FIGS: Mixed Outlook Warrants A Cautious Approach

Summary

Following my previous sell recommendation for FIGS (NYSE:FIGS) due to a weak FY23 outlook, in particular for 1Q23, the stock continued to trend downwards, and only recently recovered after the 1Q23 results. I believe expectations going into the quarter were terribly weak given the outlook provided, as such the better-than-expected 1Q23 adjusted EBITDA at $16.1 million compared to consensus estimates of $10.6 million, drove the positive share price movement. As such, it was just mis-alignment of expectations, rather than FIGS showing a strong recovery fundamentally. However, the 1Q23 results did provide certain positive takeaways that helped with the long-term growth outlook. For instance, underlying demand trend remains healthy from customer reactivation, strategy to penetrate extended sizes, and normalization of purchase frequency. However, when put together with the ongoing overhang on inventory issues and possible margin pressure in the near term, I am shifting to a hold rating. I am also maintaining a cautious approach going into 2H23 as the macroeconomy continues to be uncertain, which might disrupt the demand trend as consumers pull back on spending.

Revised guidance

First off, on the bright side, FIGS raised its guidance for FY23, projecting revenue growth of 5.5-7.5%, which is about 200bps higher than the previously guided mid-single-digits%, gross margins inching closer to 69%, and adj. EBITDA margin at 12-13% (100bps improvement at the mid-point). Revenue growth of 8-10% is anticipated for the 2Q, with gross margins of 68%-69% and adj. EBITDA margins of 9-10%. Overall, there is nothing much to complain about this outlook, in fact one should be happy that things are expected to be better than the dreadful outlook provided in 4Q22. However, revenue in the third quarter is likely to be hit the hardest by delays in product launches and advertising. Working backwards using management guidance, it seems like growth in 2H23 is going to be slowed than 1Q/2Q on a percentage basis despite, which I am not sure if management is being conservative or it’s because of a tough 2H22 comps. I would not rule out the possibility of further guidance revision if 3Q performance comes in better than expected (new launch was more welcomed and promotions ROI was good, etc.)

Inventory issues easing

One of the problems I flagged previously was FIGS' inventory issue. Thankfully, the situation seems to have eased as the rate inventory growth moderated to 76% from the 107% last quarter. In particular, management emphasized that 55% of existing stocks are in core styles and classic colors that pose little risk of obsolescence, while 20% are in emerging styles and colors. While the mix is similar to previous quarter of 60vs/15%, I would point out that the shift towards 500bps increase for upcoming styles is positive as it shows that FIGS is still preparing for growth. If the increase was in the core styles and classic colors, then, I would be more worried as it shows that FIGS is pulling back on R&D – which means lesser growth prospect in next growth cycle. Despite the continued increase, I have faith that FIGS can resolve their inventory problems as underlying demand seems to remain healthy (more below). Moreover, management is optimistic that the 25-week supply goal can be met by the end of the year, and they anticipate steady quarterly progress toward that goal. Furthermore, I expect increasing improvement as management prioritizes a new strategy of less intensive purchasing, shorter lead times, and reissues of limited edition styles during the upcoming promotional 2Q.

Margin recovery timeline pushed to FY24

An update on the fulfillment project was also provided by management in the results; they estimate that it will cost between $16 and 18 million to put into action. However, the cost distribution has changed significantly, with the majority of expenses now planned for 2024, whereas previously it was expected that half of the expenses would be allocated in FY23. As a result, the business will keep using its warehouses through all of 2023. This choice accounts for the higher initial fulfillment, labor, and storage costs that would result from a larger order. From a business standpoint, FY23 and FY24 are largely interchangeable. In fact, this seems like the right decision as the business maximizes its usage of its storage facilities and have more time to ensure everything is in place. The adjustment will result in elevated expense in the near-term, as such delaying the timeline in which we could see margin recovery, at least until FY24.

Demand/innovation

Demand fundamentals appear to be holding steady, as FIGS saw its active customer count increase by 21.8% year over year to reach 2.1 million. LTM net revenues per customer, however, fell by 4.4% year-over-year for the company. I think a difficult macro backdrop is to blame for the decline in revenue per customer. Despite decreases in net revenues per customer, management reported record customer reactivation rates in the quarter, indicating strong demand. As a result, FIGS now has a larger customer base from which to expand (larger pool of customers to re-target), which bodes well for the company's upcoming growth. The rate of purchases also showed encouraging signs of normalization compared to the previous quarter. All in all, customers' propensity to make purchases is increasing, which bodes well for future earnings thanks to these enhancements. In addition, FIGS demonstrated its abilities to expand its TAM as it showed success in extended sizes offering, with 5 percent of its new clientele opting for these sizes. I am encouraged to know that FIGS is finding success in this venture and I expect the company to increase the number of products available to further penetrate this market. That said, I do expect the challenging macro backdrop to persist, leading to a continued impact on purchase frequency. In this regard, management did not do nothing. The fact that FIGS wants to start moving sales toward promotional selling days is encouraging. In my opinion, these initiatives will be tactically planned to mitigate the effects of the macroeconomic challenges and keep sales on an upward trend.

Conclusion

In my opinion, FIGS has shown mixed performance in its recent results. The revised guidance for FY23 indicates improved revenue growth and margins, but the third quarter may face challenges due to delays in product launches and advertising. While the inventory issues have eased, the margin recovery timeline has been pushed to FY24, impacting short-term expenses. Demand fundamentals remain steady, and efforts to expand the customer base and penetrate new markets seem successful, but uncertainties in the macroeconomy continue to put me on cautious mode.