The Empress’s New-ish Clothes

The value propositions of Rent the Runway, The RealReal and Stitch Fix are indisputable. As these concepts grew quickly through the 2010s, the digitally-driven rental, resale and subscription business models induced dopamine rushes in the fashionista set and strategic anxiety among fashion industry execs.

Yet RENT and REAL gush red ink – arterially. Even pre-pandemic. SFIX was nominally profitable until the pandemic and is now back to profitability in its most recent quarter, but the company’s multiple growth initiatives, I believe, will likely not add much more to the bottom line.

So, why don’t these fabulous concepts also make fabulous money?

The RealReal

Buy gently used upscale and designer fashion at a fraction of retail? What’s not to like? Consign your least joy-sparking items for a quick buck? Ditto. The RealReal, while experiencing a dip during the pandemic’s depths, continues to grow revenue and customers significantly over 2019 levels.

The company will never make serious money if any at all. Its accumulated deficit in retained earnings last quarter summed $659 million. The major problem is the high variable cost of receiving, processing, and inventorying individual items for resale. Think: Opening the consignor’s box, inspecting, authenticating, photographing, retouching, pricing, describing, posting, and warehousing each item. Then add on consignor acquisition cost, CAC, fulfillment and, in many cases, reprocessing the return. The contribution profit per order in 2019 was a record high $20 per order, while the fixed cost per order was $53. I estimate they’ll need to sell four times their 2020 revenue before they make a decent return to investors.

That won’t be easy. Fashion resale is a huge business online, where the intake and selling processes are less labor and fulfillment intensive; and even then, judging by the lack of corporate chains in resale and the predominance of nonprofits, it’s not a big, per-store moneymaker. There’s also plenty of online competition: think Vestiare and ThredUp (a more mass model but also burning cash) and the platforms Poshmark and eBay, among other formats. You might be surprised where the largest number of authenticated Birkin bags are offered.  

Rent the Runway

My wife founded and ran a nonprofit. During her 10-year anniversary campaign (in the Before Covid Times), she pitched big money donors and attended many events. Her wardrobe solution was, of course, Rent the Runway. Given her exquisite taste, even her for-profit husband was thrilled at the selection and flexibility the service afforded – for a perfectly reasonable, subscription price.

Reasonable prices for customers, yes, but not for shareholders. Like REAL, RENT’s business model is operationally complex. Returns are built into the model. After wearing, each garment is shipped back, received, cleaned, and returned to inventory. And depreciated. Even in its last pre-pandemic fiscal year, investors would have been better off if, for every dollar a customer spent, the company simply rebated $1.50.

RENT has been in business for over 10 years, and still filed its S-1 as an “Emergent Growth Company” entailing a “high degree of risk” for future buyers of its common stock. Another sign that the business model is inherently problematic is RENT’s lack of peers. LeTote filed for Chapter 11 and seems a shell of its former self. CaaStle supplies a rental platform for other brands to use. Who did I miss? Who’s killing it in clothing rental?

Stitch Fix

SFIX has a different value proposition than REAL and RENT, and a business model architected to make money. The company’s clients subscribe to receive personal style advice and periodic outfit selections, in return for buying, at full ticket, items mostly in the better and contemporary price segments. Healthy gross margins, check. If a client returns everything and purchases nothing that period, they still pay a $20 styling fee.

The company further utilizes an array of 140 data scientists who match purchase behavior with customer demos and product characteristics to model and maximize conversion and AOV and minimize returns. Check, check and check. The company also uses the data to guide development and selling of higher-margin private brands. Finally, the business continues to grow its topline, even through the pandemic by expanding into new customer segments (plus, kids, men’s) and geographies (the U.K. so far).

SFIX returned to nominal profitability in its latest quarter, but implicit in its reporting of outsize growth in and emphasis on non-core growth strategies is that the core women’s business – its largest and likely most profitable segment — has matured, despite a ~$250 billion TAM. (What keeps an articial lid on their women’s business, it seems to me, is that their brand imaging is too literal and practical rather than aspirational and emotional.)

The Business Back Story

These three businesses are all 10+ years old. Why haven’t they yet figured out their profit models? I have a few thoughts.

All three of these concepts were/are venture financed. These tech entrepreneurs and financiers are willing to take on substantial risk to play the long game, solve for complex business models, invest until they completely dominate their sector, and figure that’s approximately where “scale” will begin to deliver an ROI.

It’s worked before. High fixed cost creates a barrier to entry; low variable costs create a steep and predictable glide to profit. But when variable costs are also high (and contribution margin low), as in the cases of RENT and REAL, the path is longer, and the expected error dilates. What happens if the market ends up being smaller than you thought, becomes very competitive, or the model is just inherently unprofitable at any scale? Well, maybe the public markets will be frothy enough to bail you out.

In SFIX’s case, I believe founder and former CEO, Katrina Lake, always had the company’s profit model guide its decisions. However, I think she and company shareholders may have overestimated the ultimate appeal, and peak SOM, of subscription clothing for all.

A wild card in these models is stock-based compensation, which applies to SFIX currently and may affect the others’ future P&Ls — if they should be so lucky. For the top-tier executives living in San Francisco (SFIX, REAL) and NYC (RENT), they accept relatively “modest” salaries and finance their Model S Plaids with stock grants and options. SFIX traded largely flat after its debut four years ago, mostly in the $30s, until this winter, when prices briefly rose over $100. Stock- based compensation this last fiscal year blew a $100 million hole in its P&L.

There’s always the pivot. In recent earnings calls, REAL mentioned that they are opening more stores – because they are more profitable; RENT now encourages you to buy its clothes; and SFIX is strongly promoting its new, “Freestyle” non-subscription platform. Less dopamine, but more real.

The Covid Chronicles

An example of shopping during the Covid pandemic

Being declared nonessential during the Covid-19 pandemic lockdowns perfectly captures the literal truth about mall-based specialty retail.

In fact, specialty stores only exist in the first place because they are magic. They invite us into beautiful stage sets, create new aspirations and help cater to our most refined tastes. Les Wexner, the one-time owner of over a dozen specialty retail chains, frequently reminded his executives that they were in the “wants” business, not the “needs” business. His most scathing (and still printable) critique of his brands’ marketing or displays would be “this looks like JCPenney.” The more magic his stores created, the more margin. The…math…was…that…simple.

Over the past decade, we’ve witnessed a broad and steady decline in that magic, inflicted in part by the infectiousness of a handheld supercomputer that brings the world directly to us. During this pandemic, we worry whether a trip to the mall would be safe; but the journey had already become increasingly unnecessary and banal.

So, what’s next for the malls and their tenants?

The Covid Chronicles

There’s a group of retail executives in Columbus, Ohio who are still committed to perpetuating that magic. We call ourselves CBUS Retail, with the motto, “We love retail.” We are currently producing — supported by Klarna and other like-minded sponsors – a nine-episode, streamed video series entitled “Specialty Retail in Crisis: The Covid Chronicles.”  The series describes the massive disruption in this sector, paints a view of its future and suggests strategies for post-pandemic success. So far, we’ve interviewed 40 analysts, operators and founders from retail hubs across the country. Here is a synthesis of the series.

1. Pre-Covid

Of course, the mall economy was already troubled well before the pandemic, plagued by a persistent supply-demand imbalance, eroding margins and falling productivity. The dynamic duo, Michael Dart and Robin Lewis list several key reasons:

  • Oversupply
    • Persistent falling manufacturing costs.
    • Continued growth of non-mall options – discount, value, outlet and off-price; clubs and big boxes; everything digital.
  • Shrinking demand
    • The mall’s targeting of, and dependence on a shrinking middle class.
    • Consumers spending more on experiences and health & wellness, and less on physical products (aka “dematerialization”).

Other speakers highlighted two other distinct failures of the mall’s tenants:

  • A generation’s-long inability of department stores to increase mall traffic.
  • Specialty chains’ increasing lack of novelty, creativity and differentiation.

In short, too much product, too many stores, and not enough magic.

2. Direct Impacts of the Pandemic

If zombie malls with zombie stores filled with zombie product populated much of the retail landscape pre-pandemic, Covid-19 appears to be finally killing off many of these walking dead. Since March, retailers will have announced the closure of an estimated 25,000+ stores, and a net ~300 malls are projected to “repurpose” or succumb during the next three years. So far, over two dozen specialty and department store retailers have declared bankruptcies, with most emerging much slimmer, with new owners. We are told to expect more Chapter 7’s and 11’s this spring.

NPD’s Marshal Cohen describes “The Discretionary Divergence” in consumer spending.

Shows the categories diverging in spending

3. The Silver Lining

As the pandemic continues to wreck stores, profits, jobs and livelihoods, not to mention lives, our speakers see plenty of future upside for the sector. First, much of the structural oversupply will be gutted from the marketplace. BMO Capital Markets analyst Simeon Siegel argues that the current crisis allows public retailers to strategically downsize without incurring shareholder ire. Most agree that digital commerce is racing through puberty during the pandemic and now stands at least as tall as its offline parent. All in all, there’s a scramble to re-form and reform retail: The future of specialty retail is up for grabs.

4. The Future

A More Diversified and Dynamic Landscape, With Faster Lifecycles and Lower Peaks

With malls and legacy retailers hobbled, the barriers to entry for emerging retailers have never been lower. Traditional wholesalers and DTC brands are finding more mall vacancies with lower rents and more flexible terms, according to Steve Morris, Asset Strategy Group’s CEO. Ottawa-based Shopify provides inexpensive Retail-as-a-Service to over a million ecommerce merchants, who can also co-list their products on other shopping and social platforms including Amazon, eBay, Facebook and Instagram.

Forrester’s Sucharita Kodali foresees an intense battle over the next decade between legacy analog brands now adopting digital first mindsets vs. digital natives seeking heightened customer connection and growth through operating stores.

Whoever wins, the spoils will likely be smaller than before. Analog-first brands that took a generation or more to build tend to top out at $2-3 billion in the U.S. at retail, according to Siegel, with only NIKE swooshing beyond. The current generation of venture-fueled concepts – monied, impatient, and viral-when-successful – will peak faster, but at a level limited to consumers’ goldfish-sized attention spans.

Given the increasingly complex and integrated nature of the equation, analog + digital = sale, J.Crew’s Billy May believes we should focus mostly on market and customer profitability, not channel.

Oliver Chen of Cowen argues that community is the unlock for sustaining consumer loyalty in an attention-deficit world. Aerie and Glossier use social media especially well to foster engagement, according to Chen. Pre-pandemic, Revolve, a brand positioned to party, hosted big, fab, in-person parties instead of investing in brick and mortar.

A Re-Engineered Retail Value Chain

During the pandemic, the design and merchandising teams at the tween girls’ retailer Justice took the whole product development process virtual — from inspiration to concept to line — removing months from their calendar. The compressed timelines prioritized merchant conviction and improvisation ahead of test-read-react. Truly energized by the speed, efficiency and empowerment in the new process, VPs Kat Depizzo and Julia Hanna  are convinced these changes will largely be permanent.

More frequent and smaller buys closer to floorset/listing is a recurring theme. Lower markdowns will make up for slightly higher unit costs. Supply chains will be leaner, faster and more distributed, avoiding single points of failure. Inventory transparency is doubly important as omnichannel options proliferate. Good forecasts are the ultimate lubricant in a lean, forward-positioned supply chain. From a tech perspective, Karl Haller demonstrates how IBM projects demand to the store level.

In stores, all agree that we’ll move towards contactless customer service and payments post-pandemic. Kodali states, “a customer should never have to wait in line to talk to a person.” WD Partners’ Lee Peterson reports that Alibaba is way ahead on these and other innovations in his talk “Innovation, Alibaba Style.” There was widespread agreement that Chinese companies and consumers provide a good benchmark for what’s ahead.

A New Role for Physical Stores

Cathaleen Chen wrote a Business of Fashion article in August, both profound and so obvious (as in why-in-my-decades-in-this-business-hadn’t-I-thought-of-it kind of obvious). There are four roles for physical stores: brand, service, immersive experience and community. Think slow on this.

A future strategy for a market-based store “portfolio” makes sense. Some stores offer full brand presentation, high-touch service and interactive community building; at the other end of the spectrum, are dark stores that only fulfill pick-ups and deliveries.

Less Algorithm, More Imagination

Author of “Aesthetic Intelligence,” Pauline Brown, states that in business there should be a tension between analysis and aesthetics. But that the only way to beat the robots is through the uniquely human ability to create beauty, infuse joy, and surprise and delight customers.

Aaron Walters, CEO of Altar’d State, asserts that the larger a business gets, the more it needs to either simplify the model or empower its employees. He advocates bringing the “special” back to specialty retailing.

Former Google executive and arts student, Abigail Holtz, observes that ecommerce has not evolved for 20 years and now seems emotionless and flat, not effortless and fun; and stores have their own shortcomings. She created online shopping site The Lobby to merge the best of both channels, where they curate emerging brands “doing something special” and make shopping fun with an original, authentic and very human-centered interface.

Magic.

NOTE: This is just a small sample of the smart commentary in the series. Please visit https://cbusretail.org/covid-chronicles-season-one/ to stream for free and join our live Community Roundtable https://cbusretail.org/member-events/ on January 6 to discuss the series content with several of the speakers.