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FIGS (NYSE:FIGS) is a healthcare apparel retailer famous for its high-quality, trendy scrubs.
I started covering the company in March 2024 with a Hold rating. The rating was based on the company’s low operating margins, dilutive stock-based compensation, decelerating growth trends, and increasing competition. The company’s adjusted EV was too high in comparison with its operating profitability.
In this article, I review the company’s 1Q24 results and earnings call. The results are not out of expectation, with revenues flat and margins down thanks to an investment program launched by the company last year. However, the stock reacted very positively, jumping 20% in the days after the earnings release. I believe that given the appreciation was not justified by the company’s fundamentals, the stock is even less of an opportunity now than it was in March.
Unimpressive results
Flat revenues: FIGS posted revenues down 0.8%, the second quarter of low or no growth. According to the 1Q24 MD&A, the company’s customers increased by 9%, but this was offset by a lower frequency of purchases (given that AOV was flat).
Investment eats the margins: FIGS’ operating margins were low, close to breakeven for the quarter. Given that Q1 is the smallest quarter because of seasonality, lower margins are expected, but in this case the decrease was exacerbated by higher investments.
FIGS’ gross margins decreased due to changes in product and geography mix. The company is selling more internationally, more non-scrub products, and is leaning on newness for its scrub lines. Although international is less than 10% of revenues, and non-scrub is about 20% of revenues, these categories carry lower margins because the company is not operating with the same scale as in its core markets. FIGS expects that margins will improve with scale in the medium term.
Selling expenses were down thanks to accounting changes to the treatment of export duties, but are expected to grow next quarter as the company carries a fulfillment center transition.
Finally, marketing was flat, but management has commented on its commitment to maintaining investments in brand marketing. The company launched a campaign with a wild fauna veterinarian, recorded in South Africa. It recently launched another campaign around Nurses Week, which involved bringing nurses from around the country to ring the bell of the NYSE.
So, most of the cost increases came from growth investments, such as new products, changing the company’s fulfillment center, and not decreasing marketing.
One exception is G&A, which grew by 5% YoY. I dislike this category of expenses because it is generally where most of a company’s excess costs are located. For example, G&A carries management compensation (two of FIGS’ officers made $10 million in FY23) and headquarters expenses.
Management’s ‘strong’ cash flow: The company’s management talked about strong and robust cash flow generation several times during the call. However, management was not fully sincere about this. Indeed, the company generated $12 million in FCF in 1Q24, but $11.6 million was stock-based compensation. This is not a robust cash flow generation model; it is simply paying expenses with stock and diluting the shareholders. This is an indication of a lack of sincerity, which is a fundamental basis of trust between shareholders and management. Very bad, in my opinion.
Revisiting the valuation after the rally
Some market participants may have been happier with the company’s results because FIGS’ stock jumped 20% after it released earnings. Maybe some investors saw flat revenues as a sign of bottoming and are speculating about the company returning to growth.
The chart below shows that FIGS’ EV is $760 million, but I believe we need to adjust for the shares and options that the company uses to generate the ‘strong cash flow’ mentioned above. The figure below is based on 170 million shares, but the company could issue up to 35 million additional shares in the form of RSU and options. When adding this, the company’s market cap becomes $1.22 billion, and its EV becomes $970 million.
What kind of expectation is embedded behind this valuation? For example, for the company to generate an EV/NOPAT multiple of 15x (NOPAT of $65 million or operating income of $92 million), the company’s operating margin should be 17% or about 10 percentage points above the company’s historical average (and 12 percentage points above current levels).
Conversely, to obtain the same EV/NOPAT multiple but on 8% operating margins, FIGS should grow revenues to $1.15 billion, or 110% from current levels.
So in order to offer a reasonable (still, in my opinion, elevated and definitely not opportunistic) multiple on earnings, the current stock price has to embed extremely optimistic assumptions: a duplication of revenues or a duplication of historical margins. Even if these amazing feats materialized, the stock would simply be reasonably valued.
Therefore, I believe that FIGS’ stock is not an opportunity at these prices.
What to look for in future earnings
I believe two topics are essential for FIGS in the future.
The first one is international sales, which I believe are one of the company’s main opportunities, given the product’s success in the US. I would speculate that FIGS’ customer awareness in the US is already very high among doctors, nurses, dentists, etc. This leads me to believe the company has probably already captured most of its market opportunity in the country. People not buying FIGS today probably have reasons to do so (like its high price) rather than simply not knowing about the company. However, many professionals have never tried FIGS’ excellent products in Europe, Canada, Asia, and Australia and could become customers.
The second one is competition in the US. My coverage initiation article mentioned several DTC brands operating in the high-quality scrub space. Given FIGS’ super high gross margins of 60%+, these companies have a lot of room to undercut FIGS in prices. Indications of higher competition would be FIGS increasing promotional activity in the US or gross margins taking a big hit not explained by a change in product mix.
