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This piece originally appeared on the blog of Bainbridge Growth. It is being republished by The Current with permission.
The end of summer brings investor scrutiny of the apparel and retail industries, and pressure is being felt by department stores, specialty apparel retail, and digitally native brands. The primary headwinds include excess inventory, elevated fuel surcharges, and returns combined with inflation’s impact on consumer spending.
Whether the category is eyewear (Warby Parker), women’s event wear (Lulu’s), footwear (Allbirds), or bags and accessories (Vera Bradley) much of the commentary and proposed solutions are similar. A notable part of this analysis was that all four companies reduced full-year 2022 revenue guidance in recent weeks to reflect softening demand and higher expectations of promotional discounting. This report will dive into recent earnings reports and walk through some of these subjects and how DTC brands can position themselves as they encounter a shifting macro situation.
Inventory and promotions
The Bainbridge Blog already covered inventory issues at big box retailers earlier this year. Excess inventory has predictably now reared its head at smaller DTC brands, and these companies have shared with investors their strategies to deal with the extra product they have on hand.
Lulu’s perspective on this challenge has been a reiteration of their non-seasonal and less fashion-forward catalog. They increase wedding and college-homecoming inventory in line with demand, and actively avoid seasonality that is driven by weather or holiday spending. Even with this approach, Lulu’s management mentioned $5M of their $48.5M in Q2 ending inventory is excess.
Allbirds wrote off a significant chunk of their first generation apparel catalog inventory in Q2, centering their second generation of apparel around evergreen (non seasonal) line up that is not confined to a particular functional use case or weather pattern. On the most recent earnings call, even after the write down Allbirds identified $10M out of their $122M as excess. Vera Bradley wrote off approximately $5M in inventory and finished the most recent quarter with $149M in goods on hand, with most of the write off centered on masks and the exit of their retail start up brand.
Many ecommerce retailers have called out financial pressure from higher shipping costs, add-on fuel surcharges, and elevated returns. As gas prices have tapered off from their June highs, certain transport markets have seen reduced shipping rates and fuel surcharges but most of this favorability will be in the coming quarters.
Lulu’s referred to high fuel surcharges in Q2 and accessorial fees imposed by carrier partners, in addition to a sudden jump in returns they attributed to macro softness. Those two variables hurt gross margins by roughly 300 basis points, accounting for most of the gross margin drop to 45.8% vs 49.6% (Q2 ‘22 vs Q2 ‘21). Recall in our earlier piece this year we covered Lulu’s ongoing transition to useing robotics in their Eastern Pennsylvania distribution center that commenced in Q2 ‘22. The robotics rollout and the expansion of the Northern California distribution center drove a 30 basis point increase in variable labor within SG&A as a percentage of net revenue.
It will be key to monitor the future P&L improvements in gross margin and SG&A as a percent of revenue as Lulu’s reaps the benefit of this fulfillment network investments. Allbirds is investing in supply chain efficiencies that include a dedicated third party returns processor in the US as well as new manufacturing relationships and more automated distribution centers.
Store count growth vs. sales growth
Omnichannel DTC brands have also continued to aggressively expand their store footprints over the last 6 months, leading to deleverage in the P&L as sales growth slows. As these brands open stores, they increase SG&A. They are hoping that the new stores increase sales and therefore the increase in sales is greater than the increase in costs. But in many cases, revenue growth for omnichannel brands is converging with or falling below the rate of store count growth. We believe that the next several quarters will see significant divergence in margin performance of digital native brands versus omnichannel strategies.
Omnichannel brands are beginning to see sales growth below store growth. (Chart by Bainbridge Growth)
The reaction from consumers under the $45K to $55K income level has been the most consistent call out by large retailers and Bainbridge DTC Index members. The recent common refrain has been around the sales slowdown that began in mid-June as national gas price averages ticked up above $5 per gallon. Brands like Warby Parker with average household income per customer of over $100K were quick to point out their upmarket positioning. Allbirds also has a relatively upmarket positioning as 65% of their sales was from households with income over $100K.
Even with their large exposure to affluent customers, Allbirds management mentioned that “persistently high inflation has started to take its toll on consumers” and pointed out a sales slowdown beginning in mid-June. The business saw additional pressure on the international segment from foreign exchange rates and Europe’s subdued growth. Allbird’s decided to lay off 8% of staff and slowed new hires after their 15% YoY growth quarter was also marred by a substantial inventory value writedown that drove a gross margin drop from 56.1% down to 36.1% (Q2 ‘21 vs Q2 ‘22).
Allbirds customer mix by income segment. (Courtesy photo)
Warby Parker saw slowness start in the back half of May, with Q2 landing at a growth rate of 13.7% even after a 22% increase in store count from 145 to 178 (Q2 ‘21 vs Q2 ‘22). When accounting for inflation this is quite a concerning growth rate given the increased store count, subsequently Warby took action to layoff 63 people, equating to 15% of their corporate headcount.
Warby Parker revenue and store count. (Source: Warby Parker)
Retailers of all stripes are clearly facing a range of challenges, with the impacts more pronounced for certain business models. Lulu’s continues to show the profitability of monochannel ecommerce combined with a data driven inventory approach. Their focus is on constant improvement of the fulfillment cost structure and maintaining their industry-high inventory turns. From an omnichannel perspective, Allbirds and Warby Parker are having a tougher time navigating the macro slowdown due to their capital plans being focused on store count growth.
It’s hard to quickly pivot a brand's growth story once it is built around expanding store footprint as analysts begin to ask more “path to profitability” questions. If consumer spending quickly reaccelerates, omnichannel players may be better positioned to acquire customers at efficient CACs. For the time being, the brands that have avoided layoffs are ecommerce only brands (LVLU) or omnichannel players with slow or no store growth (VRA). These business models may weather the current macro environment better.
Trending in Economy
The company is pulling back after breakneck pandemic expansion. Will it sacrifice the shopping experience along the way?
Amazon is in a period of rebalancing.
The company has long scaled at a relentless pace as it sought to not only provide a marketplace for commerce, but the infrastructure that enabled it, as well. Amazon found another level of overdrive over the last two years, as demand spiked to unseen heights during the pandemic and the company tried to build to keep up.
This wasn’t necessarily a period that saw the kind of invention that Jeff Bezos made an existential tenet of the company, but it nonetheless seems to be shaking out as a cycle that included risk and fallout.
In this case, the risk was not a new device like a smartphone or a move to bend the future to Amazon's will like drone delivery. Rather, it was an expansion that took its already-vast operations to new heights.
Nowhere was this more evident than the company’s logistics network. As CEO Andy Jassy described it to analysts Thursday on an earnings call, the company doubled the size of a fulfillment network it took a quarter-century to build in two years. It also built out a last-mile delivery network that was the size of UPS, which is one of the top two carriers in the U.S.
In 2022, all of that expansion ran into 40-year-high inflation, war in Ukraine and a pullback in demand for goods amid reopening. The company first admitted the problem: It had overbuilt.
But the solution is not to tear down. It had to keep expanding as only Amazon does, while still cutting back in a period of “belt-tightening,” as executives have put it.
That’s evident in watching developments out of the logistics network alone. Amazon pulled out of some areas, and canceled plans to expand into some new warehouses. Yet, as Business Insider reported, it still added 79 million square feet – a footprint that is equal to half of next-closest competitor Walmart’s entire distribution network. It is also expanding Buy with Prime, a new program that will allow direct-to-consumer brands to offer Prime benefits, and, by extension, access to Amazon’s logistics network. Another service, called Amazon Warehousing and Delivery, is designed for upstream storage, necessitating more space to be made available in the network.
At the same time, it will seek to keep doing more for consumers.
Jassy indicated as much when he was prompted to outline his priority areas. Beyond cost-cutting, he said speed is the second highest priority for Amazon. As if to conform this, he said later in the call that one-day shipping is getting off the ground in North America.
Selection is another priority area. At Amazon, that phrase translates to a few things, but top of mind is “expanding the third-party seller marketplace.” Third-party sellers accounted for 59% of sales in Q4. Beyond sales, Amazon’s work with the sellers who post their products on the marketplace is also lucrative for the company. Amazon allows these sellers to tap its logistics network to offer Prime through the Fulfillment by Amazon program. Its business segment called third-party seller services grew 20% year-over-year in the fourth quarter, right in line with the massively profitable cloud computing division Amazon Web Services.
Price, Jassy said, is another area of importance, especially with the consumer pullback on discretionary purchases being observed amid inflation.
“I think pricing being sharp is always important,” Jassy said. “But particularly in this type of uncertain economy, where customers are very conscious about how much they're spending, having the millions of deals that we put together with our selling partners in the fourth quarter was an important part of the demand that you saw.”
Finally, Jassy cited a priority of improving the customer experience. He said Buy with Prime would give subscribers the ability to use their benefits across the web, and noted that virtual try-on for shoes brings change to the shopping experience.
But it’s in this area that the tradeoffs that may be happening under the surface may rear their head again. GlobalData Managing Director Neil Saunders noted that online shopping generally is becoming “more difficult" on Amazon.
“While the Amazon marketplace is far from a terrible place to shop, it has become more complex and cluttered with a multitude of products, delivery options, and prices levels for shoppers to sift through,” Saunders wrote in note released at the time of the earnings call. “The result is that impulse buying has dropped and that more people are migrating away to other retailers. This is not yet a serious problem as erosion has only happened at the margins, but it is something Amazon will need to address and arrest to prevent further decline.”
Taking a rhetorical step further, the journalist John Hermann wrote this week that a “junkification” of Amazon is taking place, while arguing that “everything is going according to plan" for the company.
He placed the growth of the third-party seller marketplace at the center of this trend. But it also comes as Amazon grows its advertising business, with many taking note of a growing number of ads on the platform. The company also wants to keep growing Prime, and is now using content such as Lord of the Rings and NFL’s Thursday Night Football as key acquisition channels. Both had “record” signups of new Prime members, CFO Brian Olsavsky said.
“We see a direct link between that type of engagement and higher purchases of everyday products on our Amazon website,” he said.
It will have to do each of these things at once, while entering a period that will require it to be “more targeted with its growth ambitions,” as Saunders put it.
"Since its inception, Amazon has had a culture of throwing dollars at many different things to see where they led and what they could learn," Saunders said. "That approach worked well for a younger, fast-growth business. It works far less successfully for a more mature entity. In our view, management deserves credit for recognizing this and quickly responding. However, the shift requires a lot of care because Amazon needs to find a new balance between being ambitious and innovative and being more frugal with its spending – which will be very challenging."
Jassy said the changes of the pandemic made its logistics a "different network." That may be true of the whole company. Rather than an isolated cycle of overbuilding and pulling back, this may prove to be a period that changes Amazon altogether. The bets will still be there, but the risk will be magnified with fewer dollars that don't pay off to go around. As hinted by the logistics buildout of the pandemic and even Buy with Prime, they also may look more operational.
Less delivery robot, more delivery optimization.
As Jassy put it: “We're going to be very thoughtful about how we streamline our costs, and I think you see a lot of that, but we're also going to continue to invest for the long term.”
The recipients of those investments will say a lot about where it wants to head in this next year.