#6 Direct-To-Consumer Business Models and the curious case of the 500 Cr Revenue Run-Rate
This edition explores the enablers of the rise of the D2C industry, and decoding the customer acquisition and financial metrics of a growing D2C marketplace leader set to achieve the 500 Cr revenue.
What caught my attention last week was the coverage (by both The Ken and ajuniorvc.com) of the hypergrowth of D2C companies, which highlighted the case of a particular company that has a revenue run rate of INR 500 Cr for the year ending March 31, 2021. The same company had revenue of INR 16.8 Cr in the year ending March 31, 2019. This coverage also reminded me of a great insight I read in the HBR article on “Reinventing the direct-to-consumer business model”:
“Ninety-eight percent of DTC brands are out of business, they just don’t know it yet,” said Gary Vaynerchuk, founder and CEO of VaynerMedia. “They don’t have the fundamentals to continue to acquire customers at a value that’s right, and the [venture] money will eventually dry out.”
To this, I decided to write on decoding the reported numbers by D2C brands, and the enabling factors that will drive long-term sustained growth and competitive advantage. I also try and touch upon some points with regards to the emergence of D2C from a larger industry perspective from both the consumer and the business side, building upon the great work done by the excellent writeups of The Ken and ajuniorvc.com.
D2C Business Model - An Introduction
Consumer Retail in India as well as abroad has been dominated primarily by large firms, with a limited number of brands in the space. Earlier, the primary channel for sales was limited to Kirana stores (local mom-and-pop shops), dedicated brand-related stores, multi-channel retail stores like DMart or Big Bazaar. With the increase in internet connectivity and the rise in eCommerce, retail companies realised the benefits of an omnichannel or that of an augmented online retail channel as a more efficient business strategy.
Omnichannel -- also spelled omni-channel -- is a multichannel approach to sales that seeks to provide customers with a seamless shopping experience, whether they're shopping online from a desktop or mobile device, by telephone, or in a brick-and-mortar store.
From a systems perspective, the rise of D2C companies and business models emerged from the following enabling factors of the industry:
Perception of high mark-ups: by the consumers on retail products sold by traditional firms like Unilever, P&G, Tata, Reliance, etc.
Limited R&D and product innovation: that translated into traditional firms launching fewer brands and products in the space.
Perception of value dilution: From a behavioural economics perspective, the perception of the consumers in value generation on dedicated segments of the D2C markets (fashion, cosmetics, etc) was higher than established firms doing the same under various brands.
Rise of the new-target segments of consumers - the Millenials and the young working class of consumers under 35 years.
Massive network effects: that came in through the new target group of customers were huge, which were fuelled by rising social media consumption and ad-wars on platforms like Facebook and Instagram.
Rise of the creator economy: and the birth of influencers, product videos on Youtube, Instagram, and TikTok, along with increased customer engagement channels and relatable agents promoting the same.
Supporting infrastructure: in terms of both online infrastructure (Shopify, AWS) as well as offline infrastructure (hyperlocal logistics and warehousing).
VC Funding: Venture Capital saw untapped potential in specialised and niche product areas with high consumer traction and definite inelasticity - eyewear, lingerie, cosmetics, being some of the initial thematic areas. The investments grew as more startups started engaging directly with the customer through D2C offline/online channels, without paying hefty commissions to the various entities in the middle of the value chain.
Other factors: include regulatory relaxations on eCommerce, push for make-in-India, increased information asymmetry on the products, health and dietary fads, rise in consumer awareness, and impact of financial instruments like BNPL (buy-now pay later) and other financial transaction platforms.
Curious Case of INR 500 Cr Revenue Run Rate
One of the large D2C brands was extensively quoted in the media with projections of INR 500 Crore revenue run rate by the end of March 2021. This metric for success was particularly impressive considering the revenue at the end of March 2019 was INR 16.8 Cr.
This meant, the company grew 30x in two years. Mind you, not 30%, but 30 times (30x).
“From a meager revenue base of Rs17 crore in financial year 2019, the company has seen a meteoric rise with financial year 2021 revenues at about ₹500 crore. Base portfolio has grown well and new launches have also contributed”
— Equity analyst report
Here are some of the observations that emerged out of my many conversations with brand loyalists and friends familiar with the product and the landscape of the D2C industry on the success of the company in context:
Revenue run rate vs Revenue
The technical difference is the extrapolation of one month’s revenue (or a definite time period’s revenue) spread over 12 months, and the other being the actual revenue numbers themselves. When in 2019 the company had Rs 16.8 Cr revenue, that number was the actual figure achieved, recorded in the books of accounts. In this case, the Rs 500 Cr revenue run rate means more from the perspective that their current monthly revenue is around Rs 41 Cr, or that the quarterly revenue achieved by the company is 125 Cr - which is extrapolated to one year. This does not definitely indicate the fact that the company has actually achieved the Rs 500 Cr revenue target.
Customer Acquisition
To achieve a revenue target of Rs 500 Cr, we require about 4.16 lakh customers per month If we take the average transaction value of the customer on the D2C to be Rs 1000. If the average range of transaction value varies between Rs 800 to Rs 1500, we get the desired customer base in the range of 5.2 lakh customers to 2.7 lakh customers.
There are complex calculations pertaining to customer retention and CLV (customer lifetime value) that I have avoided at present due to the lack of data. However, we can safely assume some of the following customer metrics:
A high organic customer growth rate that transacts on the D2C platform is required.
Turn-around time for a customer may be at least one month (in this case of hair oil, shampoo, etc), hence the share of organic customers per month far outweigh the customer retention on the platform.
To achieve say a minimum of 2.5 Lakh organic customer growth rate per month, we require at least 50 lakh impressions on the D2C website per month, considering a 5% conversion to revenue. Though conservative, this aligns with the current Alexa global web traffic score of 2.8.
Financial Metrics
The following table illustrates an estimate of the D2C company performance based on the annual financial reports.
From a mere 5 crore revenue in 2018, the company grew about 20 times in two years. The gross margins averaged at 55-60% through the years. The company rolls grew 11 times in the two years, with a five-fold increase in legal and professional fees.
The interesting part of this business model (which can fairly be extrapolated to the larger industry) is the fact that these brands donot manufacture the products on their own, and aggregate the manufactured products and use their own branding on the same. This is how they are able to have such high margins.
Even though the business saw high gross margins, the company continued to be under losses due to the following critical cost components:
Freight and Logistics: The company spends just over Rs 135 per transaction as freight and logistics charges per transaction. This may be inclusive of the charges of collection from manufacturers, and last-mile hyperlocal delivery through their D2C platform.
Marketing Costs: Marketing costs increased four-fold, with spends touching 45 crores to generate an inventory of 48 crores. The company spends about Rs 400 per transaction (if the average value of a transaction is Rs 1000).
Inventory turnaround: The company held about 13 Cr worth of inventory at the end of March 2020, which had to be actualised to revenue. A shorter turnaround time will add to the performance of the company.
Sales Commissions: Omni-channel ensures the company has to pay heavy commission charges to players like Amazon, Flipkart, and others. In this case, it ballooned 23 times in one year (2019 to 2020).
Owning a D2C platform for a company brings about a significant expense on IT, which rose 10 times within a year.
Implications and Path to Profitability
Looking at both the customer acquisition metrics along with financial performance, there is no doubt that the growth in the D2C segment is nearly impossible without the fund of VC investments with deep pockets. While the Rs 500 Cr revenue run-rate seems achievable, it speaks nothing about the profitability, not to mention the path to profitability. However, in this case, the large consensus of equity analysts has been that the D2C companies are on the path for profitability in the next 12 to 18 months, it is my personal view that these companies have a long way to go. Some of the key takeaways on enabling these companies to be on the path to profitability include:
Efficient inventory turnarounds and effective inventory management systems.
SKU management - through optimisation algo’s on customer transactions.
Logistics optimisation - both on the supply side and demand side.
CAC to LTV ratio: reduce customer acquisition cost (while keeping a steady and increasing organic customer growth rate) whilst increase lifetime value (through retention, referrals, etc).
D2C is here to stay. The coming months and years will look at a lot of consolidation of D2C companies, as well as strategic acquisitions. However, the path to an IPO exit (which is a favourable outlook for these startups and their investors) will require taking a long hard look at the underlying operations and business models.
Leonard A. Schlesinger, the Baker Foundation Professor at Harvard Business School mentions some of the following points as a natural evolution for D2C companies in his HBR article here:
Omnichannel is a necessity. As DTC distribution becomes a bottleneck to growth, digitally native brands must cross the chasm into IRL retail (even if physical retail is on hold during the current coronavirus pandemic).
Differentiate through community. A unique advantage of DTC brands stems from their ability to have one-to-one relationships with their consumers while capturing valuable data that would be impossible to glean at traditional retail. Increasingly, this looks like a two-way relationship in which community members collaborate with brands in order to co-create new products and services, something that Pattern Brands calls “direct with.” While community will remain a strong differentiator from incumbents going forward, the challenge for modern brands with mass ambitions is to successfully scale that intimacy as they move beyond DTC.
Expand margins via vertical integration. Borrowed supply chains may work at launch, but not over the long run. As mature brands compete for the same digital impressions as scrappy upstarts, they obliterate the arbitrage that was once a DTC’s competitive advantage. And any margin that early DTCs preserved by cutting out middlemen was ultimately lost to expensive, individualized distribution. As customer acquisition costs (CAC) increase across the board, brands must plan to vertically integrate (by, for instance, creating their own manufacturing operations instead of contracting it out) in order to preserve margins and survive past Series B.
Prepare for the voice revolution. In the next decade, voice interfaces stand to reshape commerce in much the same way that the internet did 30 years ago. Existing supply chains, marketing strategies, and brand systems are optimized for the screen-based way that we currently interact with the web. Companies that are not thinking ahead to the next platform shift will inevitably fall behind.
As brands begin to engage with these strategies, the term direct-to-consumer feels less relevant by the day. “DTC” was the product of a specific moment that catapulted a handful of early entrants to stardom. But today’s environment suggests that that model is no longer sustainable. Success today requires an understanding of both evergreen business basics and also the lasting ways in which the DTC model has permanently reshaped the industry.