Last week Farfetch acquired New Guards Group—the brand platform behind Virgil Abloh’s Off-White and a handful of other wholesale-driven brands—for $675 million in cash and stock. New Guards has been looking for an acquirer since at least January, when news of LVMH’s interest leaked. New Guards is a key example of a company that was able to bundle a number of undifferentiated skillsets—creatives with large social followings; global distribution; owned boutiques and retail stores; high quality factories; and rapid design—into a machine that was unique and valuable. 

Coordination across New Guards’ brand portfolio, with the whole being more valuable than the sum of the parts, made LVMH an ideal suitor, since the luxury conglomerate remains rather siloed between different brands, which severely limits speed and efficiency. New Guards was a solution to this problem, albeit on a much smaller scale than LVMH operates. For New Guards, LVMH presented a potential home with nearly unlimited resources and an appetite for how it does business. 

Because a deal with LVMH made a lot of sense, the sale to Farfetch is a surprise—for three reasons: Farfetch’s volatile cash position, the promise and risk of blended margins, and the complexity of New Guards’ brand ownership.  

Farfetch’s volatile cash position

Farfetch does not have a lot of cash on hand—only $678 million as of Q2. As a result, it had to take out a $334 million line of credit to prop up its balance sheet in order to use its existing cash to buy New Guards. Sure, taking out a loan might make sense because of low interest rates, but along with rising losses, Farfetch’s cash is increasingly limited. While New Guards is financially healthy—$345 million of revenue in the year ending April 30; $95 million in EBITA; a 59% year-over-year revenue increase for the first half of 2019—Farfetch won’t be able to invest in the platform like LVMH could have with its close to $5 billion in cash on hand. 

Since Farfetch announced the deal, investors recoiled and sent its stock down 35% as of this writing. Because Farfetch is paying for part of the deal in stock, there will now be a drastic number of post-closing adjustments as a key form of compensation for New Guards was slashed. This should give New Guards pause about how much Farfetch can invest in its future. 

The promise and risk of blended margins

Farfetch plans to leverage all of the customers, data and boutiques it has access to along with New Guards’ design, production and distribution capabilities to build “Brands of the Future.” The idea is true vertical integration, allowing Farfetch to earn more margin than it does currently as a global platform for boutique retailers to sell their products. 

Here’s their logic: Traditionally, New Guards buys a product from a factory for $20, sells it to a retailer for $45, netting a 55% margin, while the retailer then sells the product to a customer for $100. With Farfetch and New Guards combined, they can buy the same product for $20 and either sell the product for $100 directly to a customer, netting an 80% margin, or sell it to a boutique for $45 who will then sell it on Farfetch to a customer for $100, which enables Farfetch to earn a 55% margin on wholesale and a 30% margin on the retail sale because of its take rate, for a blended margin of 73%.

That math sounds great, but there are three main caveats: 

  • 95% of New Guards’ current revenue comes from traditional wholesale accounts, where it nets a 55% margin. Only 5% of sales are direct-to-consumer, either on its brands’ websites or in their retail stores. While some of the 95% likely ends up on Farfetch—the platform says Off-White is a top-ten brand, a key piece of data that likely justified the acquisition—shifting New Guards to a direct-to-consumer business is a pivot that will take a lot of work. Sure, New Guards’ core capabilities don’t change, but the way they are used and measured will. This also requires Farfetch to start carrying inventory—traditionally the problem of boutiques on the platform—and doing so creates a lot more risk and requires an immense amount of capital.   
  • The increased margin from selling New Guards brands directly on Farfetch, not through partner boutiques, means that both companies are going to prioritize the direct sales channel. This will likely frustrate Fafetch’s boutique partners, both because it will divert inventory and sales away from them—Farfetch is now competing more with its partners—and because Farfetch will be double dipping, as described above, when it sells New Guards brands through a boutique partner. Even though boutiques are not losing any direct margin in this scenario, they have a better argument that Farfetch should lower its take rate since the platform earns more money on the same transaction. 
  • Farfetch announced its Store of the Future initiative in 2017, which aimed to bring augmented reality and a range of other technology into physical retail stores. While it announced partnerships with Thom Browne and CHANEL soon after, very little has materialized in the past two years, which should throw some cold water on Farfetch’s promises around “X of the Future” initiatives and the speed at which they make an impact. Vision is easier than execution.  

The complexity of New Guards’ brand ownership 

New Guards owns about 75% of each brand in its portfolio. Off-White is by far New Guards’ most successful brand and could make up 50% of the group’s revenue, meaning Off-White generates $170 million in annual revenue, which is not a stretch. However, Virgil Abloh owns the Off-White trademark while New Guards owns the majority of Off-White’s operating entity, which has an exclusive, multi-year licensing deal for the trademark. This raises two issues: 1) the exclusive license will run out sometime soon; and 2) the chances of a renewal are very low now that Virgil is the creative director of Louis Vuitton men’s, a crown jewel of LVMH. Had New Guards sold to LVMH, it likely would have had a much longer runway to build Off-White, but the sale to Farfetch introduces a lot of risk. If Off-White pulls out of its New Guards deal—say LVMH offers Abloh a blank check to rebuild the brand under its umbrella, which it likely will—a significant portion of what Farfetch just paid for would evaporate. This might have been LVMH’s reason for passing on the deal, since it might not need to pay anything for New Guards since it has Virgil on its side. 

The other challenge is that there are not many Virgil Abloh’s in the world—people with a potent mix of taste, relevance, social credibility and digital marketing power. Assuming Off-White generates many times more revenue than New Guards’ second biggest brand, finding the next hit on his level will be hard, if not impossible. New Guards could say it doesn’t need to find another Virgil and instead just needs a dozen brands led by creative directors that are half of what Virgil is, which could work. However, managing so many different entities and finding powerful creative leaders to helm each brand creates a lot more operational complexity and is a less proven path.     

Going Forward

Overcoming the numerous challenges and risks detailed above is possible, but Farfetch needs an immense amount to go right. The limited investor appetite for more losses is one of the biggest issues, since this plan will take years to materialize and seeing it through will be harder and slower if investors are keeping Farfetch on a short leash. For New Guards, it will know very soon if this deal was a blessing or a curse, with LVMH watching from the sidelines and Virgil stuck in the middle. 

Risk creates opportunity and it is often worth taking, but it needs to be calculated. Right now, Farfetch’s math on paper looks promising, but paper and reality are radically different.