Late last month, Wayfair, the leading online-only furniture brand, reported dramatic sales growth and yet year-over-year profits fell significantly. Unsurprisingly the stock took a steep hit. In its most recent earnings announcement, Stitch Fix, the online styling subscription service, reported sales up over 25%, yet profits were essentially flat. When they signaled that profits were expected to get worse as they grew, their stock also took a beating. Several non-public online-only retailers are said to be facing similar issues of growing sales and non-existent profits. We shouldn’t be surprised.
Not too long ago it seemed like e-commerce was going to eat the world. Pundits, equity analysts and venture capital seeking entrepreneurs alike declared the death of physical retail. Many even predicted online shopping would surpass 50% of all retail sales by 2025 (spoiler alert: it will be lucky to break the 20% mark by then).
What got lost in the hype were two fundamental things. First, in many instances, brick-and-mortar locations actually add value to the shopping experience. It turns out lots of consumers prefer going to a physical store for all sorts of reasons and for all sorts of products and services. So it’s hardly shocking that once digital-only brands are now opening stores and that many “traditional” retailers continue to add to their store fleets as well. Second, and more importantly, a great deal of e-commerce remains unprofitable and often struggles from significant diseconomies of scale. This latter factor likely helps explain what’s going on underneath the surface of recent earnings concerns, including from brands as disparate as Blue Apron and Walmart.
Without access to internal data it’s impossible to say for sure, but having analyzed several pure-play brands’ customer metrics over the years I can hazard a guess at the challenges these brands are facing. Here’s a typical growth pattern for a pure-play online brand and why most eventually hit a wall, some never to recover.
Phase 1: The Liftoff
Having identified an interesting market niche and put together a solid business model, the brand launches. The first tranche of customers are acquired relatively easily as they quickly “get” the new concept and are already comfortable shopping online. They tend to be acquired inexpensively as they are the quintessential “heavy users” who are apt to learn about the brand through social media and word-of-mouth. Accordingly, many are likely the perfect fit customers, likely to be loyal and less reliant on discounting. Lifetime value is very high, cost of acquisition low. Bingo!
Phase 2: Momentum Builds
With success in Phase 1, the buzz starts to build, and flush with a big round of VC money the website gets optimized, investments in branding are made and marketing is expanded. Growing awareness leads to the relative ease of aquiring “look-alike” customers at a generally attractive cost of acquisition. It may take a bit more promotion to incentivize trial, but hey you got to fuel the rocket ship right?
Phase 3: Time To Go Find Customers
In this phase it becomes readily apparent why building an online-only brand isn’t so easy. Here, in order to sustain hyper-growth, the brand must start moving beyond its obsessive bullseye core customer to the outer rings where, on average, the customer spends less per year, is less loyal and is more promotionally driven. There also tends to be more direct competition as a brand expands. It also turns out that to break through all the marketing noise and gain the attention (and first sale) from these more promiscuous shoppers, the brand has to start spending more on expensive highly targeted marketing channels (i.e., Google and Facebook). Cost of customer acquisition starts to escalate, gross margins start to be depressed and the average lifetime value of the marginal customer acquired declines.
Phase 4: ‘Ruh ‘Roh
Here despair starts to set in for many as it becomes apparent that the cost of acquiring a marginal customer is often greater than the lifetime value of the customers being acquired. In the initial stages of Phase 4, the best brands are playing around with their marketing mix, finetuning their assortments and generally optimizing all manner of things to try to see if they can change this trajectory and convince investors that they aren’t throwing good money after bad. Some conclude that the only way to sustain growth and have a chance at profitability is to open physical stores (oh, irony, you are a cruel mistress). This is also often the time someone calls Bentonville or other deep-pocketed “strategic partner” in hopes of securing a lifeline.
Phase 5: Crossroads
Quick, name the pure-play e-commerce brands that made it through Phase 4 and came out alive (it doesn’t count if they got acquired by Walmart). To be fair, it is still too early to say whether many of the brands that find themselves at this difficult crossroad will make it out alive or join the many others in the retail graveyard. And to be sure it’s certainly not unusual for customers that get added later in a company’s growth cycle to be less profitable. What is different for pure-play e-commerce brands is that it is almost impossible to avoid rapidly escalating marginal customer acquisition costs (which is only like to get worse as Instagram and Pinterest figure out how to raise their prices for targeted ads). Rising cost of acquisition with declining lifetime value is a difficult equation to work through.
When it starts to look like every incremental customer that gets added to a brand makes profits worse, investors might want to start think about heading for the door.
A version of this story appeared at Forbes, where I am a retail contributor. You can check out more of my posts and follow me here.
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