Aritzia (TSX:ATZ)

Price: $22.91   P/E: 16.6x  Market Cap: 2.53b   Enterprise Value: 3.34b  Date: 06/10/2023

Note: all figures in CAD unless otherwise noted. USD = 1.37CAD exchange rate is used

Investment Thesis

Aritzia is a high-quality fashion brand with a long growth runway. Due to a nearly 50% decline in share price YTD, amidst concerns about margin pressure and inflation, Aritzia now trades at a steep discount to peers, considering the fact that Aritzia hasn’t stepped outside half the States in the US. This is an interesting opportunity to own Gen-Z’s most admired clothing brand with a growth runway that could bring excellent returns in the long term.

Background

Aritzia is a vertically integrated mid-luxury fashion house that was founded in 1984 by Brian James-Beaumont Hill, headquartered in Vancouver, Canada. Brian grew up in the clothing industry. His father founded the retailer Hills of Kerrisdale which sold a variety of luxury brands. Brian worked for Kerrisdale as a teenager, doing a variety of maintenance tasks, mentored in the industry by his dad and uncle. After returning from his poor stint at Queen’s University, he and his brother opened the first Aritzia boutique in the Oakridge Centre in Vancouver, aimed at filling the gap between luxury and modern trends, all aimed at young girls. Brian designed a variety of in-house brands to cater to various needs from work wear to winter coats.

In 2005, Berkshire Partners bought a majority stake, giving the capital Hill needed to open the first US stores in Seattle and Santa Clara, California, and a Manhattan flagship store of over 13,000 square feet. Since the launch of the first U.S. stores, Aritzia’s store allocation gradually balanced out between the U.S. and Canada, from 1 US stores to 13 Canadian stores in 2008, to 1 to 1.7 stores in 2022. 

In 2012, Aritzia launched its ECommerce business – aritzia.com. Since its inception, Aritzia’s ECommerce platform has seen unprecedented growth largely due to the pandemic but its success continued post-pandemic. From fiscal 2016 to 2020, it had revenue growth of more than 36% on a compounded annual basis. Then for fiscal 2021, it experienced 88% growth during the pandemic and 33% in 2022 post-pandemic. Its eCommerce revenue as a percentage of total net revenue grew from 23% in fiscal 2020, pre-pandemic to 38% in fiscal 2022. In October 2016, with 75 stores, 59 in Canada and 16 stores in the US, Aritzia went public with an initial offering of $16.00 per share, Berkshire exited their position a few years later. 

Aritzia depends on its staples, simple versatile pieces that are fast-fashion resistant. Still, Aritzia continues to break into new spaces. Most recently, it’s been trying to enter men’s wear with the  acquisition of Reigning Champ in 2021.

Recent conundrums

Aritzia’s stock has been pummelling, down almost 50% YTD. Concerns amidst rising inventory levels and lower margins signalled to investors that the perils of inflation had arrived at Aritzia’s door steps. People are trading down as prices go up, especially true for people in Aritzia’s higher income target market. Rising input costs damaged profitability, sending net margins down over 50% year-over-year. Inventory more than doubled. Year end guidance announced gross profit margin will decrease by approximately 200 bps, SG&A as a percent of net revenue will increase by approximately 150 bps compared to last year. This has also been driven by distribution centre project costs and the annualization of investments in talent and increased retail wages made in the back half of the previous year. 

The market has acted on uncertainty, FMR, Aritzia’s largest institutional shareholder, which holds 9% of the company, sold 15% of their stake following disappointing earnings results in May. However, we think the long-term fundamentals of the company remain attractive. Even the sell-side analysts, while now way more negative on the firm, agree that the price movement has been an overreaction. At multiples below peers, we think Aritzia is trading at a steep discount. 

Breaking down Everyday Luxury

Aritzia occupies a unique niche in the fashion space, which they describe as "Everyday Luxury”, generally in between mid-market and sub-luxury. They offer high-quality apparel in North America. Their product range includes t-shirts, tops, bodysuits, sweaters, jumpsuits, skirts, activewear, pants, dresses, jackets, shoes, and accessories like hats, socks, face masks, belts, and bags. Aritzia's in-house brands generate 95% of their revenue. Prices typically range from $50 to $400 per item. Aritzia’s brand can be described as aspirational and classy, with quite a unique style. Their fabric is stretchy and comfortable, and pieces have very unnoticeable logos and are mostly in neutral colour schemes. The designs are typically classy and subtle. The brand is built on quality basics, timeless items that can last them years. 

Figure: Aritzia Brand Perception Map

Aritzia targets young to working age women. Aritzia owns 12 in-house brands, each catering to a different kind of woman at a different age. Sunday Best is targeted at younger women. Denim Forum sells denim and jeans. Babaton sells classy business casual clothing for working women. The Group by Babaton has a lower price range and has more basics. Tna is for athleisure. Superpuff or Super World sells winter wear. Wilfred and Wilfred Free function as the in-the-middle general Aritzia brand. Younger customers don’t have much funds to purchase extremely expensive luxury goods, which allows customers to achieve the feeling of status and classiness at a more affordable price.

Figure: Aritzia Brands

Aritzia’s cash cow is the Superpuff winter coat. It has excellent quality that rivals brands 3 times more expensive like Canada Goose. The Superpuff has the highest margins and comprises 30% of sales despite being only 3% of total SKUs. TNA and Wilfred Free take up the largest % of SKU’s. Wilfred is the most popular brand in Canada in terms of volume while in the US, Babaton is the best-selling. 

Aritzia hires designers around the world. Craftsmanship is all in-house, while wide net retailers like Zara tend to outsource these functions. With 12 in-house brands catering to different needs, Aritzia exposes itself to a ton of competitors but diversifies the risk of brands losing steam. Superpuff winter coats are not doing so well, maybe Sunday Best’s blouses are popping off. This keeps the overall brand afloat despite momentary declines in respective brand popularity. Still, Aritzia keeps a large list of staples. Aritzia dabbles in fast-fashion but is not at all dependent on it. In fact, 80% of product iterations are on existing items. Customers who fear changing trends can safely return to timeless classics. 

Each brand remains consistent with the overall Aritzia identity. A customer buying Babaton will tell their friends it's Aritzia, similar to how someone who bought an Ultraboost still understands it’s an Adidas shoe. Compare this to a firm like Zara who has a whole bunch of brands yet a Massimo Dutti owner will say it’s from Massimo Dutti, they won’t even know it’s owned by Zara, or LVMH where a Tiffany & Co. owner will tell their friends its Tiffany & Co., not Louis Vuitton. This hammers in customers the idea that Aritzia is a lifestyle brand that spans all kinds of categories, which explains why they can successfully open a chain of coffee shops without people turning their heads, the brand is about the Aritzia woman, not the specific item they’re selling.

Aritzia spends little on formal marketing, all marketing expenses make 4-5% of sales. According to our primary research, 90% of participants learned about Aritzia either through word of mouth or walk-in, no advertising needed. When asked to pick their top 3 favourite brands, over 80% tell us Aritzia is their favourite (although Aritzia is more popular in Canada), followed up by a mixed bag of different low end brands, such Zara and Uniqlo. In fact, around 30% of participants' annual clothing carts is 50%+ Aritzia. 80% of sales come from customers who spend $5000 or more every year, which gives them discounts and special promos. Aritzia is cheap enough for middle-income consumers to afford, and expensive enough for high-income spenders to appreciate. In fact, we found that a lot of luxury spenders have traded down to Aritzia recently, which can provide somewhat of a buffer to recessionary cycles. 

Shopping Experience

The shopping experience is one of a kind. The stores are beautiful: large plants, glittery statues of birds, and custom furniture litter the space without overcrowding it, giving a homey elegant feel.  Stores are typically large, spacious, with strong lighting. Lots of sofas. There’s an arcade machine for the guys to hang. Some stores even have Aritzia’s A-OK Cafe where shoppers tend to sit down before or after shopping. The shopping experience online is also unique. Items are delivered in shopping bags to give the feeling like you actually went to a store. 

Figure: Aritzia store in Upper Canada Mall

Aritzia presents their ideal woman as accomplished and ready for anything, and this branding emanates throughout the shopping experience. Many of the best-selling items are pieces that can be used for both casual and business casual. The models are usually depicted with a stern face, strong body language, usually in outdoor or business settings. Changing rooms have no mirrors, forcing shoppers to test their items with other shoppers. 

Employees, the “style advisors” call you by name, follow up, and help you find the right pieces. They are selling machines, incentivized through a ranking system where shifts are determined by your sales numbers relative to other style advisors. Store managers make half of their salary through commission. Front-end workers are competitive, and customers have noted some sense of imposter syndrome when entering an Aritzia store, which we think adds to the aspirational brand image the store is trying to achieve. 

Sales channels

Aritzia operates through retail boutiques and e-commerce. It has 116 locations in Canada and the United States, with 49% of revenue from Canada and 51% from the US. The company has three distribution centers to serve these locations. Retail boutiques contribute to 65% of revenue, while e-commerce accounts for 35% for FY2023.

Aritzia operates 116 different boutiques across Canada and the U.S. with an average size of 8000 square feet, on the larger side, in order to create the feeling of scale and grandness. The real estate selection process has been described as rigorous and conservative. Aritzia receives investments from its landlords through both landwork and tenant allowances as well as favourable lease terms which helps its bottom line. Brian Hill himself is quite hands-on, preferring to choose store locations in high-income busy areas, oftentimes willing to pay a high price for prize locations. Boutiques don’t follow a format or formula, each usually having a  different layout with design choices completely delegated to store management. (See Appendix 3 for general criteria on store selection). More successful stores have the A-OK cafes.

Figure: Aritzia Store Economics

All these factors result in great store economics, with an estimated average of 25% ROIC for each new store investment. In fact, throughout its 37 year history, Aritzia has only closed down one store, and even that one closure was pandemic-forced. This can be attributed both to its dominance in its market niche as well as management’s cautious approach to expansion.

On the e-commerce side, Aritzia has done a good job of bringing their e-commerce operations up to speed. Much of the work has been in improving capacity to absorb much higher traffic. The new ECommerce 2.0 project will mostly involve overhauling the software infrastructure to integrate newer more powerful systems. Adding new features to improve the shopping experience has also been an area Aritzia needed to catch up on. Boutique pickup, online customer care, and concierge centre, and store inventory visibility are a couple of the key improvements Aritzia added recently.  Aritzia plans to launch its own app and expand distribution centres, concierge facilities, support offices, etc. We think with the launch of ECommerce 2.0, Aritzia should be on-par with established retail e-commerce websites. 

E-commerce has been crucial to US growth. E-commerce now accounts for 60% of US sales, being the primary lever of entry into untapped States. In total, 38% of revenue comes from e-commerce, up from 23% pre-pandemic. E-commerce should eventually reach 45% of sales long-term, which will materially raise margins per unit due to higher operating leverage.

Supply chain

Aritzia's distribution network comprises three strategically positioned distribution centres, with two located in Canada and one in the United States. The first facility is a 223,000-square-foot centre in New Westminster, British Columbia, operated directly by Aritzia. The second and third facilities, spanning 150,000 and 240,000 square feet, respectively, are third-party operated centres in Mississauga, Ontario, and Columbus, Ohio. To efficiently manage inventory for both its boutiques and eCommerce operations, Aritzia employs centralised inventory management across its distribution network. The company leases external facilities when additional storage space is required. 

Aritzia faced difficulty raising capacity to meet growing demand. One ex-employee told us after relocating and massively expanding the BC facility, it took only 3 years for the whole distribution chain to be “tearing at the seams.” This led to overstocking and consequently lower margins alongside unfresh products when they hit the market. In response, Aritzia completed retrofitting work on the New Westminster distribution centre to enhance its capacity and capabilities. This expansion aimed to accommodate the increasing growth of their eCommerce segment without the need for additional space. Aritzia also launched a new DC facility in Vaughan, Ontario this year. This new 550,000-square-foot distribution centre replaced the older 150,000-square-foot centre operated by a third-party logistics provider. 

Aritzia plans to further expand its Columbus, Ohio distribution centre. The facility's size will increase from 255,000 square feet to approximately 560,000 square feet through retrofitting work. Aritzia also commenced construction on a new 380,000-square-foot facility in Delta, British Columbia. Upon completion, this facility will be directly operated by Aritzia and is expected to become operational in Fiscal 2026. The current New Westminster facility will be retained for storage, office space, and other purposes. 

US growth opportunity

Figure: Aritzia Boutique Location Map

What we find most compelling about Aritzia is its under penetration of the US market. Aritzia ventured into the US in 2007 and has been growing its presence there ever since. Aritzia’s boutiques have had a CAGR of 9.7% since 2008. A major point of emphasis is Aritzia’s plans of geographic expansion into the U.S. with a goal of opening up 8-10 new boutiques and expanding 3-5 existing boutiques annually. Its goal is to open in 18 new USA markets and to reach a total boutique count of 150 by FY27.

US Growth Runway Methodology 

We gathered population data for all the cities in which Aritzia stores currently exist for the US and Canada as well as store count. Aritzia currently has stores in 21 out of the 50 states in the US and in 43 different cities/towns. However, it only averages 1.16 stores per city and 2.38 stores per state, while Canada has 1.87 stores per city. To estimate a conservative estimate for the growth runway for the remaining states in the US, we used the current stores per state average of 1.16 * 29 (remaining states) and rounded down to reach 69 stores. Then for new stores in existing states, we used Canada as a baseline that represents a fully saturated market. We calculated a ratio of Female Population Per Store (FPP) for Toronto and increased it by 25% to adjust for the brand loyalty of Canadians (upward bias) to reach a Baseline of 170k FPP. Then we calculated the FPP for all the existing US cities. If the FPP for a city was lower than our baseline, we assumed 0 new stores. If the FPP was higher, we calculated how many more new stores are needed for it to become the same as the baseline. 

To calculate the number of new stores in new states, we took a conservative approach and used the average number of stores per existing state and multiplied it by the remaining 29 states to get 69 stores. In total, combining the two figures we reached 129 new stores possible in the US for Aritzia’s geographical expansion before market saturation, which is larger than all the stores they have right now. Given management guidance of 8 new stores per year, giving Aritzia a growth runway of around 16 years before they saturate the US market which is highly positive given the attractive store economics. (See Appendix 10 for full results and sensitivity analysis). 

Figure: US Store Expansion Opportunity Quantified

Country	Average Stores per State / Province	Average Stores per City	Total Stores Expandable In Current States	Total Stores Expandable in New States	Total Stores Expandable
Canada	10.14	1.87	N/A	N/A	N/A
U.S.	2.38	1.16	60	69	129

Figure: Historical Aritzia Boutique Count Growth

Each new boutique has a 12-18 month payback period and with every new market, its eCommerce platform sees an average lift of 80%. What is most encouraging is that international expansion can amplify these figures even more. Despite Aritzia not having any stores beyond North America, according to one of our sources, 10% of ECommerce sales are international, surprisingly high despite the website being described as “shitty,” so there seems to be some brand following  internationally and future plans of expansion could be very successful once management is done with the US expansion, although it’s not a priority currently. China is the most lucrative market for Aritzia outside of the US, and Western brands such as Brandy Melville, and Lululemon have achieved a cult-like following there. Abercrombie & Fitch also has decent success in China, so it is safe to assume that Aritzia could follow in the footsteps of these previous successes. International expansion is not crucial to our thesis, but rather a way for Aritzia to extend its growth runway if management sets it as a strategic priority.

Fierce Competition

We believe Abercrombie is the scariest competitor. Abercrombie, previously plagued by ruined reputation, has managed to turn around the brand, closely copying Artitzia’s style, quality, and price. Abercrombie is now more size-inclusive, much less logo-centric, and has a much larger focus on staples. Abercrombie has managed to revitalise its sales per sqft which has resulted in significant growth in sales. Abercrombie has a larger capital base, bigger store count, and wide international reach. While it will take time for the fashion community to start fully revisiting Abercrombie, we believe Abercrombie poses a threat to Aritzia’s position within the mid-luxury market. 

Dozens of other small similar brands also exist: Oak and Fort, Reformation, Club Monaco, & Other Stories to name a few. While they have less than half the stores Aritzia has, they run a tighter ship, respond faster to quality problems, and generally have better customer service. The fierce competition was our primary concern going into the company, but our research tells us Aritzia has some key factors that are quite hard to replicate.

One is product selection. Customers we’ve spoken to told us they prefer to shop at Aritzia more than Abercrombie or any other similar brand combined due to product selection. The treasure-hunting experience is key to the shopping experience. Aritzia sells everything from sportswear to winter coats. Abercrombie, for instance, focuses mostly on casuals and jeans. All the small similar brands typically have a limited selection too, focusing on tops, pants, and jackets. While Aritzia is smaller than Abercrombie in terms of revenue and store count, they have many times the SKU count. Newness is important. While Aritzia is known for its staples, they need to keep bringing in new exciting products and have to dabble into fast fashion too to stay relevant, and competition will need to spend significantly in the design, manufacturing, and sourcing of new SKUs and product lines to catch up to Aritzia. This requires scale, which immediately puts the small copycats out of the game.

The other is brand, and this particularly applies to Abercrombie. Aritzia has already built up mindshare that their items are high-quality, aspirational, subtle design, and inclusive. You need scale to out-market your brand on social media and through word of mouth, which puts smaller similar brands at a disadvantage. Abercrombie will take time to rebuild its brand. Abercrombie was originally a posh outfitter founded in the late 19th century, it had become a struggling retailer by the 80s, selling a variety of outdoor and sports apparel and gear, from tennis rackets to $40,000 elephant guns. The firm was acquired and Michael Jeffries took over as CEO, stripping away everything except for the apparel, now rebranded to target teens at a high price point. Jeffries had 6-pack men on advertising, quarterly magazines with topics on pop culture and sex, and at one point even a TV show featuring a bunch of near-naked kids playing beach volleyball. Exclusivity, the need to be "cool" according to Abercrombie, was what gave it its brand loyalty. From 1995 to 1999, revenues were compounding north of 40% annually. But this wouldn't last. Soon, the public pushed swathes of criticism over its exclusionary practices, which even included hiring people that fit its "checklists," typically conforming to white beauty standards. Its logo quickly became tarnished. Coming out from the '08 crisis up until the pandemic, Abercrombie grew revenues, on average, less than 1% annually. Fran Horowitz become CEO in 2017, and she’s proved excellent in changing the brand, but most buyers are still unwashed, and immense marketing effort and time will be required for Abercrombie to have a chance against Aritzia, by which time they will probably have wide enough reach to make their position a lot more defensible. (See Appendix 5 on case studies). 

In reality, Aritzia faces competition from a variety of retailers due to their diverse selection of products, ranging from Lululemon and Alo for sportswear, to Canada Goose and Arcteryx for winter wear. They pretty much compete with most high-end apparel brands. We think Aritzia’s unique market position gives it a niche that these competitors won’t be able to break into because their customers have a different kind of mindshare about their brands. Competing brands in Aritzia’s niche are strong and we don’t think Aritzia’s advantages are insurmountable, but they will need plenty of investment and time to pose a very significant threat.  

Growing pains

The most significant risk we believe Aritzia faces is decline in quality. Various customers we’ve seen on Reddit and Twitter mentioned declining quality as a key issue with the brand, which started around 2020-2021. This is especially bad for Aritzia because their clothes are known for being made with the best materials and lasting more than several years. 

Ex-employees have attributed this to a variety of factors. One explanation is expansion. Similar to most apparel companies, expansion is expensive, and many are pressured to cut costs to sustain margins. Wall Street is demanding, requiring consistent growth every quarter, and so this is something management had to deal with after going public. As a result, they cut corners in designs and source materials from lower quality producers in Asia rather than in Europe. Increasing the distribution capacity is difficult because if you are at capacity, adding one warehouse will incur higher per unit costs until the demand fills it up, which doesn’t look good on the income statement in the short-term. On the flip side, when demand is way too high, you may want to spread volume to lower quality factories and suppliers when all the best ones can’t handle any more. A few items that used to be made of silk are now made of nylon. Some skirts that used to be double layered are now single-layered. Lower quality wool leads to faster pilling. 

The other explanation we’ve heard is that Aritzia is still reeling from Covid supply chain issues. Aritzia wasn’t ready to handle the hundreds of thousands of e-commerce orders that flooded in at the onset of the pandemic. Air networks couldn’t absorb freight capacity, and shipping rates went up 3x. Massive amounts of product were stuck in the supply chain, leading to inventories losing it’s newness and relevance by the time they hit the market. In an attempt to tighten supply chain efficiencies, Aritzia just stopped buying materials for products that weren’t selling as well. Because Babaton sales dropped dramatically, they just stopped replacing their materials with nylon and stopped purchasing silk altogether. Lower margins items were met with lower cost materials. Management had to cut costs severely to stay afloat without closing many stores. After all, e-commerce fulfilment costs were higher than it cost to ship to retail. The pandemic and the timing of the quality decline also line up. Ex-employees tell us many of these constraints have yet to be reversed. For instance, Aritzia's sourcing strategy has been to find the best and develop strong relationships with them. Their wool is sourced from one supplier. Their crepe is sourced from one supplier. This means they get better economies of scale because they are buying at larger bulks, but it also means cutting them off forces them to rebuild relationships or find another quality supplier, which takes time. 

However, when we compared late 2010s versus current items during our store visits, both material breakdown, feel, and overall design were exactly the same. Customers we interviewed gave a more positive response, less than half noted a decline and quality, and even then most said quality only went down a little or for select items. (See Appendix 7 for more detail). 

Sentiment Analysis

Data scraping we conducted on Twitter shows that 65-70% of accounts that tweeted about Aritzia had positive things to say about product quality, so perhaps the complaints have been from a small subset of upset customers. (See Appendix 8 for detailed methodology and retail store google reviews). Moreover, nearly 70% of customers we surveyed valued style over quality when it came to why they shopped at Aritzia, so it seems that the brand is not fully dependent on quality.

We still think quality decline is inevitable as the company grows, but many still-successful retailers known for their quality have had quality declines while continuing to grow. Moreover, Aritzia’s expansion has been way slower than retailers such as Lululemon which have been adding 40 stores every year for the past decade. 

Hill and Wong

Jennifer Wong took the reins of CEO May of last year. Hill is now Executive Chairman. Like most leaders in the firm, she came from within the company, starting out as a style advisor from almost the very beginning in 1987, slowly working her way up to COO, which she held since 2007 until she was selected as CEO 15 years later. While she came from a sales background, she knows the company inside and out and has proven to be an excellent operator. She has been credited with pushing into e-commerce and leading the development of Aritzia’s distribution chain. People greatly admire Wong, for her story of climbing her way to the top and being one of the few female public company CEOs in North America. Nevertheless, it seems that it is still very much Hill’s company, and his culture and way of doing things have not been changed.

Former employees describe Hill as conservative when it comes to capital allocation, preferring profitability over growth. For instance, he will not expand to a region if he is not sure that stores there will succeed. As a result of cautious expansion and focus on profitability, Aritzia has consistently grown its sales productivity, more than peers. 

While they have wanted to grow at 8-10 stores annually, the real numbers have been more varied. In other words, there is no strict KPI, it depends on the return on store spend. We hear he actually prefers to increase the profitability of existing stores through simply expanding their square footage, usually creating a whole new section featuring one brand. Aritzia plans to do 3-4 store expansions each year. Brian is very hands-on with real estate, usually selecting areas in high-income areas with a variety of other high-end retailers. He is willing to spend lots on very good commercial centres or streets. One of the shining moments of his career was during the 2008 financial crisis. Aritzia just opened their first stores in the US. Yet while retailers were contracting, Aritzia was buying prime real estate at dirt cheap prices. 

As Hill put it:

“It was very difficult initially for us to find retail locations in the U.S. that were the same quality as our real estate in Canada. Now we're finding the availability. Because of the recession, there's not a lot of competition - there are not a lot of new retailers starting out. And landlords are excited about our performance in some of our centres.”

Hill has been a long-time friend of Chip WIlson, another Vancouverite, founder of Lululemon. Seems that Wilson has taught him some key lessons Lululemon has had to learn themselves overtime: that location is everything, sales productivity is more important than square footage growth, and cautious expansion will keep you safe from recessionary doom. In 2010, Hill mentioned he planned to double Aritzia’s $200M revenue within the next 5 years by adding 50 more stores in the US. He did do that – while adding just 8 stores in the US.

Aritzia’s people tell us there’s some pride in the fact that they always try to do things differently, their way, which is first and foremost present in its branding and unique market position. On the people's side, first, everything is done in-house. Including the interior designing of stores, real estate management, creating new products, procurement of raw materials, planning and operating distribution centres, they even have their own internal consulting group. Second, because sales associates are compensated through sales ranking or commission, associates who truly enjoy and are good at selling end up being highly incentivized to perform. Third, Brian seems to have put in place a very strong test-and-react culture where every new idea will be tested at minimal scale before it is released at large. This goes for new products where new items will be tested in a small selection of stores to evaluate its potential. New e-commerce features are released as minimum viable products to test its reception with users before it’s fully fleshed out. These are some of the things that Aritzia does that are quite unique to other retailers. But this non-conformation to the standard also presents challenges. Data and logistics employees noted how sales and operations managers didn’t always listen to the data. In an attempt to “do their own thing,” there is somewhat of a confirmation bias within the team, especially because most managers came from the sales floor and did not have a strong background in data or numbers. Seems like this is changing as Aritzia hires more and more engineers and data scientists. They now have a whole supply chain engineering department.

Overall, it’s clear to us that Brian has the vision and is largely responsible for the direction of the company, while everybody else works more towards its execution. On the downside, his vision also means there is some level of autocracy in employee decision-making. This seems to be more present in the retail department, where some employees have commented that they are simply “told what to do.” 

The sales incentives of associates have also resulted in certain locations developing cutthroat workplaces. Associates fight over customers, get jealous over rankings, etc. Competitiveness in the workplace seems to emanate across the organisation. But it can also be very rewarding, and most people agree that either you love or hate Aritzia’s work culture. It rewards high performance. For the most part, employees really respect both Brian and Jennifer, so we are confident that the competitive work environment should weed out those who are capable of bringing in results.

Incentives

Brian Hill is a large individual shareholder, with a 18.4% stake in the company. The rest of management and directors collectively have less than 1%. Compensation tied to performance is extensively applied to executives. Wong receives about 55% of compensation (half options, half stock) in equity. Performance-tied stock grants are awarded based on fiscal year net revenue and EBIT, an anchor to top and bottom-line growth. For other executives, equity compensation is about 43% of the total, tilted a lot more on options versus stock. 20% of executive compensation is determined by the annual bonus. The bonus is tied to net profitability. In sum, 75% and 63% of CEO and executive compensation respectively is tied to growth and profits. Hill himself receives an annual salary of $1 but $3M in equity (half options, half stock). Jennifer and CFO Todd Ingledew own $28M and $7.8M in options respectively. Overall, incentives are pretty good, but would love to see less options, and have compensation more tied to return on capital against a benchmark.

Capital Allocation

Berkshire Partners, Aritzia’s first investor, exited their position in 2019 shortly after Aritzia went public. Aritzia agreed to buy back a portion of their stake, worth $107M, roughly 6% of the company at $16.9, which was near the IPO price. Further share buybacks have been done, although with the sole intent of offsetting dilution from exercising options and share issuances. The company took on debt during the pandemic to sustain operations, and since 2021, the company has been debt-free. While the company has a large lease liability, even with depressed margins, they are still able to cover interest payments 4 times over. In summary, management doesn’t seem to be doing anything very value accretive or destructive on the financing side so far. Management anticipates a cash balance of over $1 billion by FY27. If this is successful, management plans to return the cash back to shareholders through dividends or buybacks.

Most cash flow is either used to pay back loans or is reinvested back into the business. They’ve spent plenty on investing in eCommerce and Omni-channel innovation, geographic expansion, product expansion, and distribution channel expansion. 

Figure: Aritzia Management Goals

Management plans to spend $500M in capital expenditure from 2024-2027 in building out boutique network and distribution. Operationally, they’ve under-promised and over-delivered. 

Reigning Champ Acquisition 

The company acquired 75% of Reigning Champ based on a total enterprise value of approximately $63 million, representing an EV/EBITDA multiple of 12.6x based on Reigning Champ’s CY2021 financials, a fair price. Strategically, the purpose of the acquisition is to speed up Aritzia’s expansion into men’s wear and open up opportunities for a brand-new consumer base. Management plans to grow Reigning Champ from $25M to $75M in annual sales by FY27 by multiplying style count, launching new categories, and innovating and optimising existing categories. Aritzia completed a Follow-on Equity Offering totaling $70.176 million by issuing 1,360,000 common shares to finance its expanding operations and help with the acquisition of Reigning Champ. 

Expanding product selection seems to be the primary goal on the retail side. Aritzia chose Reigning Champ because both the style and niche fits with the Everyday Luxury position. It’s also to acquire talent. Expanding into menswear will be difficult because the Aritzia brand still centres around women. The shopping experience is designed for women. Successfully developing a menswear line will mean getting the contribution of people who have experience in menswear marketing and design. There’s still a disconnect between the Reigning Champ and main Aritzia lines. Integrating Reigning Champ’s Canada-only supply chain into Aritizia’s global supply chain resulted in some quality declines. The designers who used to work with a small group of clients in a small niche are now serving millions of customers. It will also take an immense amount of time and brand education before we will see menswear becoming a normal aspect of Aritzia’s product selection. Nevertheless, this is a new growth opportunity and should further diversify away the risk of brands losing popularity.

Valuation

Other than Abercrombie, Zara can be recognized as Aritzia’s most direct competitor, while H&M is a cheaper alternative. Canada Goose’s puffer is a luxury alternative to Aritzia’s Superpuff. Lululemon competes with Aritzia in its athleisure wear segment, specifically women’s pants, tops, puffers, and men’s wear. Zara and Lulu are seen as the most dominant players in both segments, but Aritzia’s multitude of brands have better synergies between each other which allow for an easier transition between price points and style for consumers. In terms of valuation, Aritzia is trading at a lower EV/EBITDA, P/E, and Forward EV/EBITDA, and a higher Forward P/E compared to its competitors – see table below.

Figure: Trading Multiples

Company Name	TEV / EBITDA LTM	P / Diluted EPS LTM	NTM TEV / F EBITDA	NTM F P/E
Aritzia	9.6x	22.0x	7.68x	17.25x
H&M	9.3x	39.3x	7.20x	18.61x
Inditex (Zara’s owner)	11.4x	22.6x	10.41x	20.04x
Lululemon	17.2x	46.5x	17.68x	28.54x
Canada Goose	11.4x	37.3x	8.05x	16.38x
Abercrombie	4.2x	26.3x	6.56x	12.58x
Average	10.7x	34.4x	9.98x	19.23x

Forward P/E is likely lower due to margin pressures cited by the company but we believe it will normalise by FY25 and does not affect the long-term thesis.

Valuation model

A DCF approach to valuation yielded a stock price of $32.94 a share, representing a 43.78% upside to its current stock price. We decided to use a 10-year DCF due to Aritzia’s massive growth runway as discussed previously. To project revenue growth, I projected growth for retail and eCommerce separately. For retail, I calculated growth based on revenue per boutique of $8m per new store and assumed a boutique opening rate of 8 per year based on management guidance. Since new stores take time to reach the average level of revenue and differ in terms of when they open during the year, I applied a 0.25x discount multiplier (assumes all stores open in 4Q) to adjust for the additional revenue they provide. I projected 2% organic growth (same-store sales growth) in FY24 due to near-term margin concerns and projected a 3% growth in the retail revenues of Aritzia in FY24. For FY25, I expect margin pressures to ease and growth to include comparable sales growth of 8% (slightly lower than the historical average of 9%) and project a 9% increase in retail revenues. This is then repeated for FY26-33 with lower organic growth each year. eCommerce growth was projected based on a 30% boost in eCommerce traffic for each store opened, and assumed a 1% conversion rate. I assumed low organic growth of 5% for eCommerce in FY24 and reached a projected 13% revenue growth. This is repeated for FY25-33, and the eCommerce and retail segment revenues are combined to get projected growth rates of total revenues. Hence, the total revenue growth converges to around 5% in FY33 and the revenue mix becomes 56% retail and 44% eCommerce which is fairly consistent with management expectations of 55% and 45%. 

Figure: Revenue Projections

For gross margin, for FY24 a 300bps decrease is expected by management, so I projected a 500bps decrease to be conservative. This is then recovered to around 39% from FY26-33 which is slightly lower than its historical average. SG&A is projected similarly with a 400bps increase in FY24 (management expects 300bps increase) and recovers in FY25 to average levels. Depreciation & amortization was calculated as a % of sales using a moving average since it mainly consists of depreciation of inventory, plant, and equipment which scale according to sales. Change in NWC was also calculated as a percentage of sales since the amount of working capital required to fund operations scales closely to how many clothes they sell. For income taxes, a 28% corporate tax rate is used with a +0.2% adjustment as Aritzia has been slightly higher taxes over the past. To estimate interest payments, I multiplied the total debt outstanding by the coupon rate of debt to get the interest payments for FY24-33. For capital expenditure, estimates are based on management discussions of spending $220M in FY24, and $500 million between 2024-2027 mainly on opening and expanding boutiques, improving distribution centers, and investing in technology. Beyond FY27, Capex stays around $120m to cover the costs of opening 8 stores per year, the expansion of distribution centers, and plans to return cash to shareholders.

For the discount rate, a WACC calculation is done with CAPM for the cost of equity using an equity risk premium of 5% for Canadian equities via NYU, and the average coupon rate for the cost of debt which gives a value of 8.80%.

When conducting valuation through a multiples approach, I used the average EV/EBIDTA of the apparel industry from NYU Stern which is around 7.02x. Using this multiple multiplied by terminal year EBITDA, the stock is priced at $61.35 which is 168% upside. A sensitivity analysis was conducted with both methods yielding a bull-case upside of 200% and a bear-case upside of -14.63%. 

We believe the base-case DCF approach result of 43.78% upside is the most realistic. (See Appendix 9 for the full DCF model).

Figure: Sensitivity Analysis DCF

Figure: Sensitivity Analysis EBITDA Multiplier

The near future

Aritzia may face margin pressure in the near term due to rising raw material prices, particularly in cotton, amid increasing inflation. Higher costs for building new stores, creating products, and shipping could impact the company's profitability. Aritzia's expansion into the US presents growth opportunities but carries the risk of underperformance in new markets. The proliferation of quality decline due to expansion can cause customers to switch to competitors at a cheaper price point and affect brand image/loyalty. The acquisition of Reigning Champ and entry into men's wear may face challenges if men are hesitant to embrace Aritzia's products, given its strong association with women's wear. Macroeconomic conditions, including exchange rates and employment rates, could also impact Aritzia's performance. A stronger Canadian dollar could have a negative effect, while rising unemployment may reduce consumer disposable income and demand for Aritzia's higher-priced products. Inflation in Canada and the US can also influence consumer preferences. 

However, Aritzia has a proven track record of navigating economic uncertainties, such as the pandemic, and carefully planned boutique expansions, which help mitigate these risks. We are confident in management’s ability to grow steadily without overreaching as well as maintain its competitiveness through product selection and brand equity. We think the company is valued low enough where it’s either we win or don’t lose, and we look forward to holding this asymmetric risk-to-reward opportunity long-term.

Appendix

Appendix 1 - Aritzia Historical Financial Performance:

Source: Aritzia 2023 Annual Report

Appendix 2 - FY1Q23 Financial Results and Price Drop:

Aritzia reported quarterly and year-end results on May 2, with a 46.9% net revenue increase from FY22-23 from $1.5b to $2.2b. This figure beat analyst expectations by $400m or 22.2%. Important to note that this unprecedented growth occurred during a period of elevated cost pressures and a highly unpredictable macro environment. Adjusted EPS was $1.86, an increase of 21.6%, compared to $1.53 in FY22. 

Why did shares drop by 25% despite historical numbers?

1. Gross profit margin to decrease by approximately 200 bps compared to Fiscal 2023, reflecting ongoing inflationary pressures, normalized markdowns, pre-opening lease amortization and additional warehousing costs related to inventory management, partially offset by lower expedited freight costs.

2. SG&A as a percent of net revenue to increase by approximately 150 bps compared to Fiscal 2023, driven by distribution centre project costs and the annualization of investments in talent and increased retail wages made in the back half of Fiscal 2023.

3. Inventory at the end of Q4 2023 was $467.6 million, an increase of 124.7% compared 

4. to $208.1 million at the end of Q4 2022.

How does the market interpret these figures?

1. Aritzia will see margins shrink beyond the next year.

2. Aritzia is not spending in SG&A efficiently and will carry over in the long-term.

3. Aritzia is losing its popularity and growth will slow significantly moving forward. They can no longer maximize full-price sales.

How do we interpret these figures?

1. Short-term margin decreases are necessary for Aritzia to sustain its growth trajectory for geographical expansion. The extent to which a macro downturn will affect sales is overstated.

2. This is a positive sign of management investing in growth. Aritzia’s new distribution centre in the GTA will help fulfill growing eCommerce demand.

3. In Fiscal 2023, Aritzia strategically increased its inventory base to support unprecedented sales growth and mitigate supply chain risk. Improved freight timelines led to inventory arriving earlier than expected, contrasting with the prior year's delay. The company anticipates inventory normalization by the end of the 2QFY24 and expects normalized markdowns in FY24 to be comparable to pre-pandemic levels. 

Appendix 3 - Management’s criteria for expanding stores:

1. Demographics: Aritzia looks for locations with a target demographic that aligns with its customer base, typically young women with disposable income.

2. Market Demand: The company assesses the market demand for its products in a particular area, considering factors such as population size, economic conditions, and consumer preferences.

3. Shopping Centers and High-End Districts: Aritzia often seeks locations within prestigious shopping centers or high-end districts known for attracting fashion-forward and trend-conscious shoppers.

4. Foot Traffic: Locations with high foot traffic, such as busy streets, shopping malls, or tourist destinations, are favorable for Aritzia to maximize exposure and attract potential customers.

5. Competitor Analysis: Aritzia evaluates the presence of competitors in a potential location to gauge market saturation and assess the opportunity for differentiation and market share.

6. Co-tenancy: Aritzia may consider neighboring stores or brands in the vicinity, seeking synergies or complementary offerings that can enhance the overall shopping experience.

7. Accessibility and Convenience: Aritzia looks for locations that are easily accessible, with ample parking or proximity to public transportation, to ensure convenience for its customers.

8. Store Size and Layout: The company considers the available square footage and store layout to ensure it can effectively showcase its products and create an inviting shopping environment.

9. Long-Term Viability: Aritzia assesses the long-term viability of a location, considering factors like lease terms, rent affordability, and the potential for sustained customer traffic.

By evaluating these criteria, Aritzia aims to select store locations that align with its brand image, cater to its target market, and maximize the potential for success in each chosen market.

Appendix 4 - Previous cases of brands failing:

Under Armour (UA)

UA was wildly popular for its focus on high-performance wear and instantly gained a cult-like following from athletes and bodybuilders alike. However, UA did not patent its famous ‘moisture wicking shirts’ and Nike and Reebok copied the technology. UA could not compete with those companies on price-point due to fewer economies of scale and lost market share in its most popular segment. Slowly, the brand shifted towards athleisure and lost focus of performance which killed the brand identity. 

Abercrombie and Fitch

Abercrombie & Fitch, once known for its fusion of Calvin Klein's allure and Ralph Lauren's American aesthetics, marketed to aspirational adolescents at slightly premium prices. However, its downfall was attributed to a lack of inclusivity and its targeting of popular, affluent American teenagers. The brand faced criticism for being discriminatory and perpetuating unrealistic body standards, which became increasingly unpopular in the era of body positivity and cancel culture. Notably, it had a reputation for its overtly sexualized branding, featuring male models with six-packs in its stores. Abercrombie & Fitch has since attempted a turnaround through rebranding efforts, aiming to adapt to changing cultural norms and consumer expectations, and emerged as a pseudo-competitor to Aritzia. Aritzia stands out as a brand with lower risk compared to Abercrombie & Fitch and other similar fashion companies. Aritzia's strength lies in its diversified portfolio of multiple brands, each with a clear and well-defined demographic target and brand positioning centered around "Everyday Luxury." The company also places a strong emphasis on ESG (Environmental, Social, and Governance) values, aligning with modern consumer preferences. Additionally, Aritzia promotes body positivity, which is a stark contrast to the unrealistic body standards often associated with fast fashion brands. These factors contribute to Aritzia's reputation as a more socially responsible and sustainable choice in the fashion industry, reducing potential risks associated with cancel culture or shifting consumer values.

Appendix 5 - Ecommerce delivery times and costs vs. competitors:

Retailer	Standard Shipping Time (NA)	Express Shipping Time (NA)	Standard Shipping Time (Asia, ME, Europe)	Express Shipping Time (Asia, ME, Europe)	Free Shipping Threshold (NA)	Standard Shipping Cost (NA)	Express Shipping Cost (NA)
Aritzia	3-5 business days	2-4 business days	4-7 business days	2-4 business days	$100	$10	$25
Zara	2-4 business days	1-2 business days	N/A	N/A	$50 USD	Free with $50 USD order	N/A
H&M	3-6 business days	2-3 business days	N/A	N/A	$60 (members $40)	$7.99	$14.99

Appendix 6 - In-Store Quality Analysis:

Aritzia

To assess the severity of quality decline, we conducted an in-store sampling to compare items now versus pieces purchased prior to 2019. The focus was the material composition, feel of the fabrics, and pricing. Most of the prior items are no longer in store, but the select items still available had the same material composition and no noticeable changes in quality. A surprising finding was that the pricing of the products was fairly similar to pre-pandemic and recent inflation, possibly indicating that Aritzia’s margin decline is largely due to tanking higher input costs while keeping prices constant. We also noticed that manufacturing was mainly done in China and Vietnam while raw materials for the more expensive lines were sourced from Italy.

To evaluate the online forum claims of cheaper materials used in Aritzia clothing, in particular polyester, we analyzed the composition of several pieces. We found that the composition of 70% cotton, 30% polyester was common for new items as well as old items bought pre-pandemic. Hence, we conclude that concerns about “cheaper” material could be just nitpicky customers complaining online instead of a serious quality decline.

We also noticed more young men shopping at Aritzia for select unisex Tna items, in particular pants, hoodies, and fleeces. These are similar items to Reigning Champ which bodes positively for its potential future success in the premium casual men’s wear market.

Appendix 7 - Online analysis:

Customer sentiment analysis

The customer sentiment analysis for Aritzia was conducted by assigning sentiment scores to Twitter tweets containing the keyword "quality." Here is a summary of the method and findings:

Method:

To assess sentiment, the analyst examined various tweets about Aritzia on Twitter. Positive comments were assigned a score of 1, while negative comments received a score of 0. Tweets that were noticeably biased were excluded from the analysis. The analyst then calculated an average sentiment score based on 105 tweets.

Twitter Score:

- Sample Size: 105 tweets

- Average Sentiment Score: 0.67

Conclusion:

The analysis suggests that the decline in quality for Aritzia's products does not appear to be as severe as initially expected based on empirical data. Qualitatively, most complaints about the brand came from a younger demographic with limited purchasing power. These customers expressed dissatisfaction with Aritzia's high price points when compared to cheaper alternatives offering similar quality.

However, it's noteworthy that comments regarding product quality were still generally positive. Some customers did mention a decline in quality for the same price point, but they remained willing to purchase Aritzia's clothing due to the brand's style and perceived better quality in comparison to competitors.

Overall, this sentiment analysis provides valuable insights into customer perceptions of Aritzia's product quality and pricing, highlighting areas where the brand can potentially improve to address customer concerns and maintain a positive reputation.