Buying This IPO Could Be a Big Mistake

Join Motley Fool analysts Asit Sharma and Emily Flippen as they discuss the challenging business of resale and renting and if Rent the Runway (RENT 4.84%) has what it takes to turn business around. 

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This video was recorded on Nov. 2, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, November 2nd, and I'm your consumer goods host, Emily Flippen. Today, I am joined by Motley Fool Senior Analyst Asit Sharma, and we're going to be talking about Rent the Runway. It's a business looking to redefine what it means to have rent close, to have your wardrobe in the Cloud as they put it. Asit, thank you so much for joining.

Asit Sharma: Emily, thank you for having me, especially after all the times that I, myself have stumbled down the runway. I'm looking forward to talking about this with you.

Emily Flippen: This is one that, especially for our female listeners out there, they may be intimately familiar with. In fact, prepping today's show. I thought that I already knew what Rent the Runway business model was before coming into the research and actually found myself pretty wrong. In my mind to Rent the Runway was a site that you could go to and you could get address for one-off occasion. Let's say you had a friend's wedding to go to, a formal event, you can go rent yourself a relatively inexpensive designer dress for one night out on the town and then send it back the next day. This is the premise behind the Rent the Runway, they've actually pivoted to a subscription-based model. I won't call it Stitch Fix, but Stitch Fix asks more than 80 percent of their revenue actually comes from subscription-style agreements with customers that pay monthly fees to gain access to their wardrobe and the Cloud. I was actually really intrigued by this pivoting.

Asit Sharma: Me too, Emily. I remember this company from several years ago. I had the same visual in my mind's eye. But as I read through this perspective, to me if ThredUp and Stitch Fix had a child, it might look a little bit like this. I should say before we go any further, I have to now make up for, I think the last week where I was really very critical of a CEO letter we read at the beginning of a prospectus. I actually really enjoyed Jennifer Hyman, she's the co-founder of Rent the Runway. Her shareholder letter, it begins like this, it started with a dress. She's watching her sister Becky, about to put money on the credit card to buy a dress for one event, and this idea comes into her mind to start a business which rents high fashion clothing, but as you know, it's migrated into a different business model.

Emily Flippen: Yes, and it's so interesting because when people think about special occasion rental clothes, at least my mind immediately goes to taxes on prom night. The classic example of what rental clothes look like. But this co-founder was finding that women were spending a ton of time and a ton of money on clothes that were worn only a handful of times in most cases, just once. There's an opportunity there. It's really interesting and actually use cases extends far beyond what I imagined. Again, I keep talking about these events, or talking about an occasional formal event that you need a long dress to go toward. But actually they found that more than 50 percent of their use cases currently are actually from customers that say they are using it for casual wear. Going out on the weekend or sitting at home. They even said loungewear has some of their use cases. I started racking my brain, thinking about all the ways that Rent the Runway can apply to you. It's not just people who are posting on Instagram and need to have a new designer sweater for every post, but theoretically it just regular people looking to look nice on an everyday basis.

Asit Sharma: One statistic really jumped out at me. They have different levels of subscription but for the subscription, which is the most, I think, long-lasting during the year, the typical customer will wear those articles that come from Rent the Runway 83 times in a year. Which was just amazing because it really does invert the idea of having a special piece of clothing for one event versus renting clothes that are fashionable that you feel good in and want to wear multiple times during the year. They also give some statistics on the price savings of buying, let's say one outfit at retail, I think the price point they show in their prospectus is 350 bucks versus the utilization you get from renting that item at a much lower cost and being able to enjoy it for an extended period of time. This is a different business but I guess to really understand whether we like it as an investment or not, Emily, we should start breaking down the economics of this model.

Emily Flippen: This is where things get a little dicey. I will say I was happy to see them moving a little bit away from what would normally be a very high upfront cost model business. Only around 46 percent of their clothing today is purchased wholesale by Rent the Runway. That stem going directly and owning those items themselves as pieces of clothing better than rented it out. Fifty-six percent of those closings actually used on either consignment or through what they call exclusive designs. Rent the Runway doesn't pay upfront or pays very little upfront, and instead, just revenue shares with the luxury designer partner. That's a higher-margin business. It's a more asset-light business and the executive exclusive designs are made to actually be more durable. It theoretically should extend the life of those pieces of clothing over time.

Asit Sharma: I like how these percentage shifted from prior years in fiscal 2019, wholesale items equaled 74 percent of their purchased items, Emily, and those shifted, as you said, are just 46 percent that were purchased wholesale in fiscal 2020. What that means is that they are able to have fewer touches on these pieces of clothing. They are in inventory-based model for the clothes that they manufacturer or purchase wholesale, so they subcontracts in manufacturing. That's an expensive process if you don't do it right. That's why I was comparing them a bit. If we've got Stitch Fix the subscription model on one side, I was comparing them to ThredUp, the fashion e-tailer, which also works in a sustainable fashion and is in the used clothing market. They're really, really good at handling their inventory. You have to be very highly focused on costs in this business. As we'll see as we talk further about this model, it is not an easy one to make a profit on.

Emily Flippen: Yes, and I have to say about part of my other day job here at the Fool is working on a portfolio called Trend-Spotter. We've gotten a lot of questions. But what about resale as a trend? Why aren't we playing this industry in that portfolio? It's so funny because I see the very real tailwinds that exist for the resale market. There's no denying that demand is there, and I love what it means for the world. Extending the useful life of our clothes, making it less financially burdensome, but also just less wasteful. But whenever we get into the actual financials of businesses that are trying to make resell work, it just gets really challenging. Rent the Runway is in a weird position of both, giving the option for people to purchase those closings directly from them, but also just trying to extend the useful life of the sale of clothing so they can rent it out more times. 

It just makes a really challenging financial picture. Hey, let's talk more about that. The good news is that management does think they have some flywheel effect here. They collect data on the types of clothing that are rented and purchased. The more they're able to provide things like personalized styles, as well as provide that information to their partners, that data for the partners like which items rent most frequently, how long they last, etc, theoretically, the more customers and the more partners they pull in. They did find that subscribers who have used their personalized recommendations had nearly three times the average tenure of the subscribers that didn't engage. Although they didn't actually provide what those average tenures were, and so I found myself just scratching my head a bit, wondering how long the average person stays subscribed. But interesting nonetheless.

Asit Sharma: I agree. Just before we came on for this episode, I was looking a little bit more closely at a chart or a table that is they have on their product ROI, so the return on investment risk typical product. It seems like over the last couple of fiscal years or at least from fiscal 2019 to the first half of this fiscal year, Emily, they've got the same lifetime turns per unit. You might think that a higher subscription base and people who are looking at their recommendations ordering equal more lifetime turns per unit. There should be a correlation between what people want to buy and that item being in demand. But that number hasn't really changed, they're spending more upfront for each piece of clothing but they are extracting a little bit more revenue from each piece of clothing for that, so the profit margins on a product basis are growing up slightly. There are some numbers that are starting to shift a little bit to make this look like the model could have some legs. But overall, as we're going to see it's not something that leaps out to me as viable as it scales. There has to be in any business which is a little bit capital-heavy, a path to eventual scaling, that fixed cost base and getting a nice margin on products. I don't really see it here. I think this might have something to do with an observation you made to me about that subscriber base.

Emily Flippen: Yes. This is so interesting. When I heard that Rent the Runway was going public, I thought to myself, what a strange time to choose to do so because certainly 2020 was not a great year for them. The formal events were off, people were unemployed, that this is a luxury that was certainly being stripped from budgets. I was really interested to see what their business looks like in 2019, how it's rebounded in the 2021. But man, things were worse than I expected. If you have done a little bit of research into Rent the Runway prior to listening to today's podcast, you may be aware it's being ripped apart by financial media right now because of its financial performance. I can understand why. When you look at just how small the business is, it's a little bit concerning. At the end of 2020, they had only 95,000 total subscribers and only 55,000 of those were active paying subscribers, so not people who had paused their subscription. Now, this was somewhat due to COVID. Paying subscribers were down from 133,000 in 2019. But it shows just how easy this is for people to cancel when times get hard. While the number has rebounded a little bit in 2021, most recently there are a 127,000 total subscribers, just under a 100,000 of them were active. It's still only a very small portion of their nearly 2 1/2 million lifetime customers. This is very much an expensive product, verging in the prices of $100 a month to $300 a month. That is not necessarily something that is maybe going to appeal to a mass market the way that other resellers may.

Asit Sharma: True. Fewer subscribers than I expected, Emily, and a higher subscriber spend than I would've thought. Their statistics show that an average customers can spend up to 3,800 or so on average with them each year. That's a statistic that was surprising to me. I didn't realize, and this is primarily women's clothing, that the average or baseline metric for a wardrobe purchase and replenishment every year is about 4,000 bucks. I've got a wide range of friends and I have few of my female friends. We'll start with my wife who purchased anywhere [laughs] near that a year in clothing. That number surprises me and I think that's what it indicates is that the market for this as a closet in the cloud, which just how they market it, is smaller than one would expect. As we get out of COVID and moved to a world which is more hybrid in work, then you're cutting down the use cases for clothing. You're cutting down the reasons that people may want to use the service. Now for those women who really love to feel good in their clothing, look good, and don't mind a little bit of a higher spend, maybe for their leisure clothes, there's still a big market. But when you think about the exogenous factors that are hitting not just the resale market, but the fashion market in general. Couple that with this small subscriber base and the slim ROI that I was talking about, you get a recipe for losses. Maybe, Emily, walk us through what that looks like in a few big numbers and I've got some comments there as well.

Emily Flippen: Let me mention what's good here that's going to make your losses sounds strange. Is that they actually do an interesting job of breaking down what they call their product return on investment, that product ROI. How much they pay upfront to get a piece of clothing and how much they spend to fulfill it. How many turns they get, so how many times it's rented out, and then figuring out the lifetime value of that product itself. It's always taking a product approach as opposed to a customer approach, but they keep their customer acquisition costs very low. Less than 10 percent of revenue has been spent on marketing every year on average, which is pretty low for this business. They actually calculate their own product ROI in terms of profit in the first half of 2021 at 3.6 times. They're theoretically making money on each piece of clothing that they acquire. With the customer acquisition costs below $55 and spend, I think on average somewhere around $100-150 per customers within the first year. You would think to yourself, "Well, this is painting up to be a really profitable picture." But in actuality, the numbers paints a totally different story. When you look at just their net losses, net losses have been expanding over time and they have cumulative losses of over $670 million. Despite that low overhead in terms of marketing costs, they still have a ton of costs associated with fulfillment. A lot of money spent upfront to acquire those customers, and then this very heavily depreciating asset, only 20 turns on average, that that clothing goes through before it's no longer usable to be rented out. On top of the revenue shared, they have their partners. It actually ends up painting not that attractive economically.

Asit Sharma: Yes. I may be mistaken in this, but I believe that the average depreciation period for the clothing that they have on their books is three years, which is as fast as you amortize software. Now, that doesn't mean that they get rid of clothing in three years. If they're able to keep items for five years or longer, certainly they'll do it, but fashion shifts, so the numbers that they used to depreciate the clothing may be indicative of how long they can actually keep a piece before it really has little demand in the marketplace. That's one issue. Emily, you're right that the cost associated with moving clothing inventory to hang on to it, to disposing of it, figuring out what's obsolete. Those are not simple costs. You have to spend a lot of money to automate processes to make that profitable. They have not been able to do it yet. I was curious, just looking at the balance sheet. If I close my eyes to everything else and look at these cumulative losses, compare that to the assets on the balance sheet in the liabilities, I see what does that accumulated deficit account looked like at the bottom of the balance sheet? How have the loss has been supplied? They've been supplied through multiple preferred share issuances, and these are convertible shares. The company has a history of diluting its shareholders. Something else which bothered me about the balance sheet is they've got a very large piece of debt relative to the size of the rest of the balance sheet. That is basically their working capital line, which is more or less at this point equivalent to long term debt. They were paying 15 percent interest on that, they've refinanced it in a subsequent event after the filing of it's perspective. 

Now they're only paying 12 percent [laughs] on that debt. You can hear my air quotes there around the word only. They are allowed to pay up to five percent of that interest in kind. What the heck does that mean? [laughs] Interest in kind is a very arcane function in the finance world. You don't see it a lot these days, but what it means is that if I owe Emily interest and I have a bunch of bananas and I owe her, let's say 12 bucks on a loan that I've got out to her, I can trade her some bananas for part of that interest [laughs] and pay a little bit less out of my pocket. That's exactly what this company is doing. With It's working capital financing, it is paying 12 percent on its line of credit and it is offering warrants on its stock up to five percent of that total interest cost, so the cash burden is less. But you know who's picking that up? Yes, it is you and me shareholder. If we buy this stock. We're getting diluted two ways. This company likes to issue shares historically to supply it's losses and it likes to cut deals to try to make the burn on that high interest feel a little less hurtful on its cash bottom line. Now, I have to point out here that you don't start out with such financing overnight. Once you get to what really is, wow, really high rates of interest. It takes a period of years where your model just isn't working. You can just look at the terms on their debt and understand what the past history has been. I wanted to point out here that, and lead to a very nice job of walking through the product ROI. They also show how, over a five-year period, they've returned something like 300 percent expansion to their retail clothing partners in terms of the gross merchandise value those partners have been able to sell on the platform. What that means is that this model is working really well for a lot of parties. It's working really well for their clothing partners, who are selling more and more each year. It's working great for those 55,000 subscribers who can wear those items 83 times a year and realize much less cost. It's working well for the lenders, it is working well for those who received preferred shares. Who's this not going to work for? In my opinion, this might not be such a good deal for common shareholders who buy into the company.

Emily Flippen: There were a lot of things that confused me in this report, but I have to say. I think one of the things that confuses me the most was actually, as you mentioned, that marketing spend and the customer acquisition. We spent a lot of time talking about unprofitable companies on Industry Focus but companies are typically unprofitable because they're scaling really dramatically. Part of that scale, it means, "We're here to land grab, we're here to get a lot of customers all at once. The value of those customers over time will mean that this venture ends up being really profitable for us at some point in the future." It is really strange to see a company that is posting over, I think for the first half of 2021, over $80 million in net losses, while spending less than $10 million of that on marketing costs. I almost wonder why they have this strategic decision to spend so little on marketing if these ROI numbers they have on their products, as well as our customer costs, are so economical. It makes me think, "It's really probably not that economical, they haven't been in a financial position to be able to spend money on marketing to scale up their product. They're just trying to make this very small customer base profitable and it's not working at the scale that they exist with today." I just found myself really scratching my head because it really flipped the script, I guess, on what we're accustomed to seeing with these subscription-based models, especially for things like clothing.

Asit Sharma: Yes, and it makes me think, Emily, that the original pricing of the models were off, and that the company somehow didn't optimize the way they should've priced this. The small customer base it's active now, I think maybe can rebound some after COVID, it's been more active in the past, not by a lot. But I wonder when you have such a high product ROI and you still have these big losses, yes, part of it you can see in product obsolescence, they got these costs on its income statement, the high depreciation, but part of it is just that this model isn't scaling. They're putting money into marketing and they're not getting a yield. It's like a hamster on that wheel. This must be a lack of pricing power, they don't really have that much of competition. Sometimes you can start business, however, and convince investors that this model will scale. But the pricing is off, the investors don't question that seriously and you get a certain number of years into that model and you can't change customers expectations. It will be very hard to go back now and raise those subscription prices by the 20-25 percent. They would really need to start showing some ability to scale if revenue increases and it is a mystery. I think it's a very great point, Emily. Why they're not putting more money into marketing for that land grab to try to get more active customers? As I mentioned to you, when we were exchanging flax and preparing for this episode, this came across to me as a company that was irresistible to try to figure out what the mystery is here. You know from the start you don't want to invest there. I hate to say this, I'm not going to call it a train wreck, but a minor car wreck on the road, you can't help but look as you go by. I found myself spending a lot more time on this than I expected to. Emily, as you know, I got into the weeds and you helped me out looking at the exact way they are accounting for their overhead cost just trying to do some thumbnail calculations. Everything seems a bit off here. There's another little mystery for those who are interested in nerding out on this. In why on their income statement they lumped together, depreciation costs with some revenue share costs on their below the line expenses. It's almost like they don't want you to break out. What is the exact amount of revenue share that they have to pay to their partners? What is the amount of depreciation on the clothing that they own that they're recording? What is the depreciation on their fixed assets? There's a little mystery in there that if I had the time, I would try to unravel further. But yeah, a great story here, Emily. I really love the concept. I like the metaphor of the closet in the cloud. I like that this empowers women and I feel that there's so many great things about just trying to participate in a circular economy. But I flip this back to you as we head out here. Enough about my opinion, would you be even interested in keeping this on your radar screen?

Emily Flippen: I might keep it on my radar not because I think it's going to turn around its business, but because I genuinely want it to succeed. Again, I love when I see businesses that I think have really important missions. Well, Rent the Runway is clearly a bit more luxury, been something that is operating more downstream. I still think they are doing something important that has an opportunity. I just think they are not [laughs] executing well at at all right now. I almost feel like it's too early for this company to be public. In addition to everything else we mentioned, their internal controls were at horrible mess, very much gave the impression that there's somebody sitting in front of an excel sheets who is managing their financial statements. I'm being dramatic when I say that, but yeah, their journal entries right now are not being reviewed, they're largely manual processes. With the small number of subscribers they have these huge losses, it just begs the question of, why are you going public? I think you answered that nicely, which is to say they need the money. So I'll keep an eye on it out of maybe more of a curiosity, but I completely agree this is not the type of business that I will be investing in anytime soon.

Asit Sharma: Sounds good, we'll keep watching it then.

Emily Flippen: Well, Asit, thank you so much as always for joining.

Asit Sharma: Emily, this is so much fun, I appreciate it looking forward to the next one.

Emily Flippen: Listeners, that does it for this episode of Industry Focus, if you have any questions or just want to reach out and say, hey, shoot us an email at [email protected] or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against any stocks mentioned. So don't buy or sell anything based solely on what you hear. Thanks to Tim Beyers [inaudible 02:55:25] screen today, for Asit Sharma, I'm Emily Flippen. Thanks for listening and Fool on!