Naked Wines: The Playbook

Is it going out of business?

In my first post about Naked Wines, I discussed the premise of the business—how it claims to sell quality wine for less money—the validity of that premise, why participating winemakers like it, and the company’s history of growth to date.

In this second post, I’ll discuss five topics:

1) the company’s unit economics, including the repeat customer business and its investments in acquiring new customers,

2) how I model the business,

3) recent financial results,

4) how I think this business could play out over time, including several different possible scenarios and corresponding equity valuations, and

5) a potential catalyst that could cause an upward move in the stock.

Unit Economics

Naked’s unit economics have been very good. Like any growing subscription business, it comes down to a) how much the company has to pay to acquire a customer, and b) how much that customer is worth to the business over that customer’s lifetime.

When Naked invests in new customer acquisition, it forecasts a 5-year Payback, which is defined as:

This exhibit from their mid-year FY22 slides shows the original 5-Year Payback forecast for each annual cohort made at the time, the latest 5-Year Payback forecast updated with current information, and the cumulative Payback to date.

For example, the FY16 cohort was initially projected to have 3.1x 5-Year Payback. As you can see, they nailed that. And payback to date is higher at 3.7x since we are now beyond the 5-year period. The FY20 cohort was initially projected to do 2.6x but is now projected to do 2.9x because things have gone better than initially expected. So far, it has paid back 1.5x only about two years into the 5-year period.

One thing you’ll notice is every cohort met or exceeded management’s original 5-Year Payback forecasts. The pandemic certainly contributed to that. What’s also noteworthy is these cohorts continue to pay back well beyond 5 years. Here’s a slide from their year-end FY22 presentation that shows contribution profit by cohort over time. Clearly, this level of detail is quite far beyond what most companies are willing to disclose.

You can see how a cohort’s contribution profit decays over time, but contribution profit retention approaches 100% as cohorts age. For example, the FY13-FY15 cohorts as a group have decayed over time but just retained 94% from FY21 to FY22. If that were to remain at 94% going forward or tick higher as one would expect, those cohorts will contribute a very long tail of contribution profit. What’s happening is the long-tenured Angels who remain enjoy being Angels and naturally tend to be higher-spending. Another factor could be that people tend to get wealthier as they age, which could lead to some trade up to higher-priced wines.

The returns Naked generates on its investment spending are attractive. Exhibit 1 shows an illustrative example of the investment in new customers, Year 1 payback, and the same sort of contribution retention the company has experienced in the past.

I penciled in £35m of investment in new customers, which is the mid-point of their FY23 guidance range. Year 1 Payback is the contribution profit generated in one year as a percentage of the prior year’s investment in new customers. It was 68% in FY22 and has ranged from 67% to 82%, the high end of which was goosed by the pandemic. In this example, Naked would earn £24 of contribution profit in Year 1. Finally, the Contribution Profit retention numbers are intended to reflect something they might typically experience (see prior exhibit).

As you can see, the £35m of spending results in £66m of 5-Year cumulative contribution profit, which works out to a 1.9x 5-Year Payback and a 34% 5-Year IRR. In reality, the true IRR is higher because the cohort has positive contribution profit beyond five years. Management considers a 5-Year Payback of 1.75x-2.25x to be their “goldilocks” range where the payback is not so high that they are underinvesting and it’s not so low that the investment is not providing an attractive return.

The big question for Naked is “How much can they productively reinvest in customer acquisition over time?” No one truly knows the answer to this, although CEO Nick Devlin would say that spending £50 or £60 million on new customer investment doesn’t need to be in the same channels or in the same way as the first £30 or £40 million, ie. brand marketing could play a major role in addition to performance marketing.

Here is the historical annual investment in new customers, which increased during the pandemic due to the very strong returns.

Management’s guidance for FY23 is £30m-£40m, which is down as a result of the lower 5-Year projected paybacks.

At a high level, management is very data driven and committed to only ramping new customer investment when it expects to generate sufficient returns. The current pull back in investment is the result of a soft patch in their 5-Year Payback metric, driven in part by inflationary costs in supply chain, logistics, and transportation. More on that later.

How I Model the Business

When I was beginning to lay out Naked’s KPIs and figure out the key drivers of the business, I realized that management does not explain all the components of sales. Revenue on the income statement is broken down into a) Repeat Customer Sales and b) New Customer Sales. As you can see below, those were £315.1m and £34.0m, respectively, last year to total to £350.3m (including £1.2m of other revenue mentioned in the footnote).

Repeat Customer sales retention is an important KPI. As shown above, it was 80% in the FY22 fiscal year (80.4% to be precise). So the first thing I did was start with £283.9m of Repeat Customer sales in FY21 and multiply it by 80.4% to see how much of that was retained into FY22. The answer is £228.2m. It’s somewhat odd that Naked’s reports never discuss this number or even make references to it.

As you can see above, Repeat Customer sales grew 11% (13% on a constant currency basis) to £315.1m in FY22. My first thought was, “Hmm, how can Repeat Customer sales grow if only 80.4% of it was retained from one year to the next? Something is missing. And it’s not new customer sales because that is broken out separately. What’s going on here? There’s £86.9m missing.”

Here’s what is going on.