Aritzia Stock: Why Fashion Risk Doesn’t Worry Me (TSX:ATZ:CA)

2023 was a perfect storm of negative events for Aritzia Inc. (TSX:ATZ:CA) (OTCPK:ATZAF): downward guidance, choppy store traffic, inventory buildup, discounting, product cost inflation, and temporary warehousing costs have led to terrible quarters in FY’24:

While all of these issues have contributed to the negative outlook, we argue that each one of these issues is manageable and will either reverse or be offset by other growth factors over FY’24-FY’25.

Overview of a High-Quality Business

Founded in 1984, Aritzia is a premium women’s apparel fashion house with multiple in-house brands which range from athletic wear to “everyday luxury” or more sophisticated and elevated styles.

Their brands include Babaton, Wilfred, TNA, Sunday Best, Denim Forum, Superworld, and Reigning Champ (a recently acquired, premium athletic menswear brand).

Significant Brand Momentum

Much of Aritzia’s growth story revolves around their expansion into the U.S. market. This is visible in their United States segment’s sales quickly overtaking Canada’s after two years of spectacular growth.

Another way to measure their brands’ momentum is by looking at Google Search Trends. By indexing their values from January 2019, we saw that Aritzia has clearly outpaced the average peers’ index values.

Aritzia’s Instagram follower base has more than doubled since 2019 to 1.4M+, but still has plenty of room to grow (Victoria’s Secret has 85M+). We’ll touch on the customer’s connection to the brand more specifically in the section on fashion risks.

Strong Value Generator Relative to Peers

Only Aritzia rivals Lululemon (LULU) from a growth and ROIC standpoint (key drivers of value creation by any metric).

However, Aritzia only has 117 storefronts compared to 681 for Lululemon. We will get into our storefront growth outlook in a later section on revenue inflection, but we are surely bullish on Aritzia’s growth potential relative to its peers as key markets remain un(der)-penetrated. At these high returns on capital, we expect significant incremental accretion to earnings.

Aritzia has also been very prudent in their placement of boutiques, achieving exposure to higher-income demographics when compared to peers.

Fashion Risk Isn’t Relevant

The bearish perspective of Aritzia’s place within the fashion universe is that its SSS deceleration is a sign that it is fundamentally a fad-driven business in a hyper-competitive industry and has been too reliant on their popularity during COVID, which is now declining.

Instead, Based on our analysis of past case studies where fashion retailers did experience adverse fashion-related pressures (GAP (GPS) or Abercrombie & Fitch (ANF), for example), Aritzia is well-protected against fad risk. The recent dip in SSS is attributable to temporary factors such as lack of “newness” and macro headwinds that are set to reverse.

Based on the analysis of these case studies, we identified the following common themes to those truly exposed companies, and here is our stance relative to Aritzia’s exposure for each:

1. Limited Product Offering

No. Frequently a one-stop-shop for customers’ apparel needs, doesn’t heavily rely on any single product.

On average, Aritzia makes up ~26% of the dollar value of women’s wardrobes who have purchased at least one item from Aritzia before.

2. Limited Style Options

No. Aritzia has 11 in-house brands – each addresses different apparel styles, and doesn’t rely heavily on any single style. Aritzia merely seeks to provide customers with products they are asking for (a “pull” strategy), instead of trying to get customers to buy into a specific style (a “push” strategy)

3. Limited Customer Base

No. Aritzia provides a very wide range of products and styles that appeal to women within the targeted age range of 14 to 45 across diverse product categories through its 11 brands, as proven by the ubiquity of Aritzia products in customers’ wardrobes (as per point #1 & 2 above).

4. Large Exposure to Seasonal/Fashion Items

No. ~80% of revenue comes from proven sellers, providing a stable core revenue base; only ~20% of revenues are from “new sellers” (seasonable fashion items).

5. High Churn Risk Among Aritzia’s existing clientele

No. Aritzia’s loyal customer base shows minimal churn. From talking to Aritzia’s customers, we’ve observed a high level of emotional connection to the brand. Approximately 80% of in-store revenue comes from customers who spend $5k per year there.

Both the corporate and brand culture have been described as “cult” like. In our experience looking at retailers, this attachment is extremely rare.

6. Are consumers buying Aritzia for fashion reasons above all

No. Based on our customer interviews, the predominant reason they choose Aritzia is due to the superior quality of the products rather than fashion.

Revenue Poised to Inflect Upwards

Consensus numbers suggest Aritzia will fall short of its FY’ 27 sales target; we hold a differentiated view. Here are the drivers we expect to translate into higher sales.

Driver #1: Product Innovation and Higher Pricing

Aritzia’s recent issue in “newness” is a temporary setback. During COVID, Aritzia had a huge boost in e-commerce. But supply chain challenges meant they couldn’t fulfill this demand. So Aritzia only prioritized their classic styles over the past 3 years.

We’re confident in management’s ability to execute on “newness” due to:

1. Strong culture
2. Founder involvement
3. 2-decade history of creating hit products

Interview with IR reveals that management is holding off price increases on proven sellers while introducing new products at higher price points.

Driver #2: E-Commerce Uplift

Aritzia lagged industry peers on e-commerce growth previously due to founder Brian Hill’s conservative stance.

Under the guidance of new CEO Jennifer Wong, Aritzia has intensified its digital efforts, driven by website optimization, search engine optimization, safeguarding keywords, and digital marketing investments.

We’re confident that Aritzia e-commerce sales can match peers at 45% of revenue by FY’27 (stood at 35% as of FY’23).

Driver #3: US Store Expansion

Aritzia’s growth is heavily reliant on expanding its US store count, supported by superior unit economics. The growing recognition of the Aritzia brand adds to the attractiveness of their unit growth strategy.

Our TAM build based on GDP shows that the total saturated US store potential to be around ~235 stores, translating into 189 new stores.

Here is the TAM build and methodology:

For reference, Aritzia’s FY’27 guidance is of 150 stores (82 US stores). As this target is still significantly below the store potential implied by our analysis, we are fully confident that Aritzia can reach its guidance target.

Incoming Margin Rebound

While investors have long-term concerns about Aritzia’s margins, we think the issue is transitory. Here’s a base care margin forecast and our expected uplift:

Going through these item-by-item:

1. Transitory Headwinds

Our gross margin forecast for FY’24 is in line with the Street forecasts with ~300 bps margin compression driven by product cost inflation, markdowns, and increased warehousing cost, partly offset by freight cost reduction.

2. Cost Normalization

As per management commentary, elevated cost is set to normalize contributing ~150 bps margin improvement. From Q4’21 to Q4’22 inventory rose 187% leading to heightened inventory management costs. With supply chain pressure and inflation easing, inventory headwinds should ease.

3. Higher Pricing

Interview with IR reveals that management is holding off price increases on proven sellers while introducing new products at higher price points. We are confident that the improved initial mark-up (IMU) from pricing will add ~150 bps.

4. Rent Decreases

We see ~20 bps improvement in gross margin through a decline in ROD expense within COGS. Management commentary reveals that Aritzia has been securing favorable leases amid traditional retail closures:

We got a store in New York which is double the square feet but only half the gross rent of a previous New York store –CFO Todd Ingledew

5. Geographic Shift to the U.S.

We see ~20 bps improvement in gross margin through a geographic shift to the US since US stores are more productive than their Canadian counterparts. These factors include 20% higher price points in the US due to exchange rate passthrough, more affluent customers, and increasing awareness for the brand.

Valuation

First: Why I Trust Management

1 – History of Delivering on Guidance

Based on our primary research, Aritzia utilizes a Co-CEO structure: Jennifer Wong oversees operations (backend), and Brian Hill handles design and culture (front end).

The management team has been running the company together for years, with both the Founder/Chair and CEO here for 35 years.

Up until this past year due to transitory issues, Aritzia was a company that has consistently achieved and surpassed its guidance.

2 – Aligned with Shareholders

Management holds a significant equity stake in the company and receives compensation mainly through stock options.

3 – Positive Feedback from Primary Research

The aggregated feedback below is indicative of the overall comments we’ve encountered during our primary research. While this does not imply management is faultless, the degree of positive endorsement from both insiders and analysts is an added argument in favor of management.

4 – Open-Market Share Purchases

The management team took the opportunity to increase their personal stake in Aritzia amid the stock sell-off, signaling a strong view of the company’s higher intrinsic value.

Output Summary

Based on the prior foundation of management’s character and our ability to trust them, as you’ll see much of our base valuation case relies on management’s guidance.

Model Inputs

As you can see within the red-lined rectangles, revenue inputs are purposefully within the guidance range. However, Adjusted EBITDA remains well below guidance, the base case has a clear upside to it.

Other assumptions not based on guidance visible in the above forecast include:

• Gross margin recovery to historical average over 1 year.

• Assuming increased store-level staffing and wages.

• Normalized stock-based compensation and income tax expense.

• No share repurchases, dividends, or accretive M&A.

The exit multiples were chosen based on industry peers. However, the base multiple chosen here reflects a 5 turns de-rating from the current multiple, and the bear case a de-rating of 8 turns.

The output shows a compelling 2.2x risk/reward ratio with limited downside.

Risks

1. Recession Risk

ATZ’s industry is driven by consumer discretionary spending and recession risk is material to Aritzia. However:

• Risk is largely reflected in the stock given the historically low multiple.
• 2020 demonstrated management’s ability to capture market share even in challenging periods.
• Despite our bear case implying a hard-landing recession, the overall risk/reward is very attractive.

2. Fashion Risk

Based on extensive case studies research (Abercrombie, Urban Outfitters (URBN), Gap, and Victoria’s Secret (VSCO)), we believe ATZ avoids many common pitfalls and is sufficiently insulated from fashion risk at least over the next 5 years. (See relevant earlier section for more details).

3. Competition Risk

We recognize the risks posed by competition, yet we believe Aritzia is less vulnerable to significant impacts from this. This is due to the company’s strong value proposition to customers as well as its consistent track record in capturing market share in the North American women apparel industry.

Catalysts

1. Earnings Beat & Street Estimates Revision

Neutral sell-side sentiment on the stock but with a positive view on the long-term outlook. We expect them to flip with any positive signal.

2. Same-Store-Sales Beat

Poor SSS over past quarters due to “lack of product newness” is set to turn around in the upcoming spring season as management introduces new products.

3. Margin Rebound

Margin rebounds off trough level as temporary costs such as elevated product cost and warehousing cost abate.

4. Buyback Program

We believe there could be an unmodeled upside to EPS growth from an acceleration or upsizing of a subsequent buyback authorization due to depressed valuation.

Conclusion

In conclusion, despite Aritzia’s challenging 2023, we anticipate a positive turnaround in FY’24-FY’25 and beyond. This has created an excellent risk/reward opportunity to buy Aritzia at a historically cheap valuation

Issues like downward guidance and inventory buildup are manageable, with growth factors poised to offset them. Aritzia’s strong brand momentum, U.S. market expansion, and diverse portfolio position it favorably with drivers like product innovation and U.S. store expansion expected to boost revenue.

Our valuation, anchored in trust in management, suggests a compelling 2.2x risk/reward ratio. Despite acknowledged risks, positive catalysts contribute to a favorable long-term outlook for the company.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.