Good evening.

In his 2004 annual shareholders letter, Jeff Bezos states his view on value creation:

Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share. Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings. Future earnings are a component — but not the only important component — of future cash flow per share. Working capital and capital expenditures are also important, as is future share dilution.

This week luxury goods group LVMH and singer Rihanna announced they would suspend one of their collaborations, the Fenty Fashion House. Official response to the media from LVMH states:

Following the completion of a fundraising round where L Catterton has taken a stake into Savage X Fenty, LVMH and Rihanna reaffirm their ambition to concentrate on the growth and the long-term development of Fenty ecosystem focusing on cosmetics, skincare and lingerie.

In the meantime, Rihanna and LVMH have jointly made the decision to put on hold the RTW [ready-to-wear] activity, based in Europe, pending better conditions.

While much of the fashion press highlighted the label’s out-of-range prices for Rihanna’s broad fan base and there’s certainly plenty new aperitif conversation material on whether it’s quixotic to build a new luxury brand at all, from an investor perspective it’s worth looking backstage at the financials for additional lessons to be learned.

From the industry publication Business of Fashion:

Smaller labels often suffer within big conglomerates like LVMH and Kering for a few reasons. For a start, they are slapped with financial reporting requirements that can stifle initiative, not to mention heavy corporate charges, without really benefiting from many of the synergies that can come from being part of a bigger group as their founders struggle to navigate internal politics and bureaucracy.

And yet, not all startup labels within the larger maisons have been failures. In fact, LVMH itself provides two immediate counterexamples in its beauty label collaboration with Rihanna as well as another of its portfolio companies, Sephora.

From the same Business of Fashion column:

Start-up beauty labels are inherently easier to manage than young fashion brands. They typically have lower fixed costs than full-fledged maisons and they don’t need to prove themselves again each season. But beauty brands are also better suited to an incubator model because they can more easily plug into shared services and typically come with less ego at their creative helms.

They are also easier to distribute, which brings us to Sephora, LVMH’s powerhouse multi-brand beauty retailer which, acting as a counterpart to Kendo [editor’s note: Kendo is an incubator unit within LVMH], provides the group’s start-up beauty labels with a potent built-in sales channel.

And herein lies the seed of Fenty Fashion’s failure. Putting the above analysis in the free cash flow context at the beginning of this update, Fenty Fashion seemed to have suffered from weak earnings through mispricing and shared corporate cost overburdens, high capital expenditures due to fixed costs, and greater working capital requirements. In Bezos’s 2004 letter, he sought to impress the counterintuition that growing earnings without regard to capital expenditures and working capital could actually destroy value. But in the case of Fenty Fashion, no counterintuition is required. While the operating diagnosis rightfully consists of pricing, development, logistics, and distribution issues, financially they translate to a double whammy of poor earnings and poor free cash flow. Kudos to LVMH and Rihanna for seeing the structural issues with Fenty Fashion’s financials after just two years and, in Silicon Valley mode, failed fast so they could move on to better value creation activities.

Which leads us to an article this weekend in the Financial Times on the online luxury marketplace Farfetch:

[Founder José] Neves’s choice of a business model that differs from other online retailers such as Net-a-Porter or Matches Fashion has proven crucial: Farfetch would not buy any inventory and therefore took less risk on fleeting trends.

Similar to Alibaba, which is a partner, by foregoing inventory Farfetch’s model has had the financial benefit of lowering working capital and avoiding warehouse investments beyond what are required for logistics to “dispatch a €4,600 Balenciaga velvet red coat from a store in France to the door of a consumer in Beijing in under four days.” No wonder investors have rewarded Farfetch with an all-time high close of $69.51 as of last Friday, six times from just a year ago at the beginning of the pandemic.

In investing, it’s helpful to remember that reporting earnings are merely sinecdoches of cash, and an old aphorism holds after all: revenue is vanity; profit is sanity; but cash flow is reality.

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From Aspen, Colorado 🇺🇸

Victor

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