Description

Introduction:

Rent the Runway (NASDAQ: RENT) is an online rental service for women’s designer clothing and accessories trading at 11.9x 2023E EBITDA (low end of guidance). The company was founded in 2009 by current CEO Jennifer Hyman and came public in October 2021 at a nose-bleed valuation of 12x EV / Sales (LTM). Evidently, the stock was egregiously overvalued and since then has plummeted from its IPO price of $21 per share to the current price of $1.44 per share. A lot of money has been lost in this name and investor sentiment has soured. 

The severe loss of legacy investor capital, high-interest rate environment, and the company’s inability to provide relief for Wall Street’s short-term focus on profitability have combined to push investors far away from the stock. However, I believe this Doomsday narrative is overplayed. Rent the Runway is actually a wonderful little business with bright prospects ahead. I expect the company to experience a reacceleration in sales growth to rates well north of 15% (keep in mind that the last few quarters and the rest of 2023 are comping against huge pent-up consumer demand from Covid and a rush to return to in-person events).

Additionally, the company has recently right-sized its fixed cost structure to achieve $25mm in annual savings and pushed out its debt maturities by 2 years. More importantly, RENT possesses wonderful unit economics that I expect will translate into high returns on capital as the business scales further and achieves profitability over the next several years. Annual product ROI is in excess of 90% and inventory costs as a percentage of sales are 20 to 25 percentage points lower than your typical higher-end apparel retailer (e.g. Neiman Marcus). In addition, RENT has 750+ brand partnerships and, since its inception in 2009, has enjoyed a near 100% retention rate. This is especially impressive when you consider that the average fashion designer brand will change 10% to 20% of its distribution partners annually. 

RENT possesses the necessary infrastructure and operational capacity to support 4x its current level of active subscribers. The key goal post for me is $600mm in sales, which is a level of scale that management has said they can generate at least 15% EBITDA - Capex margins (or $90mm) with. This only requires a 2x increase in subscribers from current levels and no change to ARPU. At a 10x EV / (EBITDA - Capex) multiple, which is still a discount to brick-and-mortar peers, the implied share price is $9.3 per share, representing a 7x. If they miss this target, even getting to a 10% margin would imply a 4x in share price. I believe these targets are achievable within 5 years.

Company Overview:

RENT generates sales through three channels:

1. Subscription
2. Reserve
3. Resale

Customers can subscribe to one of four plans, ranging from 5 to 20 items at $94 to $235 per month, respectively. Additionally, subscribers can add additional item slots or shipments per month at an incremental price of $27 to $31 per item and $39 to $50 per shipment. Item add-ons have minimal incremental costs to the company and therefore are very high margin. On average, 28% to 30% of subscribers will add additional items. Additional shipments are comparatively more expensive for the company, but they are compensated by the additional fee. The Reserve segment allows customers to reserve a specific garment for four to eight days, up to four months in advance. The Resale segment is a second-hand marketplace where customers can purchase garments from RENT at up to 90% discounts to retail price.

In addition, RENT sources its inventory through three channels (as of FY 2022):

1. Wholesale (42%)
2. Share by RTR (27%)
3. Exclusive Design (31%)

Wholesale consists of items acquired directly from brand partners, generally at a discount to typical wholesale price. Share by RTR consists of consigned items acquired from brand partners under a performance-based revenue share agreement, generally subject to a maximum cap. Exclusive Design consists of items designed in collaboration with brand partners using collected data and manufactured through third parties.

Moat

What are RENT's competitive advantages that allow it to enjoy above-average unit economics?

1) RENT is one of the lowest-cost distributors of luxury fashion. The company has cultivated strong relationships with 750+ high-end brands for over a decade by introducing customers to designers that they otherwise may not have discovered. In fact, 98% of customers rent brands they've never owned before, so alongside being a distributor, RENT is also a valuable marketer for its brand partners. Indicative of the robustness of these relationships is that RENT has a near 100% retention rate of all brands it has worked with since 2009. The trust inherent in these long-term relationships has allowed RENT to continually grow its Share by RTR channel, allowing it to acquire inventory without purchasing it upfront. The company is able to take advantage of this channel because brand partners trust them to turn enough inventory to maximize the revenue share. This inventory is virtually risk-free for RENT because if it doesn't perform, they don't pay for it. Furthermore, it aligns incentives between RENT and its brand partners. High-performing garments generate more revenue for brands when acquired under revenue share versus through Wholesale. So, brands are incentivized to provide a greater amount of its products to RENT on consignment, which is a huge cost advantage for the company.

Additionally, RENT has been collecting large amounts of data on its customers for nearly 15 years. The company has a strong feel for what its customers like and do not like wearing. In collaboration with brand partners, RENT uses this collected data to design exclusive clothing that is manufactured by third parties at less than 50% of Wholesale cost and with minimal revenue share agreements. Compared to Wholesale, the necessary upfront cash outlay is lower, margins are higher, and therefore product returns on capital are wonderful. 

Brick-and-mortar inventory costs (which are mostly reflected in cost of goods sold) are typically over 50% of sales. If we compare this to RENT, in 2019, 74% of RENT's inventory was acquired through the Wholesale channel. Accordingly, capex (product acquisition cost) was $118mm, or 46% of sales. In 2022, they reduced Wholesale to 42% and capex declined to $62mm, or 21% of sales. Amazingly, if we account for the eventual liquidation or sale of rental product (which has proven to be recurring), RENT's capital requirements are even lower. Net capex as a % of sales has declined substantially from 2019 to 2022: 36.9%, 21.9%, 6.0%, 11.9%. Evidently, RENT is less capital-intensive and has a structural cost advantage over physical retailers. This gives management the excess funds to invest heavily in improving customer experience and building out its fulfillment and logistics infrastructure.

2) RENT can recurringly monetize its garments over a lengthier time frame. Think about the life cycle of a garment at a brick-and-mortar retailer such as Neiman Marcus. It will purchase a trendy or in-season design at wholesale price and mark-up the product around 2.2x to 2.5x. For the first 3 to 6 months, it will try to market this piece as best it can. Once sold, the piece is gone. It is monetized once. If it's struggling to sell, the garment will be offered at discount/promotional prices or written down as the design goes out of style. Once the new trend begins or designers release new pieces, the process repeats. The effective useful life of many of these trendier garments (which is what RENT customers skew towards) have an effective monetizable life of less than 1 year. Due to the inevitable need to discount most garments, product ROI (on a revenue basis) for this business model will be at most 2.5x over the useful life. 

This type of business model prefers having full ownership of inventory because it allows the physical retailer to have control over curation and to offer sales and promotions when necessary. Contrary to this, online subscription rental services want to purchase inventory as cheaply as possible because their goal is to turn inventory into a long-term, recurringly monetizable asset. RENT is able to monetize its inventory every time a customer selects the garment in her shipment. Per the company, the average RENT garment is rented 30-40 times and has a useful life of 3 years. As of 1H'21, the average upfront cost per item was $90. For illustration, under the $144 per month plan, each garment generates $14.4 in revenue per rental. Rented 30 times, it generates $432 in revenue for an initial upfront cost of $90. With approximately 60% contribution profit margins, RENT is able to achieve 2.9x product ROI (on profits) without even accounting for additional revenue from the potential sale of the product. This return profile will continue to improve as RENT increasingly transitions a greater percentage of its inventory procurement towards the capital-light channels.

Other rental subscription services will copy RENT's model, but they will be unable to replicate its economics because of the obstacle of time and capital. They are burdened by the time necessary to demonstrate to brands that they can move inventory, as well as by the capital to acquire the necessary product (initially at predominantly wholesale price) to even begin proving the aforementioned ability. While competitors play catch-up, RENT will continue to gain scale efficiencies that allow it to acquire a growing percentage of its inventory at further cheaper costs. 

3) RENT faces little genuine competition. The businesses with the financial resources to adequately compete against RENT are also the ones that are disincentivized from doing so. Brick-and-mortar retailers will not because the concept of renting clothing contradicts and would cannibalize their existing business models. Traditional retailers want to reinforce the notion that fashion trends go out of style quickly because they want consumers to continually come back and buy new, trendier garments every season. They can't push this narrative through a rental model. 

Additionally, when Hyman was first launching RENT, she discovered that the company's existence could in fact be complementary to brick-and-mortar retailers. Customers have been "renting" expensive dresses from retailers for decades by purchasing the garment, leaving the tag on, and returning it at a later date. The retailers have no way to prevent this behavior. In fact, they're disincentived from doing so because those customers tend to be the ones with the largest basket sizes. RENT plays a pivotal role in lowering the frequency of this activity and so it's not in the retailers' interests to compete against RENT.

Luxury fashion conglomerates like LVMH are also not competitive threats because launching a subscription rental service would over-flood the market with their product, diluting the brand value that protects their moat. So really, RENT's competitive threats are comprised of undercapitalized entrants facing the gargantuan obstacle of time and high start-up costs. True, one might contend that a large spawner business like Amazon may eventually compete against RENT if the economics and opportunities are truly exceptional (as it now does versus Spotify and Netflix). However, as of January 2023, RENT has partnered with Amazon to launch an online second-hand storefront, effectively negating any near-to-medium-term competitive threats. 

4) RENT has strong network effects. I know, "network effects" are an over-used sales pitch for virtually every subscription company that exists, but for RENT it is truly a durable source of competitive advantage. The success of a second-hand clothing rental model is predicated upon abundance and trust. Network effects deal with the former. Consumers gravitate towards rental platforms with an abundant and diverse selection of designs because they are in search of something new. Similarly, brands want an abundance of consumers that their designs will be marketed towards because it expands their reach. More subscribers using RENT will incentivize more brands to partner with the company, which further increases the abundance of garments and attracts more customers to the platform. It is a virtuous cycle that RENT has been spinning for over a decade. Of course, competitors can achieve this, but RENT's first-mover advantage will ensure that it remains ahead. 

5) RENT's logistics processes are best-in-class and difficult to replicate. As I mentioned earlier, the success of a clothing rental service is also reliant on trust. Customers need peace of mind that garments are clean and in perfect condition, and brands need to trust in the distributor's ability to turn product quickly. A traditional e-commerce company may have fulfillment costs that are 25% of sales. RENT's are slightly higher at ~30%, but this includes everything from two-way shipping to dry cleaning, wet cleaning, repairing and restoring garments, packaging costs, etc. RENT has vertically integrated all of its logistics operations to allow for the highest level of quality-control. Indeed, on a pound per hour basis, RENT runs one of the country's largest dry-cleaning operations. The company is able to receive millions of garments back from customers, clean them, restore them to perfect condition, and ship them back out with a zero-day turnaround time. This is a massive competitive advantage because it is highly capital-intensive to get off the ground, yet it is also a crucial barrier that competitors need to cross if they want to provide an optimal customer and brand partner experience (spoiler alert: they do). 

Fortunately, most of RENT's potential competitors do not possess the proper logistics infrastructure and processes. Most e-commerce and retail companies focus on outbound logistics, i.e. pick, pack, and ship. For example, 95% of Amazon's processes are built around the pick, pack, and ship process. There's no focus on restoration because if you're selling a product, you don't want customers to return it in the first place. However, RENT is the opposite. Its core competency is reverse/inbound logistics. 98% of product that comes into RENT's warehouses are products that they're receiving back from customers, so there's a need to optimize restoration of garments. To maximize the recurrence of inventory monetization, garments must be in like-new condition as often as possible. Indicative of RENT's best-in-class reverse logistics is that between 2020-2021 it lowered product deactivation rates by 30% (meaning the company kept inventory in like-new condition 30% more YoY) while maintaining zero-day turnaround times. Longer useful lives and faster turnaround times allow RENT to turn its inventory more, which drives an increase in product ROI. RENT has spent the last decade building out its best-in-class logistics and can now reap its advantages while competitors prioritize catching up. 

The following are other key supporting points for investing in the company:

Large Market Opportunity

Rent the Runway's core demographic consists of women in the US who are employed, college-educated, and over the age of 25. The company has stated that there are ~38mm women who fit these criteria, 56% of which have indicated that they'll subscribe to fashion over the next 5 years. This implies a total addressable market of 21mm women. With 145K ending active subscribers as of 4/30/23, RENT still has only ~1% market share of this estimated TAM despite being generally recognized as the market leader in this niche. Additionally, return-to-office should continue providing a tailwind.

The industry itself is quite nascent, but I think the trends are legitimate. Millennial and Gen-Z consumers are increasingly prioritizing experience over ownership. Per Euromonitor, in 2022, access models accounted for 86% of the Home Entertainment market, 69% of the Recorded Music market, and 23% of the Hospitality market - think Netflix, Spotify, and Airbnb. This is up from 71%, 64%, and 17% in 2020, respectively. These businesses rose to the top by prioritizing customer experience and value proposition. With its strong value proposition and fanatical focus on the customer, I believe RENT is well-positioned to pioneer a similar shift in the luxury retail industry, capturing share from high-end brick-and-mortar and fast-fashion retailers. 

Strong Value Proposition

Illustratively, RENT's subscription plan of 10 items at $144 per month is a cost per item of $14. The GMV that the consumer receives per month is ~$5,000, or 35x the monthly subscription price. Converted annually, the customer is receiving $60,000 in GMV while paying $1,728. The value proposition is clearly very strong. The counterargument to this is that customers wouldn't get bored of their garments fast enough to warrant wanting to pay a recurring fee to have the privilege of variety. However, what you need to recognize is that customers can continue to "rent" the same garments indefinitely if they love them (and then buy them at a discount). So, if a customer desires, they can mimic ownership while paying rental prices.

High-Quality and Shareholder-Aligned Management

Hyman is a solid manager. As an owner-operator, she has a vested interest in the future performance of the business. She is well incentivized with about 5% share ownership of the company, or around $4mm. Insiders own around 16% of the company. Additionally, Hyman possesses demonstrable business acumen. At the onset of Covid, she negotiated for revenue share agreements with a majority of the company's 750+ brand partners and secured debt financing in an environment increasingly starved of credit, which was crucial in keeping the business afloat. Hyman has a fanatical focus on the customer, but she is also prudent with marketing and product investments and has demonstrated an ability to be decisive with cost-cutting, furloughing half of the company's employee base during Covid and removing $25mm in PF annual fixed costs. Based on her track record and incentives for wanting the business to succeed, I feel confident that Hyman will be an above-average steward of shareholder capital going forward. 

Positive Environmental Impact

I recognize that there is a lack of concrete evidence supporting any correlation between ESG initiatives and firm value. However, in a world where banks are increasingly turning financing away from sectors with harmful environmental impacts (e.g., fast fashion, which is the second biggest consumer of water and accounts for ~10% of global carbon emissions), it is certainly an advantage to be ESG-conscious (as long as it's not at the expense of economic returns, which I don't believe it is in the case of RENT). 

The Numbers

Shares Outstanding (Diluted): 76.9mm

Market Cap (as of 8/30/23): $110.7mm

Enterprise Value (as of 8/30/23): $265.9mm

As I mentioned earlier, management has stated that their goal is to generate roughly 15% EBITDA - Capex margins on $600mm in sales. To be conservative, let's run the numbers at 10% margins, which I believe is very feasible on both a top-line and cost structure basis. Even at this level, RENT would be a multi-bagger. Let's break it out:

$600mm Sales Target:

The company is currently doing about $170 in monthly ARPU (on active subscribers). At this level, every 100K subscribers roughly translate into $200mm in sales, meaning RENT would need around 300K active subscribers to generate $600mm. This is about double the current subscriber base of 145.2K. Getting to this level in 5 years would imply a 15% CAGR. As the leader in a niche market slated to grow at 11% per year over the next 10 years, I think it's reasonable to assume that RENT can grow at least 15% annually.

In fact, the company has guided towards 25%+ long-term revenue growth. If we apply this to 2023E sales of $320mm (bottom-end of guidance) and extrapolate out, RENT could presumably be generating almost $800mm in sales by 2027. Can they get to $800mm? Potentially, yes, though they'd need to pull the pricing lever as well to expand ARPU. However, the point is that I strongly believe $600mm is achievable, especially since it requires minimal growth in ARPU. This also does not account for growth in the Reserve and Resale categories which will provide additional uplift.

Cost Structure:

Here is where RENT's cost structure stands as of FY 2022:

Fulfillment (variable): 34.3% (% of sales)

Technology (fixed): 18.7%

Marketing (variable): 11.8% 

G&A (fixed): 36.8%

Revenue Share (variable): 10.6% 

Gross Capex (variable): 21.0%

In 2022, technology + G&A costs were $165mm. However, this is before the impact of the fixed cost restructuring, which is expected to result in $25-$27mm in cost savings in 2023. Pro forma, technology + G&A costs would be $140mm. At $600mm in revenue, the company is guiding towards technology + G&A costs of about 25%, which would imply $150mm. I believe its reasonable to assume minimal dollar growth in technology + G&A given that the current infrastructure supports considerably more subscribers and that there's high operating leverage at greater revenue scale. 

RENT is also guiding towards 10% marketing costs ($60mm), 10% revenue share costs ($60mm), and less than 30% fulfillment costs (<$180mm). These compare to 2022 cost figures of $35mm, $31mm, and $92mm, respectively. As the company achieves greater scale efficiencies, these variable cost margins should stabilize at, if not below, these levels. The company's target is to increase the Share by RTR and Exclusive Design mix to 67% of inventory acquisition, which will drive down capex. Currently, capex stands around 22% - I think it can get to around 15% in the next 5 years. Here is where the numbers shake out:

2027E Revenue: $600mm

(-) 2027E Fulfillment: ($180mm)

(-) 2027E Tech + G&A: ($150mm)

(-) 2027E Marketing: ($60mm)

(-) 2027E Revenue Share: ($60mm)

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2027E EBITDA: $150mm (25% margin)

(-) 2027E Product Capex: ($90mm)

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2027E EBITDA - Capex: $60mm (10% margin)

There are few good public comps to benchmark against. However, Nordstrom trades at 10x-14x EV / EBIT (I reference EBIT instead of EBITDA - Capex because brick-and-mortar retailers record product acquisition costs in cost of goods sold). With lower capital requirements, higher margins, and faster growth, I believe RENT should trade for at least the same multiple, if not higher. With 77mm diluted shares outstanding, at 10x-14x, RENT's range of intrinsic values by the end of 2027 is $5.4 to $8.5 per share, representing a 4x-6x return. There is even more upside if they achieve 15% margins.

Risks

Before I finish, I think it's prudent to touch on the debt. Accounting for PIK, RENT has a $296.6mm Credit Facility due 2026 with a $50mm minimum liquidity covenant (the "Temasek Facility"). This facility currently bears interest at 12% per year (2% cash / 10% PIK) until February 2024, after which the rate will increase to 13% (2% cash / 11% PIK). There will continue to be annual step-ups of 100 bps (in PIK) for the remainder of the Temasek Facility's duration. Additionally, the 2% cash rate will increase to 5% in August 2024 (and the PIK rate will decrease accordingly). This facility was amended in January 2023 to provide for these terms. In connection with the amendment, RENT granted warrants to purchase up to 2mm shares of the Class A shares at a strike of $5.00 per share (expiring in January 2030). In January 2023, RENT was trading between $2.95 and $4.29 per share. 

Illustrated below, let's assume RENT allows its debt to continue PIK'ing until maturity. At the end of the term, the outstanding principal would be $413mm with accumulated PIK interest of $141mm. Cash interest paid would have been about $51mm, in line with the minimum liquidity covenant. Regarding cash interest, even if they let interest compound for the full facility term, the company has sufficient cash interest coverage from its balance sheet cash and EBITDA generation, so I don't think it should be an issue. RENT currently has $141mm of cash on the balance sheet. Since October 2021, they've burned an average of $23mm of cash per quarter, primarily to fund capex - implying that the current $91mm of cash in excess of the minimum liquidity covenant will last around 1 year. However, this cash burn should decrease as the business scales and as inventory acquisition channels become increasingly capital-light. In fact, the average cash burn over the last 3 quarters has decreased to $17mm - implying that the current $91mm of excess cash will last 5 quarters. I believe this positive trend will continue, leaving the company with the ability to opportunistically pay down a portion of its debt over the next year or two. This will help facilitate a refinancing, and at that point, cash burn should be materially lower. Indeed, the debt is large, but I think the risk of permanent loss of shareholder capital is minimal

Catalyst

Reacceleration of top-line growth to rates north of 15-20% in 2024 quarters. The company is currently comping YoY against elevated demand as consumers rushed back to the office and in-person events. Once this stabilizes and subsequently inflects back up, shares should converge on intrinsic value.