Well, it's pretty safe to say that the small-cap IPO hype is over. A tremendous number of companies cashed in on investors euphoria amid the pandemic, but now, with interest rates persistently high and a tough macro climate on the horizon, investors have shifted back into safety mode.
Against this backdrop, Rent the Runway (NASDAQ:RENT) has shed hundreds of millions of market value. But year to date, the stock has already tripled, driven in no small part by the recent resurgence of "meme" stocks. But while as a small cap, Rent the Runway has a reputation to be clubbed in with other speculative trades, I do think there is a real fundamental business case to assess here.
I'll cut to the chase here: while I'm certainly not betting the farm on this stock, I'm encouraged by A) the stock's recent rally and B) the company's recent return to growth and improving profitability, and am initiating Rent the Runway at a buy rating.
The next catalyst for the company is its Q1 earnings release, currently scheduled for June 6.
How does Rent the Runway Work? The company fills a void that leading e-commerce names don't fill today
Simply put, Rent the Runway offers a subscription membership to keep a rotating closet of designer items at home. The snapshot below shows the company's three core subscription membership plans:
The basic $89/month plan allows customers to have five of Rent the Runway's items at home. Customers keep can these items in their closets for the duration of their choosing, and then send them back for a replacement. Upgrading to more expensive plans allows customers to swap out items more frequently and access higher-tier products.
On the marketplace end, Rent the Runway purchases the majority of its clothes wholesale from its brand partners. In some cases, the company also contracts with brand partners to acquire inventory via consignment (i.e., Rent the Runway doesn't pay any acquisition cost upfront), and in some rarer cases still the company contracts exclusive designs manufactured just for its customers. The company plans to spend $48-$50 million (for sizing purposes, this is slightly more than half of the company's ~$75 million quarterly revenue run rate) on inventory acquisitions in FY24.
The bad news: subscribers have been in decline, which makes sense as a tough macro environment has pushed many customers to assess their costs, especially recurring subscription fees.
In Rent the Runway's most recently reported quarter (Q4), active subscribers dropped by 6k sequentially to 126%, down -1% y/y.
And yet, revenue still grew +1% y/y in the fourth quarter. While subscription represents roughly 80% of Rent the Runway's top line, management is starting to more heavily push inventory sales. The unit economics of this make a lot of sense: Rent the Runway can get a lot of mileage from a single item by renting it out multiple times and then finally selling the item to a customer that really likes it. Note as well that Rent the Runway purchases clothes at wholesale prices (whereas a typical luxury designer will mark up its pieces at 2.5x, according to the company's investor presentation).
As shown in the chart below, inventory sales revenue grew 49% y/y in Q4:
Direct sales of inventory is being more firmly embedded into the Rent the Runway experience now to encourage customers to keep their clothes. For example, if the app notices that a customer has held onto a product for several months, it will send the user a promotional code to acquire the item at a discount.
Rent the Runway is the most well-known clothing rental subscription in the market, and it fills a void that other creative e-commerce companies like Stitch Fix (SFIX) have struggled with. Stitch Fix declined because of a poor product/market fit: it originally thrived on the novelty of receiving a stylist-curated "Fix" of items, but struggled on its direct-sales model in part because it was neither cheap/fast fashion nor true designer. Rent the Runway appeals to customers by offering access to top designers at subscription prices, while encouraging purchases later in the customer lifecycle.
Improving profitability
Amid a slightly declining customer base, Rent the Runway has been substantially improving its profitability. As shown in the chart below, adjusted EBITDA margins jumped 6 points y/y in the most recent quarter to 15%:
Note that while gross margins declined -5 points y/y to 39%, underlying fulfillment expenses improved three points as a percentage of revenue to 27%, while it was a six-point increase in rental depreciation expenses (due to an accounting adjustment) that hit gross margins the hardest. Meanwhile, on the opex side, and after adjusting for one-time restructuring costs and depreciation/amortization (which, as mentioned was a hit to gross margins), the company achieved savings on technology costs and G&A.
The company is targeting a 15-16% adjusted EBITDA margin in FY24 (versus a 9% adjusted EBITDA margin in FY23), as well as breakeven free cash flow (versus -$70 million, or a -23% FCF margin, in FY23):
Note the one red flag here: Rent the Runway does have a challenging balance sheet, so it needs to get to breakeven FCF as soon as possible. It had just $84 million of cash left on its books as of its most recent balance sheet, on top of $307 million of debt:
And though not entirely applicable for a non-industrial company, we note that shareholders' equity on the balance sheet is negative, reflecting the accumulation of losses in Rent the Runway as it has scaled (something the company is hopefully correcting now).
Valuation, risks and key takeaways
At current share prices around $30, Rent the Runway has a market cap of $108.9 million, and after netting off the $84.0 million cash and $306.7 million of debt on the company's most recent balance sheet, the company's resulting enterprise value is $331.6 million.
Assuming the outlook midpoint of the company's 15-16% adjusted EBITDA margin and $301-$306 million in revenue (+1-6% y/y) for the current year, we'd arrive at ~$47 million in adjusted EBITDA in FY24, and a valuation multiple of just 7x EV/FY24 adjusted EBITDA.
That cheap valuation, of course, is laden with a number of risks:
- A debt heavy balance sheet, as previously noted
- Continued risk of subscriber churn and a possible slowdown in direct inventory sales, after a recent uptick
I wouldn't take more than a small position here, but all in all, I think there's more reward than risk here.
Gary Alexander
With combined experience of covering technology companies on Wall Street and working in Silicon Valley, and serving as an outside adviser to several seed-round startups, Gary Alexander has exposure to many of the themes shaping the industry today. He has been a regular contributor on Seeking Alpha since 2017. He has been quoted in many web publications and his articles are syndicated to company pages in popular trading apps like Robinhood.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in RENT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
