Rent The Runway, the designer women’s fashion rental service, is private and doesn’t publish earnings but it would be surprising if it was profitable. It is valued at a cool $1 billion.
Stitch Fix, the online personal styling service, makes money but its earnings are erratic. It is valued at $2 billion, over 50 times EBITDA (earnings before interest, taxes, depreciation and amortization).
Farfetch, the luxury fashion boutique marketplace, has never made a profit and every year it loses more money than the year before. It is valued at nearly $4 billion.
How do these new fashion companies convince investors to buy in at these values? I recently heard Anushka Salinas, the chief operating officer of Rent The Runway, describe the company as a “data and logistics company.” That’s Wall Street-speak for: we’re worth a lot of money. Salinas was incredibly articulate and impressive. I left thinking, wow, what a great speaker and what a great company.
Data and logistics companies are indeed very valuable. Although they cost a lot to start up and to serve the first customer, once they’re up and running and additional customers come, the incremental cost is nearly nothing. Revenue from customer number two and beyond goes right to the bottom line so profit can scale astronomically. Big data companies like Google and Microsoft are worth so much because profits build exponentially as they grow.
If you’re an investor in Rent The Runway, there’s only one problem: data and logistics companies don’t own dresses. One of the reasons data and logistics companies are so profitable is that there’s no physical product, they grow without having to buy anything. Companies that rent stuff are called leasing companies and their profitability is determined by the revenue they get and the value to their customers of what they rent. If Avis chooses the wrong cars to rent, they’re toast. Likewise, if Rent The Runway chooses the wrong garments, their future is bleak. More important, choosing dresses to rent is a lot harder than selecting popular car models and, unlike a data and logistics company, the bigger the company gets, the more garments they have to choose and the greater the risk of failure.
Don’t get me wrong, Rent The Runway is a great idea, it’s the market leader and there’s a clear need for the service. The problem is that by positioning itself as a data and logistics company, money has been raised at sky-high values, and when the market gets more real about valuation, people will suffer. Leasing companies can’t justify the kinds of values Rent The Runway can get.
Let’s Get Specific
Based on information from PrivCo, which tracks private company financial information in a proprietary database, Rent The Runway had revenue of $260 million in 2018, up from $250 million in 2017. PrivCo doesn’t say anything about profitability—I assume it’s not profitable because the rumors about that are consistent—but if we’re generous and assume it made 10% of revenue to the bottom line, or a profit of $25 million, the current valuation is 40 times EBITDA. If this was a dress business, that would be an unheard-of valuation, there’s no other like it in the market. Tailored Brands (which owns Men's Wearhouse and Jos. A. Bank) is the largest renter of men's tuxedos. It makes more money than Stitch Fix, Farfetch and Rent The Runway combined and is valued at nine times EBITDA. Investors would laugh if you said that company, or even part of it, should be valued as a data and logistics company.
In the leasing business, Avis Budget, which owns the brands Avis, Budget and Zipcar, is valued less than six times normalized EBITDA. You may say that Avis and Budget are old line brands with less potential for growth than Rent The Runway, but you’d be hard-pressed to say the same thing about Zipcar. Rent The Runway’s valuation of $1 billion is four times revenue and no leasing company is reasonably valued at that level.
Ask yourself this question: Why would renting dresses have a fundamentally different valuation than selling them? It doesn’t make sense to say that the way you sell a product changes the value of the business by an order of magnitude. You still have to buy the dresses, be right about the fashion, convince the customers to wear them, and give good service. People, that’s what a great dress shop does.
Not surprisingly, Rent The Runway won’t comment on valuation. What they will say is that they are using data to give information back to designers to develop product. “Data is a huge part of what we do,” they told me. Rent The Runway uses data about what consumers rent to develop its own private label products which have higher margins. Rent The Runway is also using its market power to get suppliers to finance inventory by selling on consignment. I imagine it is using artificial intelligence to sort out what consumers want and make more effective choices for its inventory. All of that is great, it’s where the fashion industry needs to go. But, sad to say, none of this changes the nature of their company from being a fashion business that deserves a fashion business valuation.
Who Loses?
There are two groups of people who lose as a result of overvaluation. The first is investors. Why would smart people like Franklin Templeton, Bain Capital, Blue Pool Capital, Fidelity Investments, TCV, Kleiner Perkins, Hamilton Lane, Advance Venture Partners, UIT Funds, Reform Ventures, Manhattan Venture Partners and T. Rowe Price invest at these values? The first possibility is that they’re right and I’m wrong; there’s something here they see that’s over my head and I can’t say that’s impossible. One possibility is that they were also impressed by management, a great management team can get investors excited about valuation. Another is that a recurring revenue structure also drives valuation.
But here’s what I know: when a new form of business or a new kind of product is invented, financial markets often overreact. Think back if you can to the founding of Gilt Groupe, the original leader in flash sales. When it was created, the growth was explosive and investors couldn’t put money in fast enough. Eventually, Gilt’s valuation went over $1 billion, but a short time later they were sold for a publicly-announced value of $250 million. A non-public sale was made after that and, according to my sources, that sale was considerably less than $250 million. Anyone who put money in at a value above the sale values lost their money. Financial markets, and people generally, tend to believe that current trends can be extrapolated into the future. When something is growing rapidly, markets act as if it will keep going to infinity. But there’s always a top and when growth slows, markets overreact again and you can’t give it away.
The second group of losers is employees of Rent The Runway. Not the founders, they’ll do well because even if the value declines from the $1 billion valuation, it’s way above the minimal value they got their stock at. But employees who came in later, and who are counting on the value of their stock options for their nest egg, will find that if the price of their options is based on the more recent fundraising, when the time comes for them to realize on their investment it will be worth little to nothing.
If you’re reading this and you work at Rent The Runway, I’m talking to you. You should stop counting on your options as real value, especially if you joined the company in the last year or two. Find out if you can what the strike price is on your options and what valuation is implied by that price. If possible, connect on LinkedIn to people who have worked at Gilt Groupe and ask them how they made out on their options. You may not like the answers but you won’t regret the exercise.
Wall Street is known as a cutthroat place for good reason, financial markets are merciless. On the way up, it’s a great ride but sometimes the ride isn’t justified by fundamental values. That can happen when different types of businesses like dress companies and data companies are conflated. Eventually, the uninitiated investor wises up, the ball rolls back down the hill and getting out of the way is the move. I like Rent The Runway and it provides a great service. The business can grow and it can be a very successful company. Over time, it will have imitators and competitors. But the valuation doesn’t reflect the way world works. Eventually, investors will measure the company on its profits and when that happens, the valuation will get adjusted, one way or the other.