty is rare and reflects the clear product-market fit for the brand.
Our view is that Aritzia is a durable growth story with limited fad risk. Its ability to hit trends is superior to peers due to its multi-brand setup, with different brands catering to different fashion styles. This enables the Company to shift inventory between its various brands depending on what is selling best, which enhances the brand’s “trendiness” at all times. Many on Wall Street were worried that existing customers would churn from Aritzia due to fears of fad risk, but our survey reveals that existing customers expect to spend ~5% more at Aritzia next year (vs. ~11% growth during this past year). While a relative deceleration, a ~5% growth in existing customers is well-enough to support the low-teens same-store sales growth needed to sustain the earnings growth algorithm that Aritzia has guided towards.
Aritzia’s trendiness is no accident – Aritzia is a machine with respect to execution.
Formers at Aritzia point towards an intense, data-driven culture, with management completely obsessed with process:
“Aritzia is more rigorous in their operations than any organization I've ever stepped foot in. You need a business case to make every decision, and they use something called an ABC, and every decision that's made has to be in an ABC format. The smallest decision, to remerchandise a section of the website, to hire a model, to do anything. You have to have an ABC.” – former Director of eCommerce Operations & Product Catalogue at Aritzia
“But in terms of how they do their work, it's actually an amazing machine. So everyone thinks through problems the same way. Everyone organizes their thoughts on paper the same way, and it's taught, and it really is like it's completely their own language.” – former Director of Retail Sales in the U.S. and Canada at Aritzia
“They do a lot well. I was incredibly impressed. They're coming out of some high-level, very successful brand. Walking into Aritzia, they are very structured. They have processes and tools for everything. They've encountered a lot of problems, they've come up with solutions, and they've got an amazing team that really like grease Aritzia and are very loyal and very dedicated to the brand.” – former Distribution Supervisor at Aritzia
This feedback is seen in the patience and discipline in Aritzia’s strategy. Our analysis of their storefront presence indicates a focus on AAA real estate, with the stores only in the areas with the highest foot traffic and greatest brand equity. Consistently, their stores are in the Grove in Los Angeles or in SoHo in New York City, with an emphasis on a disciplined approach towards their expansion into the U.S. Moreover, Aritzia has a unique organizational and compensational structure that enables best-in-class sales execution. Commission is a greater portion of the annual income mix for sales representatives (~$40k base / $30k+ commission), with reps forced to requalify for commission every six weeks. The culture has been described as cutthroat, but with high employee loyalty due to the potential to earn more (some sales reps earning >$100k/year). The result is that Aritzia stores see best-in-class sales per square foot (PSF) at $2.6k PSF, second to only Lululemon ($4.3k PSF).
Note: LTM Financials
Investment Thesis II: Clear Line-of-Sight to Compound EPS at >20%+ CAGR Driven by E-Commerce and U.S.
Aritzia has a durable growth runway in the U.S. given its massive TAM and market share dynamics.
Aritzia began its expansion into the U.S. in 2012 with the opening of its New York City SoHo store, but it has only recently accelerated its store presence. Today, the revenue mix is evenly split between Canada and the U.S. (up from 70% Canada as recent as FY ‘19), despite the U.S. having ~10x the population of Canada. This is largely due to the relatively small storefront base in the U.S., with Aritzia only having ~43 U.S. stores (vs. ~70 in Canada). Through FY ‘27, Aritzia plans to open ~7-10 stores a year, with nearly all of these in the U.S. In the medium-term, Aritzia has identified ~100 possible locat ions with compelling unit economics in the U.S. Our view is that this is a significant underestimate of the potential store presence.
The U.S. woman’s apparel market is massive, with ~$160bn in aggregate 2022 annual revenue. Aritzia is in its early days with respect to penetration, with only 0.8% of overall market share today. Notably, our bottoms-up modeling of market share reveals clear market share donors, with brands like Old Navy, Gap, and Banana Republic set to cede significant share over the next five years as they close stores with uncompelling unit economics. Therefore, it seems reasonable for Aritzia to continue capturing ~20bps of market share p.a. Even contemplating a GFC-level recession in CY ‘23 / CY ‘24 (-2% / -5% market growth in CY ‘23 / CY ‘24), ~20bps of market share gains per year supports the ~25% FY ’22 – ’27 top-line CAGR that we underwrite in the base case.
Brand awareness is still surprisingly low and remains the key unlock to the U.S. market.
Despite virality on TikTok, Aritzia is unable to capture a significant portion of their potential customer base due to a lack of store presence and brand awareness. Consumers are unwilling to make their first purchase online, instead opting towards waiting for a store to open in their area. Today, Aritzia’s store presence misses large swaths of the U.S., with minimal/no presence in key cities like Phoenix, Washington D.C., and Atlanta. Store expansion is a significant driver of brand awareness – our analysis of Google Trends data indicates that opening the first store in a new city drives a ~2-3x increase in Google searches for Aritzia from the corresponding metropolitan statistical area. Additionally, management has highlighted the “halo” effect of new stores, with the first store driving an ~80% uplift to e-Commerce revenue in the city.
Investors misunderstand how accretive the U.S. market is to top-line growth and unit economics.
Aritzia’s U.S. stores are much more productive than its Canadian counterparts. First, Aritzia’s stores are much larger in the U.S., with an average of ~7.5-8.0k SF vs. ~6.0-6.5k SF in Canada. This enables greater display of inventory and higher quality architectural design. Second, higher price points in the U.S. and generally more affluent customers, coupled with strong demand for the brand, results in sales PSF that are ~40% higher than Canadian stores. Due to the high fixed cost nature of the real estate (e.g., rent, utilities, etc.), this results in structurally higher margins in the U.S. than in Canada. Additionally, the success of new stores results in same-store sales growth shifting higher as U.S. stores become “comparable” stores.
Aritzia is underdeveloped from an e-Commerce perspective, with the new CEO a critical inflection point.
Aritzia is still early in its eCommerce transition, with ~34% of LTM revenue coming from e-Commerce (vs. ~45% for the industry average). The Company has put out targets at its Investor Day guiding towards ~45% of revenue coming from e-Commerce in the out-year. While we underwrite ~40% in our base case, we believe management’s guidance is highly credible with room for upside to our underwriting if they execute.
For many years, Aritzia lagged peers with respect to digital selling channels. Feedback from formers indicates that this was largely due to the conservative nature of Brian Hill, the founder and former CEO (who stepped down in CY ‘22). Our understanding is that Jennifer Wong, the new CEO, is significantly more innovative, extremely competent, and will really lean into an e-Commerce strategy.
“Oh, yes. I mean, yes, Brian -- I don't even think he has a laptop still. Like Brian's old school. He's bricks and mortar. He's family's all brick and mortar. He's an analog guy. And so he won't make a decision unless he understands it. So, you know, the only way that you could move in the direction you need to in terms of e-commerce was to convince Brian that this is where it needed to go.” – former Director of e-Commerce Operations at Aritzia
“Jen Wong, she's fantastic. I'd say she's the fast mover. She's, yes, agile, smart. Basically, anyone in the organization that really wanted something done would be like, "Can I please go to Jen?" And so, you know, he leans more into certain areas, and she leans into others. She's more HR and operations, and he's more product, e-com marketing. So, you know, I'd say, I think she's great.” – former Director of e-Commerce Operations at Aritzia
“Jen Wong, she's amazing, the opposite of Brian. Jen is super smart. She's not the center of attention like Brian is. And her people love her, like people work hard for her. They speak very highly of her. She develops people. She's very much in the background. She just puts her head down and does her work, and she's really quite amazing. And then he's got leaders all around, like the person I worked for, she's the EVP of Retail. She's been there for 35 years or 30 years.” – former Director of Retail Sales in the U.S. and Canada at Aritzia
Our view is that the e-Commerce strategy is not difficult to execute, with significant low-hanging fruit. For example, the former Senior Manager of Retail Marketing at Aritzia outlined that under Brian, Aritzia did not really even do proper search-engine optimization, which would immediately yield millions of dollars in revenue. Therefore, we expect Aritzia to see its e-Commerce growth accelerate over the projection period.
At the current stock price, the market is pricing in a low bar for execution across key growth levers.
We contemplate what Aritzia would look like at a more “mature” state after its e-Commerce and U.S. transition as follows. In a conservative case, Aritzia can eventually grow to ~100 stores in the U.S. (average ~8k SF) and retain its ~70 stores (average ~6.5k SF) in Canada. Assuming a 5-10% uplift to revenue PSF from today to maturity, we believe Aritzia can do ~$2.7bn of store revenue. And at ~50% e-Commerce / ~50% store revenue (given younger demographic of customers than industry average), Aritzia should do ~$5.5bn of revenue. Capitalizing at 20% EBITDA margins and a ~12.5x multiple, Aritzia should be worth $13.7bn in TEV at “maturity”.
At a 10% discount rate, the market is implying that it should take Aritzia ~11 years to achieve this level of maturity. We believe this vastly underestimates the pace of expansion, as Aritzia can open ~10 stores a year in the U.S. (reaching ~100 within 6 years) and expand e-Commerce to ~45% of revenue by FY ’27. Therefore, we believe the market is heavily discounting management’s ability to execute against its Investor Day targets.
Investment Thesis III: Near-term Margin Noise is Just That – Noise
Investor fears around inventory build-up are overblown.
There has been significant noise on Wall Street about Aritzia’s gross margin, which contracted ~300bps YoY in Q3 FY ’23. Since the earnings report, the stock has retreated ~22% from its 52-week high and its multiple has de-rated from ~16x fwd. EBITDA to ~10x fwd. EBITDA. This gross margin hit was driven by a buildup of inventory, which grew ~187% YoY.
Due to supply chain problems over the last year, Aritzia placed its orders for its Spring/Summer collection earlier than in a normal year. Unfortunately for Aritzia, their orders arrived earlier than expected, resulting in an excess inventory buildup. Higher inventory directly translates to lower gross margins as Aritzia was forced to pay additional workers to manage the inventory as well as lease greater storage space to store it prior to the selling season. Especially due to a tougher macro backdrop, investors are afraid that Aritzia will be forced to write down greater percentages of its inventory in the case of weaker product demand, which translates to an even larger hit to gross margins.
Our view is that this gross margin contraction is a short-term issue that will resolve over the next twelve months. From an inventory perspective, our scrape of the top 20 most popular products sold by Aritzia reveals normal (even elevated) sell-through rates, with ~20% of SKUs completely sold out and ~9% of SKUs out of stock for the near-term. Thus, inventory concerns should resolve through the year as Aritzia reports normalized inventory days by Q4 FY ’24.
Additionally, we believe investors are mismodeling normalization of freight rates, which is a significant tailwind to gross margin. Generally, we believe freight costs make up ~5-6% of revenues for retailers like Aritzia but were elevated to ~9-11% over the last year. Management called out a 200bps benefit to gross margin from freight rate normalization in Q3, and they also guided towards a 400bps benefit to gross margin from freight rate normalization in Q4. We expect this to have continued into the next fiscal year. Since the reporting of the last fiscal quarter, freight rates for retailers (China to U.S. freight rates) are down ~50%. Thus, we believe Aritzia will see a ~200bps tailwind to gross margin in FY ’24 alone, which squares to Lululemon’s recent full-year guidance (Lululemon reports before Aritzia, due to a difference in fiscal years) for a ~150bps gross margin benefit from freight rate normalization for the full year. Overall, gross margins should reset to >50% in FY ’24 (from ~48.7% in FY ’23) and resolve investor concerns over gross margin-related EPS headwinds.
Valuation & Risk/Reward
In our base case, we underwrite a 3Y PT of $88, which equates to a 2x MOIC / ~29% IRR. Our key operating assumptions include a ~25% FY ’22 – ’27 revenue CAGR supported by a ~11% square footage CAGR, ~27% e-Commerce CAGR, and 6-9% comp store growth. We are above FY ’27 revenue estimates by ~22%, and given normalization of margins and greater operating leverage, ~45-47% above on profitability metrics like adj. EPS and adj. EBITDA. Overall, we capitalize our $977mm of FY ’27 adj. EBITDA at a 12.5x multiple to arrive at our price target. This multiple is still a substantial discount against key store expansion stories like Fast Retailing (owner of Uniqlo / Theory) and in-line with hated market stories like Canada Goose. On a one-year basis, we believe ATZ reflects a compelling risk reward of 2.4x at the current stock price, with ~70% upside / ~30% downside. We recommend sizing at a full position today.
Continued earnings beats
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