Description

INVESTMENT THESIS & CATALYSTS          

The RealReal, Inc. (“REAL” or the “Company”) is an online marketplace for used luxury goods that recently went public under the JOBS Act. The Company’s business model requires a large amount of operational support and an inherently inefficient supply chain yet management characterizes itself as a “fashion and technology” company, de-emphasizing and under-investing in operations. Regardless, its human capital intensive nature limits potential automation and severely constrains any ability to scale and improve margins. Meanwhile competition has begun to accelerate over the last several months, posing a headwind to take-rates, GMV growth and increasing CAC.

The Company’s founder and CEO, Julie Wainright, ran Pets.com during its brief and inauspicious public life. She then went on to lead two other now defunct businesses. REAL’s fate may very well follow that of her prior companies. The stock got hit last Friday on the back of the FTCH and RVLV weakness. However, it appears this is just the beginning. REAL has been a cash consuming machine with multiple VC rounds, the most recent private capital coming in March at $5 per share (stock trades at $17.88). Bulls anchor REALs valuation to that of FTCH, RVLV and ETSY yet its profile is much closer to that of SFIX. At that multiple it would trade at $8. The Company reports earnings after the close today and expectations are lofty. If results fall short, there is a decent chance it will never recover. Given the timeliness we have kept this write-up brief.

Even if today’s earnings do not serve as a catalyst, the stock should unravel once people look at the numbers more closely. In Q4 REAL will be lapping a quarter that included very aggressive promotion and a spike in returns (it then re-sells and books it as very low margin revenue). Sell-side initiated last month and none of them could coherently substantiate the current valuation. The stock is presently GC.

BACKGROUND & SETUP

The RealReal was started in 2011 and began shipping items in 2015. The bread-and-butter of the business was and continues to be high-end women’s handbags. It describes itself as the “anti-eBay” offering a white glove approach to consignment. The business model involves one of the least efficient supply chains you will find. It sources the majority of its products through Luxury Client Managers who drive to the home of a seller and assist them in choosing which items to consign. REAL then picks up items at the seller’s/ consignor’s home, transports it to one of its warehouses where it is then cataloged, authenticated, priced, professionally photographed, profiled on its website, stored and then eventually shipped to a buyer.

Since each item is secondhand, every SKU is 100% unique (14k processed per day). Even if the same item from the same designer exists somewhere else in REAL’s inventory, they are not the same and they cannot be sold as a fungible unit of inventory because they are in different states of condition. The Company tried to introduce pricing automation in shoes with the intent of rolling systems out across the rest of the categories. This process failed. 

The CEO’s characterization of REAL as a “tech and fashion company” provides an insight into her priorities. This mindset is likely why leadership in operations has been a revolving door. Most recently in December, its industry veteran COO left after just ten months on the job. Primary sources indicate the shipping and logistical efficiencies the Company purports will improve scalability have already been wrung out and/ or are not attainable. Strained relations and resources constraint may also be the culprit behind the increased service complaints expressed by customers in various public forums.

The Company’s regulatory disclosure is selective but based on what is provided, customer net adds and CAC imply a 50% annual churn. This is obviously not a high retention rate marketplace. Some of the disclosure is conflicting but REAL states that 40% of consignors are new to the site thus it is constantly having to find new supply. Formers we spoke with indicated it was continuously challenging and costly to find sellers as most are liquidations for life changing events (estate planning, divorce, hardship, etc.). Since very few consignors are also buyers, REAL has customer acquisition costs on both sides of the trade. 

In 2017 REAL possessed the largest inventory of Birkin bags in the US. This would indicate that it had already saturated that category and thus had to move into other segments to sustain growth. That is in fact just what happened as the Company expanded into jewelry, high-end furniture and art. Each of these has its own challenges and likely worse unit economics than its core handbag silo. Jewelry, for one, is a much tougher proposition as it requires trained jewelers to handle the authentication versus handbags where people check serial numbers and some basic physical aspects. These other categories are also highly personalized and much lower turnover.

The International growth leg of the bull story is limited by the logistical and regulatory hurdles from Byzantine customs laws for used products, US Fish & Wildlife and other foreign trade laws. RealReal Japan which was purchased in 2013-14, ended up not being successful for a number of different reasons, one of them just being the Company just could not quite understand and navigate the complexities of the Asian resale market. 

COMPETITION

The competitive landscape in luxury re-commerce is quite crowded and recently became increasingly competitive when Farfetch and eBay launched authenticated luxury consignment platforms. Rates vary by product type but the Company’s reported take-rate in Q1’19 was 35.3% (it should be noted that it reports that number before buyer incentives). The typical all-in cut the Company charges a seller on a Chanel handbag is 40-45%. Part of the bull thesis is that REAL can raise take-rates yet it has demonstrated no ability to do so as commissions have been flat over the last five quarters. REAL’s rates are already significantly higher than comparable alternatives from peers. Farfetch and eBay’s authenticated luxury consignment platforms each have sub-30% take-rates. Below is a list of the most relevant players. 

Among the above, Poshmark and Fashionphile are the most significant established competitors. However, the most relevant change in the landscape likely came in May when Farfetch entered the pre-owned/ re-sale business. This is a logical extension of its existing focus in the luxury goods space. Despite having only launched its re-commerce portal three months ago it already has 2.7k pre-owned purses and over 10k pre-owned items listed. Farfetch’s platform has an overlapping customer base with that of REAL and by any volume metric, multiples more traffic. For what it is worth, recent sell-side survey data shows it already on par with REAL in terms of consumer awareness.

eBay Authenticate also launched in the last few months, directly targeting REAL. eBay has historically struggled to break into the luxury re-sale market but obviously has the infrastructure in place to scale fast if it is able to effectively attract buyers and sellers.

This existing competition is likely going to put pressure on REALs take-rates or at the very least put a ceiling on them. As FTCH and others push to scale up and drive volume they may likely get more aggressive. It also appears to be driving down resale prices with an increased amount of promotion and discounting and GMV as a consequence. This appears to have already begun to manifest itself as REAL itself has been offering aggressive discounts of 30-50% in nearly every daily email over the last two months. This is likely also driving up CAC across the category. Previously the Google search for “used Chanel handbag” presented paid results primarily for just REAL. Now it is just one of many.

Another component to the bull thesis is that Amazon is less likely to enter the category because it is too human capital intensive and that REAL has “an operational moat” that prevents Amazon from entering. The latter is clearly not credible. This former risk was weakened the other day when AMZN launched its new styling service Personal Shopper by Prime Wardrobe where Prime members are “offered a chance to have a team shop for them based on a customer survey for style and fit preferences.” Presumably a large part of this will be automated but still requires a higher level of customer service than the typical Amazon product. Amazon also already has an authentication program for watches.      

FINANCIAL PROFILE & VALUATION 

Luxury goods that people sell for a fraction of the original cost is a pretty niche market. Management guidance and consensus are extrapolating +30% annual GMV growth for REAL. The overall re-commerce market is expected to grow at an 18% CAGR through 2025 according to Report Consultant. For Q3’19 consensus is calling for an ambitious revenue growth rate of 49% with flat margins.

The Company’s return rates are running at 28% of GMV. REAL takes all return items back, re-sells them and records those re-sales as revenue thus taking on inventory risk and not a pure consignment marketplace business. Of course, under the JOBS Act only a couple years of numbers are provided but “direct”/ re-sales has been a major source of revenue growth, up 138% Y/Y in Q1’19 vs consignment +37%. This is much lower margin revenue with 15% reported GMs and given the servicing and restocking required is almost certainly negative margin after operating costs. This growth in return rates would also signal a deterioration in customer satisfaction and product quality. 

The Company claims high gross margins but the numbers it reported do not include any of the processing and authentication costs. This is misleading because every unit requires such service thus it should be a direct cost. Also, some SG&A needs to be included in COGS for Luxury Consultants who go to sellers’ homes. Meanwhile management and sell-side are assuming long-term EBITDA margins of 25%. You can’t get anywhere near this number on a unit basis now even if all SG&A were eliminated.

REAL is currently trading at 6x LTM EV/ sales and 40x LTM EV/ GM (before previously mentioned costs). On an absolute basis these are very rich multiples for an unscalable business facing intensifying competition in a cyclical end-market. The sell-side anchors REAL’s valuation to that of FTCH, ETSY and RVLV. The economics of REAL’s business are distinctly different from that of those marketplace platforms. The appeal of a marketplace is that it derives high margin interchange fees with limited incremental cost. Clearly not the case with REAL. Its margins are getting worse as it opens more brick and mortar locations. Despite this reality, REAL is trading at a premium to those companies. SFIX is the most comparable in terms of profile and it trades at 1.5x EV/ sales. REAL’s equity would be worth $8 at the SFIX multiple. This represents a 50% return on the short. 

The Company would likely have gone BK had it not raised money last year and in its IPO. It raised private capital at $5 in March and now trades $17.88. We could see a scenario where the stock really cracks once people look at the numbers more closely. Sell-side initiated last month and none of them could coherently substantiate the current valuation (removing some sell-side promotion risk). 

OTHER RED FLAGS & CONSIDERATIONS   

• In 2017 the Company opened a couple pop-up stores to promote its online presence. These were intended to be temporary installments as brick-and-mortar consignment is a very challenging business. Last year REAL entered brick-and-mortar and in Q2 it opened more retail stores in NYC and LA, adding $2M in annual operating lease expense.  

• Last November Chanel filed a lawsuit in the Southern District (case: 1:2018cv10626) alleging REAL is selling counterfeit handbags (bringing into question the credibility of its authentication process), infringing on the Chanel trademark and appearing as a resale partner.

Catalyst

- Earnings shortfalls from accelerated competition and unattainable expectations

- Awareness of the unattractive financial profile of the business