Description

One of my great regrets in life is that I wasn’t interested in shorting stocks around the time of the Groupon IPO.  As we all know by now, the company was egregiously valued, the overall market growth was set to slow rapidly (faddish), the business was rife with competition, and the business model doesn’t scale well.  But I wasn’t a short seller and I didn’t get to participate in the 70% decline.  Sometimes we get second chances. I believe Zulily is that second chance.  Zulily is a flash-sale retailer catering to moms, children and babies.  It features clothes, toys, housewares, etc.  The company went public last week at $22/share and is now trading +59% higher at $35.  Taking into account in the money options, ZU has a market cap of $4.8 billion and an enterprise value of $4.5 billion.  Here is a snapshot of the company’s financial performance:

As you can see, the business has grown extremely rapidly.  The number of active users has increased markedly as well – having gone from 800,000 at the end of 2011 to 2.6 million at the end of 3Q13.  While the top line KPIs are all pointing in the right direction, I don’t think the business model is very scalable and expect meaningful profits to remain elusive.  Further, it is likely that we will see more targeted competition from the likes of Groupon, Living Social, Amazon Deals and others.  In short, I think Zulia will be lucky to achieve an 5-8% operating margin over the medium term.  Even if it triples sales, this implies massive downside.

Why doesn’t the business scale well?

For those who don’t know, in a flash sale, a retailer offers a certain amount of product for sale at a heavily discounted price for a very limited time.  Product is sourced from small vendors.  According to ZU, 90% of the company’s 2012 events generated less than $50,000 in product sales (these small events represented 65% of total sales).  Hundreds or thousands of products are offered each day.  They are for sale on Zulily for 72 hours and then the buying opportunity is gone.  Organizing this is an incredibly labor intensive process.  Every day, hundreds of Zulily employees need to go out and solicit small vendors to agree to sell merchandise at a big discount.  Then it needs to take pictures of the products, write copy, and get them online.  76% of vendors who sold through Zulily in the 2011 year have returned to Zulily at least once to sell product again.  Given the growth the company has experienced/expects to experience, it needs to constantly be out attracting new vendors.  Again this is people intensive – as such the SG&A line as shown very little leverage since 2011 despite Zulily more than tripling it’s revenue.  Given the dynamics of the business, I reckon a further tripling of revenue would only give them 2-300 bps of SG&A leverage. 

Similarly COGS has shown relatively little leverage.  Large retailers achieve scale benefits which benefit gross margins as they 1) increase purchases & hit break points with suppliers to bring down prices paid for inventory and (2) over time increasingly consolidate purchases with fewer suppliers to get better bargaining power (3) increase private label penetration – these products carry much higher gross margins.  Given that 1) Zulily is already convincing suppliers to provide product at a steeply discounted price and (2) that Zulily is buying small lots of product from small mom & pop producers, it is unlikely to buy on meaningfully better terms.  There could be some COGS leverage as Zulily continues to add new users and each flash sale gets bigger.  However, it is actually possible that gross margins decline as competitors offer product manufacturers better terms.

As we’ve seen above, Zulily has successfully achieved scale in marketing expenses.  Let’s assume this continues for a bit and adds 200-300 bps of margin. 

The economics of this business remind me very much of Groupon (FYI I am short GRPN as well):

As you can see, Groupon’s gross margins actually declined as competition increased.  It is entirely possible that we could see something similar at Zulily. 

Valuation

My best estimate is that there are 45 million people under the age of 10 in the US/Canada and divide by 1.5 children to estimate 30 million mothers.  If 50% of mothers participate in flash sales actively, the total market size is ~15 million mothers.  Assuming Zulia can sustainably be ½ the market (doubtful but let’s use it for now), I get 7.5 million customers.  Let’s further generously assume that Zulily can increase it’s average annual sale per customer to $250/each (vs. $210 in 2012).  As customers are added, I really think this is likely to go the other way but for the sake of argument.  This gets me to revenue of $1.9 billion.  Starting at a 0% operating margin (today) and assuming 200 bps improvement from COGS, 300 bps from SG&A, and another 300 bps from marketing brings us to an 8% operating margin which I think is very generous.  This implies $152 million in operating profit.  Capping this at 12x produces a value of about $1.8 billion – add in $300 million in cash (adj upward to account for option cash) gets me to a total value to equity of $2.1 billion.  This implies 53% downside or $16/share fair value.  And that is a # which I likely 3 years out so

Risks

Unrealistic/favorable analyst coverage pumps up stock

Catches to MoMo wave

International?  They are/will be expanding into the UK and then likely to move further.  Even if this goes well and they are as successful as they are here in the US (and I’m assuming they can triple the business in the US).  This would imply that the stock is fairly valued but it would take them at least 6-7 years to get there ($3.8 bn in sales and $300 mn in OP).  Discounting back to today implies overvaluation.  

Catalyst