Digging into Rent the Runway
With rapidly decelerating growth rates, weakening cohort retention metrics, horrific customer reviews, limited inside ownership, and a concerning debt load, Rent the Runway is not for me.
Introduction
Founded in 2009, Rent the Runway (NASDAQ:RENT) is an e-commerce subscription business that allows people (primarily females) to rent - rather than purchase - designer clothes. The business concept intuitively makes sense. Designer clothes with recognisable brands (e.g., Gucci, Prada, Fendi, Burberry) are VERY expensive and out of reach for most ordinary people, and often only get worn a handful of times, substantially increasing the “cost per wear”. Rather than spending thousands of dollars to purchase an individual item of clothing, Rent the Runway subscribers are able to access a “closet in the cloud” and rent specific items of designer clothing for specific events.
Rent the Runway’s core customer is a working woman aged in her 20s-40s who is well-educated, socialises at least 2x per week, and wears an item of clothing from Rent the Runway around 80x/year. Women use the service primarily for casual and weekend wear.
In this article, I break down the framework I used to assess Rent the Runway over the course of 1-2 hours of research and decide not to proceed with further due diligence.
How did I hear about this business?
I first heard about Rent the Runway from a 20VC podcast last week with the Co-Founder and CEO, Jennifer Hyman.
Given the subject area, I wasn’t that interested at first but found the CEO incredibly sharp and insightful, particularly when detailing: 1) the logistical challenges involved with the business and 2) her resolve to reach profitability. I’ve previously looked at another subscription clothing business listed on the NASDAQ (Stitch Fix; NASDAQ:SFIX), so thought Rent the Runway was worthy of a further look.
What first attracted me to do more research?
1) A contrarian buy?
Since going public at the height of the tech market mania in October 2021, Rent the Runway’s share price is down an astounding 89%.
As a natural contrarian, I love looking at businesses that look oversold and hated by the market because these periods of short-term volatility often provide fantastic entry points for a long-term position.
2) An impressive investor base
Although Rent the Runway has performed abysmally since going public, it had a phenomenal list of investors as a private company.
Here’s a quick breakdown of some of the high-quality firms that invested in Rent the Runway as a private company (based on Crunchbase data):
Seed ($1.8m) - Bain Capital Ventures.
Series A ($15m) - Bain Capital Ventures.
Series B ($15m) - Kleiner Perkins.
Series C ($24.4m) - Kleiner Perkins, Bain Capital Ventures, American Express Ventures.
Series D ($60m) - TCV, Bain Capital Ventures, Reimagined Ventures.
Series E ($60m) - TCV, Bain Capital Ventures, Fidelity.
Debt financing ($200m) - Temasek Holdings.
Series F ($125m) - Bain Capital Ventures, Franklin Templeton Investments.
Rent the Runway had some impressive investors (e.g., Bain Capital, Kleiner Perkins, TCV) who each followed-on in subsequent funding rounds. That’s normally a VERY bullish sign.
The post-money valuation for the Series F round was $1.0 billion, around 7.5x above the current market cap of $133m.
All in all, Rent the Runway raised around $526m (including debt) from some of the best and brightest in private markets. In their IPO, they raised a further $357m (source), bringing the total capital raised to almost $900m.
With a current market cap of $133m, Rent the Runway is trading at around 15% of their total capital raised.
Either the above investors made a grave mistake backing Rent the Runway or it’s a screaming bargain. I’m leaning towards the former.
3) Elements of virality
Rent the Runway also appears to have some elements of virality. According to management, 80% of subscribers acquired from FY19-FY22 came through organic channels, suggesting strong customer satisfaction and attractive unit economics. Customer engagement also appears very high, with the average subscriber using the service around 80x/year.
How are Rent the Runway’s Financials?
1) Revenue/Subscribers
I’ve taken the below figures straight from Rent the Runway’s latest Q1 2023 investor presentation.
As would be expected, the business suffered a major hit to revenue during FY20 which, given the high fixed cost base of the business, had a pronounced impact on gross and adjusted EBITDA margins. However, the business recovered well in FY22 and reached all-time highs across all core metrics, including becoming “profitable” on an adjusted EBITDA basis (i.e., bullshit earnings, particularly for a capital-intensive business with significant depreciation costs). The high CapEx involved with Rent the Runway accounts for the large delta between FY22 adjusted EBITDA and free cash flow (FCF) margins.
Using an LTM revenue number (which includes Q1 FY23), Rent the Runway trades on a P/S ratio of <0.5x. Seems cheap at first glance if the business can become profitable.
87% of Rent the Runway’s revenue comes from subscriptions (where people get access to a pre-determined number of clothing items each month for an ongoing fee) vs. one-off rental agreements from non-subscribers.
As can be seen below, growth in active subscribers has slowed substantially from late-2021 to high single digits in this latest quarter. In Q1 2023, the total number of subscribers (includes paused subscribers) of 181m is roughly the same as it was in Q1 2022 (177m).
It’s clear the business has encountered major headwinds in a tough macroeconomic environment. This makes sense to me. Rent the Runway appears a highly discretionary subscription offering that that would be among the first to be cancelled in a recession or if people were attempting to reduce their expenses. It’s not like our phone bill or Spotify subscription.
One could argue that Rent the Runway should benefit in tougher macroeconomic conditions as consumers “trade down” and decide to rent vs. purchase designer clothes, but we’re not seeing any evidence of this in their numbers.
Consistent with the above slowdown in subscriber growth, Rent the Runway’s YoY revenue growth rates have decelerated sharply from 100% in Q1 2022 to 11% in the latest quarter. Indeed, revenues have declined QoQ for the last two quarters.
Q2 guidance calls for $77-79m revenue, which represents further deceleration and anaemic 0-3% YoY growth.
However, management expect growth to re-accelerate in the back half of 2023, which seems surprising given the above charts and broader expectations for a US recession in late-2023. 2023 guidance calls for $320-330m revenue, which would represent 10% growth at the midpoint. It seems like there’s a high risk of downgrades to that FY23 revenue projection.
2) Gross Margins
Gross margin of 42% in the latest quarter is an improvement from prior quarters, but are horrific in the context of an online subscription business.
There are significant variable costs involved in a business like Rent the Runway - fulfilment involved with collecting items, washing/cleaning them, packaging them, and sending back to other customers for wear, along with substantial depreciation each time an item of rented clothing is worn. This is a TOUGH business model to crack.
3) Adjusted EBITDA
Rent the Runway has consistently generated positive adjusted EBITDA over the past few quarters (6% margin in Q1 2023) and expects FY23 adjusted EBITDA margins to rise to 7-8%.
4) Stock-Based Comp
Management guidance calls for FY23 stock-based comp of $30-31m vs. $320-330m revenue, so just under 10% of revenue. In Q1 2023, YoY shareholder dilution from stock-based comp was around 4%. Given the business is not cash flow positive, there’s no option to repurchase shares to offset dilution from stock-based comp, so this is something investors need to consider.
Red Flag #1 - Customer Experience Appears to be Declining Rapidly
In their Q1 2023 presentation, management presented the below cohort retention chart to indicate that cohort retention/expansion has been strong over time. While this appears true for FY18, FY17, and pre-FY17 cohorts, I’m struggling (perhaps I need glasses?) to see cohort expansion from FY19 onwards, with cohort contraction becoming more pronounced in FY20 and FY21.
This weakening in cohort retention is consistent with public reviews which are abysmal and among the worst I have ever seen for a public company. Negative customer reviews are primarily centered around three complaints:
Opaque pricing policies with customers being charged despite cancelling their subscription.
Receipt of damaged or faulty clothes (e.g., with a stain or significant body odour).
Difficulties finding attractive clothes to wear or desired items of clothing are not available.
See a breakdown of Rent the Runway’s review on popular comparison websites:
Sitejabber - 1.3/5 from 643 reviews
Trustpilot - 1.3/5 from 118 reviews
Better Business Bureau - 1.1/5 from 54 reviews
These horrific customer reviews alone are almost a reason to pass, independent of all other factors. Rent the Runway is a business that should be delighting its customers with a cost-effective option to purchase designer clothes outright, not pissing off its customers. This portends high churn and slowing growth in the years to come.
Employees are also not particularly satisfied with Rent the Runway or their CEO. Glassdoor reviews are very average at 3.0/5 with a 43% CEO approval rating. These are very ordinary numbers for a mission-driven business.
Red Flag #2 - High Debt Load
Another potential reason for Rent the Runway’s steep fall in share price since their IPO is their high (and rising) debt load.
At the end of Q1 2023, Rent the Runway had $141.4m in cash and cash equivalents with $281.2m of net long-term debt. In other words, Rent the Runway has more than 2x as much long-term debt as their current market cap …
Taking into account this net debt position of $139.8m, Rent the Runway’s enterprise value increases to $273.2m (vs. a market cap of $133.3m).
In Q1, interest expense on their long-term debt was $8.8m and $9.3m in Q4 2022. Given that Rent the Runway is still several quarters away from generating free cash flow (at least), this debt balance is a major concern, particularly with rising interest rates.
Spending 10-15% of revenue each quarter to service interest payments on debt is a precarious position for any company, let alone one with rapidly decelerating growth and a substantial fixed cost base.
Red Flag #3 - Limited Inside Ownership
As Rent the Runway has raised substantial capital to date (almost $900m including their IPO), it’s not surprising to see that senior management has been diluted down to small ownership percentages. Based on TIKR data, these are all the senior executives with more than 0.5% ownership percentage in the business:
Sid Thacker (CFO) - 1.17%.
Brian Donato (CRO) - 1.17%.
Beth Kaplan (Advisor) - 0.86%.
Sarah Tam (Chief Merchant Officer) - 0.56%.
Cara Schembri (General Counsel) - 0.52%.
Missing from this list? Co-Founder and CEO Jennifer Hyman with a minuscule 0.30% ownership stake, equating to around $400k. Not much “skin in the game”.
Red Flag #4 - How Scalable is this Business Model?
I also have doubts about the long-term scalability of Rent the Runway’s business model. It seems like a business where margins will always be constrained by a few core issues:
Rented clothes will always need to be collected, inspected, cleaned (or repaired), and sent back to future customers, which is a difficult process to automate with machines or AI. Perhaps robots will be able to inspect and clean clothes at some point in the future, but this seems hard to imagine in the next 12-24 months.
There is a continual need to keep up with the latest fashion trends and acquire new designer clothes to offer the best selection to customers. Moreover, clothes do not last forever and old/damaged clothes will inevitably need to be replaced over time. As such, additional items of clothing will always need to be purchased each quarter, reducing free cash flow margins. This is not a business where you can rest on your laurels, even at scale.
Wrapping Up
Rent the Runway seemed like an attractive investment at first glance. It’s acquired solid scale, has strong brand recognition, has built out an impressive logistics and fulfilment infrastructure, and has attracted some big-hitter investors (e.g., Bain Capital Ventures, TCV, Kleiner Perkins).
However, despite the 89% drop in share price since their IPO in October 2021, I’m not interested in purchasing shares in Rent the Runway. Indeed, I struggle to see a valuation where I would ever consider initiating a position.
Shares might rebound from these depressed levels if inflation cools and interest rates drop, but I struggle to gain conviction on the long-term viability of the business model and terminal margins. Combined with rapidly decelerating growth in both revenue and subscribers, weakening cohort retention metrics, horrific customer reviews, limited inside ownership, and a concerning debt load, this investment is not one for me.
I much prefer to look for businesses with a more predictable path to long-term value creation, like Spotify, Axon Enterprise, or Coupang.