REAL - A Joe's Pros Interview

Joe

Good morning. It is Friday, September 3rd, 2021, and welcome to the Joe’s Pros Interview. I understand you'd like to talk about The RealReal Inc (REAL). 

Pro

Yes, thanks so much for having me. REAL is a name that we think is really interesting. It's creating an online luxury consignment shop. You might have heard of some of the other competitors in the space like Poshmark and ThredUp, but what makes REAL unique is that they actually take possession of the items and do all the listing, photography, and sales for you, and so we call that a do-it-for-me (DIFM) type model. And I think why that can be powerful is that if the idea is that you're going to be cleaning out your closet, you don't necessarily want to have to keep all the items you're attempting to sell on Poshmark with you until you can actually sell them. And so, I think there's fundamentally a different kind of customer that's attracted to REAL. 

What got us interested is on a valuation basis, as it also trades at a discount to some of these other players. We like to look at things on an EV/Gross Profit perspective and looking out to 2022, REAL is trading at about 3x their gross profit vs. Poshmark at 4.5x and ThredUp at 7.5x. And if you look at their topline growth expectations over the next four years, REAL is expected to grow 35% annually vs. 23% at ThredUp and 26% at Poshmark. So overall, you're paying less for faster growth. And we know there are a number of negative views on this stock, but I think these are largely superficial and people haven't necessarily dug down in to the unit economics. What's really attractive about this business is it's one of the few ones in retail that I think really shows strong network effects, and you do get this flywheel of people that buy [will] start to consign, which then leads them to buying more. And it's one of the few that we've seen that have really been able to bring down their customer acquisition cost per order, and it's really quite impressive when the LTV is actually increasing, and so you get really powerful topline economics in this sort of business. 

Joe

Can we go into the unit economics on a typical transaction? And then maybe break it down on what's the difference when they come to you vs. you bringing to them? If you know the percentages so far of where the behavior lies in that metric? I'll let you go from there. 

Pro

Yeah, so just to kind of cover that part to begin with-- before COVID, the majority of their supply was acquired through what they call in-house pickups, so a luxury consignment salesperson would come to your house. You would either have the items that you wanted to get rid of evaluated, or they would help you go through your closet and help you understand the value of some of the items you have that you could get rid of, and then they would take them from you and list them on the site. Well, with COVID, that completely shut down and they were forced to innovate. And I think this is one of the areas they were kind of lacking in pre-COVID because they were only offering one way. So during COVID, they rolled out virtual appointments. So instead of coming into your house, they would do it over video conference to go through your items and then a delivery truck would pick up those items. Another thing they started pushing out was mail-ins, so I can just print off the shipping label and send my items in. And then lastly, they started opening what they call “mini stores” in select locations that are really there to collect supply, but what they found is positive buying from the areas around the stores. As people get used to buying second hand, they can see in the store the quality of the items, and so [REAL] actually sees not only positive access to supply, but also buying patterns in those areas. 

They don't break out where their supply comes from-- in-home vs. store vs. mail. In-home has been returning since May, and that's where they do get a large bulk number of items and they do get them a lot of times from celebrities and other customers that don't necessarily want to be seen consigning. So that's positive from a supply perspective. On a unit economics basis, we look at it on a per order basis. They make roughly $150 - $160 an order in revenue-- that's from their take rate-- and they're spending anywhere from $16 - $18 an order to get that customer. So what you have to think about is that acquisition cost is spent on both the supply side and the demand side. They don't break it out, they fully load their acquisition costs based on both sides of the network, so that's pretty efficient. And from there, the hang up gets to, “Well, this is a really high variable cost business. Can they be profitable?” And one of the things they've been breaking out over the past few years is kind of the breakdown of how they define variable costs vs. fixed costs. And if you look back on the historicals they’ve provided, the company has been able to be profitable on a per order basis looking at variable costs, but they actually haven't been able to cover the fixed costs because they're not at large enough scale yet. And so some people argue that a lot of fixed costs are more variable. We can get into that, but I think what's important to understand is they know that this is a sales intensive business and they do not see any leverage in the sales line-- so, the people that are gathering the supply in the stores, at your home, in the warehouses-- but they have been able to show leverage from photography, descriptions, and listings as they’ve really pushed hard to automate all those. They are anywhere between 85% - 90% automated today. 

Some of the pushback might be, “Well that's great, but why don't we see that in the variable cost per order?” What you need to realize is that with COVID, there's a number of inefficiencies that are actually directly offsetting these efficiencies in the model, so you can't see the benefit flow through yet. Some of those inefficiencies are that they are having a really hard time staffing their pick, pack, and ship in the warehouse, so they're using temp workers, which are more expensive. They also, as you touched on, have an entire fleet of drivers to go pick up consignment items for virtual appointments, and as we've been reopening, people aren't using the virtual appointment. They're either now going to the store or they're wanting someone in-home. So there's really no need for these drivers, but they don't want to get rid of them yet in case the Delta variant reverses all the progress we've made on reopening. Those are some of the costs that they're currently holding onto that they don't expect to be around by the end of the fourth quarter, and so we should start to see the benefits of automation rolling through the model. 

And then, finally on a fixed cost per order basis, I think one of the frustrating parts, and I don't think they've done a great job of communicating, is we have been seeing increases in fixed costs over time on a per order basis. And so people will say, “Well that means these are really variable,” but I don't think they've done a good enough job to the investing public to describe to them what those investments are in. Those investments are going to building out their tech team to build that automation, it's going to the new warehouse in Arizona which they can operate at roughly half the cost of their California distribution center, and then it's going to headcount in the pricing/automation model. What I think is encouraging from this point forward is that they have put a hard stop on all fixed cost growth. They have told all their departments, “You will get no new hires. You will have to do more with the employees that you have today.” So, it is my opinion that starting in the fourth quarter, we should really start to see leverage in the fixed cost line item as they start to hold those costs more steady going forward. 

Joe

Thank you for that. A quick overview of the flexibility of competitors to mirror some of the things that you believe give REAL a unique brand? Maybe start with Amazon as an example, I think they have a luxury stores division. There are plenty of companies that have sort of beat back an Amazon threat or the perception of one, but perhaps you could talk about that and some of the others. How fast could other competitors toggle? And then, is this a “you get to a certain scale and then you're the winner” type of situation?

Pro

Yeah, there's a couple of points there. But I kind of view REAL almost like a Carvana where they're first to market, they're gaining so much scale and expertise, and it's going to be really hard and require a lot of capital to catch up to them. So, it's not to say that this is a winner-take-most, although I think it probably will evolve to be that way. But one of the things I touched on earlier is that this is a do-it-for-me type model and we don't see anybody else really trying to offer that because of how complicated it is and because of the variable costs associated with it. And so I think that any sort of platform like a Poshmark that is based on actual customers taking their own photos, listing their own items, shipping it out, will have a really hard time. I don't think they'd actually want to move to a do-it-for-me type model because it's just fundamentally different from the actual platform that they're building. As for Amazon, Amazon has struggled over the years in luxury in general. It's not a brand that's associated with the luxury experience and brands are pretty wary of partnering with Amazon. We've seen negative headlines hit names like Farfetch when Amazon says they're going to start doing luxury. But the brands that end up being on their platform are kind of second tier brands that are really kind of looking for access to customers, and so I don't view Amazon as even wanting to get into this space in general just given the high variable costs to implement it. There's always going to be competition in this space, but we think that the IP REAL has built up on identification-- I mean, they have the largest book of luxury items and how to verify them-- that just gives them an advantage for every new item they see because they've already probably authenticated it before. They get real efficiencies as their experience and IP over time expands, and so we do see them having such a vast headstart that it would be very hard to catch up in this space. 

Joe

Thank you. The stock, when we first talked about it, I think it was almost double this level. I know that you're a long-term investor. So, it hasn't performed well, that's never fun. Some people have pointed to selling by management. Perhaps you can discuss what's happened in the last six months since we first talked about the idea and then segue into your thinking about management, what they're doing right, what you might do differently, and then we'll go to where you think this evolves generally. 

Pro

Yeah, it's been a tough one. It was hit during COVID because it had no supply, and then as news of positive supply started coming out, the stock had a really nice run. And there's a number of market dynamics where small cap growth has gotten hit in general in this period, but what we've observed is that the market seems to be more focused now on profitability than they are on growth. And so while the company has continued to beat their growth consensus expectations and internal [expectations], the profitability has disappointed the market. What management will tell you is that they have not done a good job talking through their cost structure to the market. They tried to be very hands off and ultimately what that ended up doing is putting the consensus at an unrealistic level. So, consensus has had to take their numbers down all year, whereas internally they're actually mapping better than they expected. And so I think it's a real lack of communication on the cost side and it's really putting into question when they will reach profitability. Right now, consensus doesn't have them reaching profitability until Q4’2023 and full year in 2024, but if you actually talk to management, they think they can reach both those metrics a year early. If they can beat and surprise consensus on profitability, that’d be great, but if they can start showing incremental progress, consensus might catch on and start giving them the benefit of the doubt. But right now, no one's basically believing their profitability story.

And then on the insider selling, I think that's also hurt the stock. You have a number of things going on. First off, you have the CFO that announced he would be leaving the company at the end of Q2, that was announced on the Q1 call and that hit the stock. Matt is very good and he's really ingrained in the numbers, so I think it’s a disappointment to see him leave but he has reiterated that he will stay through for six months past once they hire someone to help train them on the model and get them up to speed. And he actually isn't going anywhere, he's just taking some personal time, and so at least we don't see him going to a competitor. You also have seen the CEO, Julie, continually sell, which has hit the stock. Every time we start seeing it move up, we get a sell report and the stock gets hit again. All I can say, there's a number of reasons they provide for her selling, but what I would highlight is she owns about 3% of the shares outstanding. If you look at other founder-led companies, the post-IPO ownership ranges fairly significantly. Netflix’s Hastings owns 1%, Affirm’s CEO owns 10%, Stitch Fix’s CEO owns 10.8%, Zoom’s CEO owns 8%, Twitter’s Dorsey owns 2%, and Peloton’s CEO owns 2%. Despite the range, these founders have all reduced their ownership stakes in recent years—ultimately, there is no empirical evidence behind insider sales as a signal since there are a number of reasons one would sell. And so, while I do not like seeing the CEO selling, especially at these levels, it's not unreasonable with a CEO/Founder with such large exposure to want to get that down. We know that she's held onto those shares and ownership for a long time. She's also older, so there's expectation that she probably wants to get moving on getting a more balanced wealth exposure. So, it's not ideal but we can kind of understand it. Julie submitted her 10b5-1 plan in February, which was then implemented in May of this year. Once it is submitted, she cannot make any changes to it and she cannot cancel it, so the plan already in place will be active until she can submit a new plan in February 2022. 

Joe

Makes sense. That's not a question on drive and vision and longevity, I take it. 

Pro

No, this is like her life. If you talk to anybody in the industry, they'll tell you that she is one of the most energetic, driven people. And this is a hard business. We were talking to the CEO of Farfetch the other day and he said if anybody can do it, it'll be Julie in this space. And so, we really like her management. We think that she's definitely still ingrained in getting this thing to profitability and getting the stock much higher than where it is today. 

Joe

Understood. Anything that if you were at a backyard barbecue trying to convince a person that this is a big winner, anything we missed that you would say, “Oh, by the way, go check what your significant other is doing and why they're using it so much” or anything like that?

Pro

Yeah, I mean, I think retail in general sometimes, especially on Wall Street, is maybe overlooked. And I think with this model, it's easy to point to high variable costs and so you write it off. But the used car market has high variable costs, as well, and Carvana has been able to reach profitability with it. And if you look at just the market size in general, we're going from a very heavy brick-and-mortar type industry to online disruption, which I think makes a much larger opportunity than it was before. And if you just look at the used car market, it's about 3x the new car market size, and so there's a real opportunity for second hand luxury to become a huge TAM and we're just at the beginning. If you think of the long term and you believe that they will continue to grow and gain share and that they can actually reach profitability like they said they can, I just think the stock is trading at extremely cheap levels compared to other names that have similar cost bases. I would just highlight that you're not paying that much for a topline grower if you believe their profitability story. 

Joe

Do you see them needing to come to the market for equity or debt any time in the next year or so? 

Pro 

I don't and management has said they'll get to profitability with cash on hand. They've been actually really smart about raising capital. What we've seen them do is some convertible notes, and with those they do capped calls, which is what we really like to see from a management team. We recommend it to a lot of management teams but they don't always listen. With REAL, they get it. The last convert they did has a capped call I think at a price of $48. That's significant upside if that can be reached from where the stock is today at $12. 

Joe

Agreed. Nice segue into what’s your blue sky scenario looking out to where everybody's valuing SPACs, in 2025? What's your target in the near term? 

Pro

Yes, we like to look at things on a 10-year DCF basis, which can be hard for an industry that's so new. But for our bull case, I can get values up in the $40s-- well, I can get them higher than that-- I can get to their capped call price pretty easily on some basic assumptions. So, I think for a bull case that makes a lot of sense and it kind of aligns with where the company is currently thinking about the valuation. From a more baseline perspective, you can easily get to the mid-$20s on some pretty basic assumptions on topline growth and limited profitability. I think the key pushback I get here is just how big is this market really? Will we see it not grow as fast? I just think you have to believe that the second hand luxury market is huge and that all this captive value in people's closets will start to be monetized as the friction to monetize it declines over time. Thinking of it as a base case $25 and bull case $45 is kind of how we're framing the opportunity. It obviously depends-- you can really tweak those numbers if they can reach profitability when they say they can. 

Joe

Understood. Why don't we leave it at that, and we really appreciate your time. Thanks again. 

Pro

Yeah, thank you so much. 

Joe

Great. Have a good day.

Pro

You too.