Readers may find my previous coverage via this link. My previous rating was a hold as I believed FIGS (NYSE:FIGS) would continue to see pressure on revenue and margin due to the ongoing inventory issue overhang. I am revising my hold rating for FIGS as I await another quarter of operating improvements before I acknowledge that the current momentum is sustainable. While the upside is attractive, there are visible headwinds that would hurt FIGS’s core customers.
Stronger active customer growth and AOV drove a 13% year-over-year and 15% quarterly increase in revenue to $138.1 million in 2Q23. The gross margin dropped by 110bps to $69.52% due to the impact of product mix, duties, promotional sales, and lower freight costs. As a result, the adj EBITDA margin ended up at 13.7%, and EPS came in at $0.02.
Based on my view of the business, FIGS should see a growth slowdown in FY23 (in line with management’s FY23 guide) and a recovery in FY24. My FY24 growth assumptions have been revised downward (vs. my previous model) by a similar magnitude (management FY23 guide vs. my previous expectations). Given the lack of like-for-like comps and little operating history, I anchored my forward valuation expectations to where FIGS has traded over the past 12 months. While growth assumptions have declined, management did expect EBITDA margin to continue improving. I believe profitable growth is more important than growth-at-all-cost today, and as such, it should be well received by the market when FIGS reports strong EBITDA growth. Consequently, the valuation multiple should also be rerated from the current 1.7x. Based on these assumptions, I have a price target of $8.76.
With an increase in growth from the previous quarter (13% vs. 9.2%) and a relatively stable gross margin, FIGS’s 2Q23 results exceeded my expectations, especially in light of the macro environment and internal inventory issues. If we examine the individual contributors to revenue growth, we find that both AOV and Volume contributed favorably. Increases in AOV were driven primarily by changes in the product mix, indicating that expansion efforts in this area are bearing fruit. Surprisingly, given the macro environment, this increase in volume was driven by an increase in total customers. I assumed it would be tough to “convince” potential new buyers to make a purchase. In particular, management has seen a healthy mix of both new and returning customers in both the domestic and international markets. The latter is crucial because it suggests that FIGS was successful in luring back some of its former customers. In my opinion, this points to capturing market share from competitors.
“In terms of reactivations, it was one of the strongest numbers of resurrected customers in the second quarter. And we think that’s really being driven by the strategies that we’re doing to communicate directly with them.” – 2Q23 earnings call
Nonetheless, management has admitted that pressures on order frequency persist; this is understandable given the macro environment.
Management also shared that their TEAMS business is rapidly expanding thanks to an increase in demand and is now at a penetration rate in the mid-single digits. It’s important to realize that this expansion is being driven by incoming requests, which bodes well for a reduced CAC. Therefore, in my opinion, despite the fact that this has lower gross margins than the base business because of volume discounts, it would still have a relatively strong margin.
Net-net, I believe this quarter revenue performance really shows that management is executing flawlessly to drive recovery.
The inventory situation at FIGS, which had been one of my primary concerns, has improved, both monetarily and proportionately, when compared to 1Q23. Inventories were down to $168 million from $180 million in 1Q23, and growth was down to 31% year over year from 76%. Also, the ratio has dropped from 1.5x quarterly sales to 1.2x quarterly sales. Looking ahead, I remain cautious on this and would like to see this trend maintain for another quarter before I would believe management guidance for achieving 25 weeks of supply by FY23.
Putting the two together, I can see why management is so sure they can reach their target EBITDA margin over the long term. Long-term, management expects to achieve 70% annualized gross margins and high teens adjusted EBITDA margins. Successful achievement of this margin target depends on FIGS’s balance sheet inventory returning to its normal (targeted) level and freight expense improving as new product is purchased at relatively cheaper ocean freight rates than those in the books today.
Even though 2Q23 performance was satisfactory, I would wait until the end of the next quarter to make any definitive recommendations. As long as rates remain at their current, historically high levels, I will remain concerned about the macroeconomic outlook for both the United States and the rest of the world. Specifically, FIGS’ primary client also faces headwinds from rising wage inflation, which will have an effect on the client’s ability to pay for FIGS’ products. These two factors may extend the time required to bring FIG’s inventory levels closer to their normal levels on the balance sheet. Last but not least, FIGS faces tough y/y comps in 2H22 (a successful year of innovation), hence, growth acceleration might not happen in the near-term.
In conclusion, FIGS displayed a promising 2Q23 performance, with notable growth in revenue driven by increased active customer engagement and AOV. Despite improved inventory management and expansion efforts, I recommend to wait 1 or 2 more quarters before affirming the sustained momentum. While management’s strategies have led to positive outcomes and recovery, challenges such as macroeconomic uncertainties, potential supply chain disruptions, and competitive pressures still warrant careful observation.