E-commerce fashion-apparel retailer Revolve Group (RVLV 2.03%) caters to women, but it's a business that all investors should get to know. The company went public in June 2019 at $18 per share but finished its first day of trading at $34. Now, more than three years later, the shares are lower than they were on day one of trading despite robust growth from the company.
To be sure, Revolve is going through a challenging time right now. But there is a case to be made for buying the stock today.
How Revolve makes money
Revolve Group sells fashion apparel online through its Revolve and FWRD platforms. Merchandise is sourced from third-party designers and from its portfolio of 30 first-party brands that were developed in-house.
Revolve believes its model quickly adapts to style trends. When sourcing inventory from third parties, it makes small initial purchases and then makes larger decisions based on what's working. And these data-driven decisions also influence the development of its first-party brands, which have better profit margins.
I'd say the business model works. When the company went public in the second quarter of 2019, there were about 1.3 million total orders placed through its platform that quarter. In the second quarter of 2022, there were over 2.2 million orders placed. The 73% growth in orders in just three years strongly suggests it's doing something right.
Why Revolve stock is down
Revolve stock is down more than 60% from the start of 2022 for several reasons. Two main issues are weakening sales and profits.
Revolve's net sales were up 27% year over year in the second quarter to $290 million, a good growth rate. And the company crossed $1 billion in trailing-12-month sales for the first time ever. While these results are good, management noted that macroeconomic conditions are leading to a slowdown. Net sales in July were only up 10% from last July, and things are only expected to cool further during the remainder of 2022.
Revolve's net income in the second quarter was down 48% year over year to $16.3 million. One of the main drivers was a higher rate of returned items, an expense that's exacerbated by high shipping costs right now.
Potentially more problematic, higher returns might signal an unforeseen behavioral shift for Revolve's customers -- behaviors it had been good at predicting. The company's high profit margin in the past largely resulted from selling the majority of its inventory at full price. For context, management says 87% of its merchandise sold within 5% of full price in 2021.
Right now, Revolve's inventory is rising. If consumers change their spending habits, it could lead to discounted prices to move inventory, something it's historically avoided and which could challenge its bottom line even more.
Why Revolve still has its merits
Revolve's business is slowing with the economy, but fortunately the company has a strong financial foundation. Right now, it has cash and equivalents of $238 million and no debt other than its minuscule lease obligations. That's a strong position for a stock that has a market capitalization of just $1.6 billion.
Moreover, Revolve's other qualities point to its financial fortitude. First, the company generated free cash flow of $22 million in the first half of the year, despite the headwinds. Second, its gross margin is a robust 56% and could trend even higher since as first-party brands make up a greater part of its sales mix. Lastly, management isn't diluting shareholder value with stock-based compensation or follow-on stock offerings; the share count is up less than 3% since it went public.
Circling back to the business model, Revolve has demonstrated success in the past. This suggests that the current slowdown will be temporary and the model will again help management identify great fashion trends and stock inventory appropriately as things normalize.
Moreover, trading at around 20 times its trailing earnings, Revolve stock is priced at an average valuation right now; investors aren't forced to pay a premium for this quality business.
S&P 500 P/E ratio. Data by YCharts. PE = price to earnings.
Yet, while the company seems very adept at winning its target demographic -- affluent, fashion-minded women -- I'm concerned that this could be too small of a target to be a good long-term investment opportunity. Revolve's management doesn't talk about the size of its addressable market. And as an investor, I don't personally have insight in that regard.
So while Revolve is a reasonably valued, high-quality company in a solid position to endure economic headwinds, it's not a stock I'm personally buying today. But investors with greater conviction on Revolve's market may feel differently. It reminds me of investing advice credited to Warren Buffett: "Know your circle of competence, and stick within it."
