Delivered Gross Margin & Always Remembering The Big Picture
For many years, prior to my recent adventures in the start-up world, I was a portfolio manager on Wall Street. It was a job I loved; as an unenthusiastic academic in my youth but a very hard worker who bucks against tradition, it was a forum where I found success in taking an unconventional approaches that often bested the well-educated consensus.
Over those years, I developed a set of Five Guiding Principles over a decade ago that is as applicable as an investor as they are in running a business.
- The best risk control is often a fresh perspective
- Cheap does not equal value
- Do not confuse data for analysis
- Always remember the big picture
- Evolution is the only way companies prosper over the long-term
I was reminded of the all of these last week while participating in an investor forum. One of the discussions was around the Direct to Consumer (DTC) landscape, particularly around the apparel space, and whether we would see good growth in that industry, perhaps some successful fundraises or exits, and whether future prospects were bright.
There is a lot of noise and activity blurring our outlook, but the big picture remains very clear. In the aggregate, the end of the holiday season will likely see a number of closures of brands, old and new, particularly those that have lost price integrity.
Below I discuss a basic tool I use to analyze companies in the industry, the monster they are all running to escape, and how the two interact before even thinking about investing.
What to Look For (At)
In analyzing consumer companies in the past I would look at cash flows, balance sheet, operating margins — the usual financial measures, and try to get a handle on the businesses momentum, usually comprised of same store sales. For the most part, I limited my investments in specialty retail or apparel companies to really unique businesses. As a value investor, those were rare, but when they succeeded, such as Cabela’s around 8–10 years ago, they could provide exceptional returns. Deviation from uniqueness was usually a path to regret.
Start With the Basics
Traditional analysis is lacking. In the past it was fairly simple: a good product would sell for a good price, customers would buy it in a store where a company would earn a nice merchandise margin. If more customers came in, those rising sales (variable) would count against occupancy costs (fixed). A company that grew its sales 10% against a rent cost that grew 2% would experience positive earnings leverage, reported margins would increase, profits grew, and investors were happy. And vice-versa. Simplistically speaking, same store sales and operating margins were adequate to understand a business.
CAC and LTV
Earlier this year while presenting to an investor conference, I was asked my view of the Customer Acquisition Cost and LTV as they are very popular as starting points to evaluate younger companies. While it makes sense as a general framework, I am jaded by watching decades of investor pitches using new methods to establish value that ultimately fail to be effective when the economy shifts.
I answered then that for companies only a few years old, there is usually not enough data to be statistically significant in a world that is ever-changing, and given the events of 2020 I think that remains a fair view, particuarly for non-subscription businesses. At the time I suggested that I believe, as I always have, that cash flow ultimately is what matters.
Delivered Gross Margin / Profit
I focus on what I call Delivered Gross Margin. A Google search does not show it so I’ll claim it as ‘new’ but it is essentially contribution margin. It is not a figure companies report, but they should. Simply defined:
Delivered Gross Profit:
Net Revenue
- Merchandise Cost (product cost + freight-in + tariffs [if any])
- Warehouse Cost (inbound stocking fee + storage + packaging + pick fees)
- Shipping Cost (shipment costs to customer’s door)
- Returns Cost (shipments back to warehouse + restock fee)
- Occupancy & labor for any physical stores
= Delivered Gross Profit
If the core business of a company is producing merchandise, selling it to a consumer, and getting it to their front door, there should be no mystery around the unit economics of that transaction.
For external purposes, it allows investors to understand unit level economics for a business. For internal purposes, it is far easier for management to define a goal around what the costs are to get a product into a customer’s hands, and align teams and incentives around those measures.
Who is doing it right?
Some companies are immensely successful. In my view, Lululemon is excellent and it is worth a moment to break down their economics. The company is growing and very profitable. Still, the Delivered Gross Margin is not obvious. While the company counts retail occupancy against gross profits, fulfillment, including shipping to consumers, is included in ‘Selling, General & Administrative’ costs as shown below:
Although it is likely imperfect, given the significant cost of shipping (Outbound Transportation) it is more appropriate to include shipping costs in gross margin calculations, particularly if occupancy is included in Cost of Goods Sold. If using the costs of a retail store to deliver a product counts as cost of goods sold, surely the cost to ship it in an e-commerce transaction is the same. As shown below, the company is growing and has very solid margins.
Further digging in, one can pull out occupancy costs from the footnotes. These probably include corporate headquarters, and the change in accounting for ASC 482 makes 2020 incomparable, but taken as a whole, occupancy costs have been stable despite growing revenue as the company expands.
Taking one final step of removing occupancy costs from cost of goods sold, we can create a very rough proxy for merchandise margin, which is probably understated given other items within the category.
The company has many things going for it, but under the surface here is what is important: LULU is maintaining, and growing, merchandise margins in a difficult retail environment. Even so, while our proxy for merchandise margin has increased an estimated 486 basis points since 2017, the Delivered Gross Margin increase has lagged by nearly 100 basis points.
There is little fixed cost leverage in DTC
Specifically, in the period 2017–2020, LULU’s total revenue increased 70%, which is excellent. Its merchandise margin increased by nearly 500 basis points in that period, also excellent. Yet its delivered gross margin increased by less as outbound transportation costs increased by 100 basis points of revenue, a notable deleveraging.
For a DTC brands, this demonstrates online margin improvement is less driven by scale of operations than it is from pricing and product — at least at smaller stages. Simply pushing more merchandise through the warehouse and onto a truck does not deliver the same earnings growth as doing the same through the fixed cost of a retail store. Although this equation changes when a company reaches the scale to operate its own warehouse, the company needs to get there first.
Many won’t reach that stage without dealing with the monster chasing everyone.
The monster chasing everyone
If the following years are anything like the last downturn, brands that aggressively discounted to keep traffic high in 2020 may find that traffic will only return at the next sale leading to permanently degraded margins.
The monster chasing every DTC apparel brand is deflation. The below chart shows that while your cable bill kept going up, and your health care costs have skyrocketed, apparel has basically been in deflation for much of your lifetime.
The core questions to be asked of a DTC company in this environment is what are your Delivered Gross Margins and can you maintain your pricing integrity? Companies that are able / willing to hold the pricing line, at least on their key products, through this period should be far better positioned than those that keep the discounting light on. Life consistently shows it is not fair; companies that happened to be weighted on the wrong side of the balance sheet early this year have a harder road.
The Big Picture
At the end of calendar 2007, Abercrombie & Fitch had a stock price around $80. It posted a -1% comparable sales gain for the year, but 2007 was a tough year for the consumer. Revenue was $3.7 billion, and a roughly equivalent Delivered Gross Margin figure was around 30% leading to an EBIT operating margin of 19.8%. And then the financial crisis hit.
Most retailers were caught in the maelstrom, and massive discounting ensued. ANF could have pursued an alternative path, but every competitor dramatically dropped price and became very promotional. Very few have thrived; all sense of exclusivity and excitement was pushed aside for massive discounting. Perhaps there was actually no alternative, but as the mall retailers destroyed their pricing models, they destroyed their businesses. Last year, ANF posted $3.6 billion in revenue, about the same as over a decade ago. Yet the comparable Delivered Operating Margin is half of what it was back then, coming in at 16.55%. The core operating margin a virtually non-existent 1.9% and the the stock is $15, less than a fifth of its previous value. They are lucky ones! Aeropostale, Jos A Bank, Ann Taylor, Brooks Brothers and many more all bankrupt.
The Simple Math
Simplistically speaking a $100 shirt with a 60% Delivered Gross Margin is $60 gross profit. On sale at 20% off, $80, it becomes a 50% Delivered Gross Margin, a $40 gross profit. A ten point reduction in margin results in a 33% decline in absolute dollars.
With CAC anywhere around $50-$100 these days, selling a few items on sale can be a money losing opportunity for many brands. Compounding that, for those companies that are using a line of credit, cost of capital can easily be 15%, further pressuring cash flows when lead times are regularly counted in months.
My Instagram feed is full of apparel brands I have never heard of, some of which look great, but nearly all of which are on sale. In the quest for survival in the face of Covid, many online retailers feel they have no choice but to slash price to move inventory while ramping up marketing spend.
The simple math will be hard for many — but those that get through will have a very nice runway for the coming years. And retail space will be really cheap to add.
