#94 - Business Casual

Rent The Runway: Polished Clothing, Sloppy Financials

Oct 10, 2021

Hi 👋 - Clothing rental company Rent The Runway filed to go public this week. It’s like Blockbuster Video for clothes. While the company has style, its financials lack substance. A look at Rent The Runway’s S1. Thanks for reading.

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Nothing gets my heart racing like the phrase “the most ridiculous thing I’ve seen since WeWork,” so my palms got sweaty when I saw this Tweet:

Grindstone Capital @KonyCapital

Rent the Runway's adjusted EBITDA calculation is the most ridiculous thing I've seen since WeWork.

WTF Is Depreciation?

All assets have limited lifespans. Trucks can only drive for so many miles. Computers and IT hardware become obsolete. When’s the last time you used a fax machine? Sweaters get holes in the elbows. Depreciation is how businesses account for the decrease in an asset’s value over time.

Rent The Runway’s (RTR) business model is buying a piece of apparel for $X and then renting it out as many times as possible, hopefully generating revenue multiples of $X. The company considers the clothing it rents out to be long-term productive assets. But styles change, mustard stains, and clothing doesn’t last forever. Like a truck or a PC, clothing depreciates.

RTR assumes that its apparel has a useful economic life of three years and salvage value of 20%, meaning that after three years, it can be sold for 20% of the purchase price1. Here’s what that looks like for a $100 dress:

Source: Rent the Runway and Below The Line.

Product depreciation is a material expense for RTR, though its management would prefer you think otherwise. In the first six months of fiscal 2021, rental product depreciation was $23.9 million, or 30% of revenue. Because clothing is depreciated over a useful life of three years, fiscal 2021 expenses are impacted by pre-Covid purchases, when demand for RTR was higher.

Accounting Isn’t Physics

The physical world is governed by ironclad rules. Gravity for instance. Accounting isn’t. An accountant’s job is to record, not evaluate. While there are standards and definitions, accounting requires many assumptions and judgements. There’s a lot of grey area. For example, RTR assumes that clothing has a useful life of three years. Another company could assume a useful life of two years or four. This has income statement implications. Using the $100 dress and 20% salvage value from above, a two year useful life translates into $40 of depreciation per year for two years while a four year useful life results in annual depreciation of $20 for four years. A business assuming a two year useful life looks less profitable in years one and two (its depreciation expense is $40 versus $20), but more profitable in years three and four after the dress is fully depreciated. Both cases result in $80 of depreciation, but take different paths to get there. Accounting assumptions impact optics and timing, but not underlying economics.

There’s also a degree of latitude in how management reports financial results. Many companies, particularly in tech, report two sets of numbers: GAAP and non-GAAP. GAAP stands for Generally Accepted Accounting Principles and is the standard adopted by the US Securities and Exchange Commission. Public companies in the US must report GAAP financials. They can also provide non-GAAP numbers so long as they legally cover their ass2 and provide a reconciliation between GAAP and non-GAAP numbers.

Net income is an example of a GAAP measure while WeWork’s much chided community adjusted EBITDA is an example of a non-GAAP measure. While GAAP is a stringent standard that’s comparable across companies, non-GAAP can be the Wild West.

Source: Rent The Runway S1. Note: RTR looks a lot better under adj. EBITDA, the definition that management defines for profitability, versus GAAP net loss. Surprise, surprise. To be fair, many companies do this, not just RTR.

RTR management has proven to be world class in at least one area: non-GAAP metric creativity. In addition to GAAP financials, the company’s S1 encourages investors to consider Gross Profit Excluding Product Depreciation (say that three times fast), Fulfillment Profit, and Adjusted EBITDA. Because I don’t want to put you to sleep, I’ll focus on Gross Profit Excluding Product Depreciation, which RTR defines as:

Total revenue less fulfillment expense and revenue share. Revenue share includes upfront payments and performance-based revenue share for items we acquire through Share by RTR and Exclusive Designs. We use Gross Profit Excluding Product Depreciation and Gross Profit Excluding Product Depreciation as a percentage of revenue, or Gross Margin Excluding Product Depreciation, to measure our total variable profit excluding non-cash expenses as an indicator of the cash gross profit available to cover our costs and expenses and capital expenditures.

This is unclear at best and unintelligible at worst. As Warren Buffett says3:

Unintelligible footnotes usually indicated untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.

Source: Below The Line. Note: Game recognize game. Adam Neumann, WeWork founder and former CEO.

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An Inconvenient Truth

There are two types of expenses: cash and non-cash. Depreciation is a non-cash expense. RTR doesn’t need to shell out $27 per year for depreciation; cash changes hands when it acquires the dress. Instead, the $27 charge reflects the dress's deteriorating economic value over time (wear and tear, mustard stains, changing trends). If you’re renting a dress for a wedding, you don’t want the sequins falling off on the dance floor.

The non-cash nature of depreciation seems to be an important consideration for RTR management's definition of Gross Profit Excluding Product Depreciation. As my wife will attest, I don’t know much about fashion, but I’ve worn enough clothes to know that they eventually wear out or go out of style. Even though it’s a non-cash expense, product depreciation is a real economic cost. Back to Buffett:

With rare exceptions, depreciation is an economic cost every bit as real as wages, materials, or taxes. Certainly that is true at Berkshire and at virtually all the other businesses we have studied.

As a thought experiment, consider what would happen if RTR stopped buying new clothes. For a time, they’d be alright. Growth wouldn’t change much and product depreciation expense would decline, boosting profitability. But keep this going for long enough and they’d eventually be left with warehouses full of mustard stained semi-sequined dresses with torn elbows. Not much rental appeal. It’s like a body: you can skip a few meals and be alright, but if you never eat, you’ll starve. To remain viable, RTR needs to keep buying new clothes and subsequently incur product depreciation expense. It’s ludicrous for management to exclude it.

Follow The Cash

As an equity research associate, my senior analyst would say, “follow the cash flow, it's the hardest thing to fudge.” RTR’s cash flow statement suggests that the thought experiment above might become a reality:

Through the first six month of fiscal 2021, RTR purchased $8.5 million of new clothing while selling or liquidating $9.0 million. It’s too soon to tell if this is an intermittent fast or the beginning of starvation. What’s clear is that the path forward is challenging. With offices closed and events occurring on Zoom instead of in-person, 2020 was a bruising year for RTR, with sales declining nearly 40% year-on-year from $257 million to $158 million. The company has high fixed costs, $380 million of debt, and is bleeding cash. A successful IPO could help it pay down debt and fund growth, but investors might balk at the deal4. For such a stylish company, RTR’s financials are awfully sloppy and its prospects awfully shaky.

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Below the Line

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