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Ep. 108 – DTC is for Scaling in Really Tiny, Frequently Ordering Niches You Would Never Find in Retail

 

December 15, 2023

 

You’ve heard me talk before, I hope, about Direct-to-Consumer being simply a channel. It’s not an industry, despite all the hype from 2010-2022. The reason it feels like its own industry is that it has access to direct, real-time measurement of KPIs like repeat purchase, cohort retention, etc. that have to be estimated in consumer receipt panels for brick retail businesses. 

 

Virtually every DTC metric is possible to measure through surveys and panel datasets for retail brands. ARPU, LTV, Repeat, Retention. All of it. And some very mature consumer brands do it using other terms.

 

One reason you don’t hear much hype about DTC anymore is that these businesses have been imploding to multiple financial pressures that make them unprofitable even after they scale.

 

But the other reason, folks, is that some of the businesses with otherwise strong DTC channel unit economics ran out of consumers. In other words, they leveraged internet-based interest-ads and networking to aggregate very tiny consumer niches that are not profitable to serve via distributed brick retail locations. But, the audience was SO tiny the internet was the ONLY way to find them at all.

 

I’ve worked with some of these DTC companies, but I’m not going to talk about what my NDA does not allow me to discuss. 

 

Instead, I want to share some principles I’ve deduced along the way, so you can understand why DTC is really only a viable, profitable scale channel when three demand variables – average order value, the addressable market in households and consumption frequency align in very specific ways. 

 

The big financial problem for DTC is that this channel is very slow to reach lower cost-to-service rates per unit, due to your initial reliance on dropshippers, much slower than your freight costs decline with Kehe or McLane. As a small company, shipping five boxes at a time per zip code via Fedex is very expensive compared to entering that zip code via a chain retailer, at least on a freight-to-shipping comparison basis. Grabbing some spare space on a Kehe truck for a pallet of your stuff is not as expensive per unit as dropshipping. This is in part why the retailer marks up your product 80-100% from the distributor’s price. They need to finance their distribution network.

 

This high initial cost-to-service  immediately raises the stakes of DTC channel for all but the lightest weight (and flat) products, early on. Raising money to cover the initial loss is risky because it assumes you have lots of cheaper-to-serve ‘retail households’ left over down the line after you gather up the easy, proactive adopters online. You may. You may not. Liquid Death clearly had those households, because it was just selling water in a can. The market of households was ginormous. But not all products that get initial traction via DTC actually have a lot of households who will ever try…like ever, ever. 

 

Early on in the life of consumer brand, DTC can make sense as a break-even or barely profitable service to heavy users of your brand in a defined region close to your point of manufacturing (i.e. usually your home region). It becomes your private Club channel of sorts years before you can get into Club or finance the inventory necessary to enter Club. It is also a great way to jumpstart an e-mail list full of fans from whom you can learn and spread the word.

 

DTC has been in the headlines from 2010-2022 for scaling consumer brands wildly fast. Warby Parker. Harry’s shaving. Doctor Squatch Soap company.  It seemed for years that this was some ‘easy’ channel to scale, easier than brick retail with its huge delays just getting a buyer meeting, the infrequency of shelf set resets, the fees and the overall length of the line of brands. The allure of direct response social media ads appealed to venture capitalists, because the effectiveness of marketing seemed easier to measure in real time, making the variable cost more palatable than $10M TV ad campaigns. 

 

Thousands of DTC companies scaled in 2020 into the seven figures because of Covid-19 subsidies and decreased consumer spending overall. And, now we know that this was a massive false positive for the sector. The cost of social media click-through had already been rising well before Apple’s privacy rules reduced the effective reachable audience on all platforms. It was bound to happen as ad platforms mature and they become more expensive in absolute terms. It became more and more expensive to acquire customers unless you had unicorn ads like those of Doctor Squatch Soap. For the other 99% of brands, acquiring customers is expensive and yields profit months later, if they repeat purchase. IF.

 

If you think of most retail volume in the consumer space as the stuff sold at Walmart, Club, Grocery etc. then you’re focusing on a world of very low ticket items. Maybe $15 at most, but mostly in the $2.5-$4 range.

 

Low ticket items also generally mean not a lot of deep thought went into selecting them. Instead, it is unconscious symbolic thought that transpires, which is why packaging and marketing symbolism matters so much in driving trial.

 

    • $249 eye glasses on Warby Parker…plenty of conscious thought, even a pupillary distance measurement on your smartphone. 
    • $8.99 premium pasta sauce. Some thought, like is this really that much better than Prego? WHy should I believe this?
    • $2 a bag of Lay’s chips? Mindless. In fact, you most likely never, ever consciously selected Lay’s or any of these market leading brands. Someone else bought them and offered them to you and then, the first time you grew up and needed chips, boom! Lay’s came to mind, like the one you’ve been eating since before you purchased food for yourself.


Ticket price *average units per order = Average Order Value (AOV). Variable #1 in my discussion of where DTC shines. Ultimately, it is higher AOV business models that can survive to scale. For CPG brands, however, this requires selling cases of product, which is just not how most people try things, unless it’s canned water (how disappointing could water be?). 

 

Even selling cases of most grocery products don’t generally lead to AOVs big enough to make money shipping DTC, because grocery items weigh too much and your customers are usually scattered all over the country. Freight gets cheapest at the half and full truckload level. This requires millions of dollars of sales annually just to one retailer. It’s a benefit of scale, unfortunately. 

 

So, DTC as a channel makes money best when AOVs are much higher than a case of Liquid Death. And, yes, LD most likely lost money per order initially, because the bet was on getting quickly into retail, which it did very successfully (after raising a $75M!) 

 

Generally $125 AOV or more, unless you’re shipping like paper or something! This is how you can.

 

The second variable critical to understanding the viability of DTC is frequency of purchase. DTC rarely makes sense when you’re selling a product purchased monthly or less unless you have a high AOV to cover inefficient (i.e low volume) shipping costs AND an ultra tiny consumer niche you are chasing. More later on this third variable.

 

Low frequency and high AOV works, but it requires a LOT of households to scale. Do you know you have them? 

 

High frequency (i.e. weekly) and high AOV works really quickly to scale, if you can initially break even on logistics and shipping, because this combination does not require a lot of households. For example, if we look at Daily Harvest in the 2010s, was shipping weekly to every customer. If you were getting smoothies and meals for two people, your AOV was easily over $125 every single week. 

 

This kind of concentrated revenue per household is unheard of in conventional food brands at grocery stories BTW. By the time consumers are bringing home cases of product per week of their favorite brand, these soft drinks and water brands cost very little per bottle…very little. 

 

Using the math above, I estimate that Daily Harvest only needed only about 500,000 households to reach its once reported scale of $250M in DTC revenue…Yes, you read that right…This amounts to half of one percent of American homes. 

 

Sounds like what you might expect from an ultra-low carb, heavy vegetable, gluten-free, vegan meal brand, right? 

 

Conversely, a brand like Dawn, you know the dish soap, has a household penetration of 66% according to Statista. A brand this widely used can find consumers basically anywhere and in large numbers per store on an annual basis. It’s only common sense to ship to retailers via the cheapest possible price per unit – full truck loads. 

 

So, the third variable in vetting the wisdom of a DTC business is – the size of your addressable audience as a % of HHs you can reasonably convert to trial. Don’t think of this optimistically. You need to think of it pessimistically. As in, which folks out there are crazy enough to pay what our stuff costs because they are THAT dissatisfied with the usually cheaper alternatives OR had no idea your Category could offer such a great experience. Kettle Chips once fought this fight when Lay’s was using transfat oil and carved out a niche for itself…Kettle didn’t actually need many households to generate a $500M business at its peak.

 

The most extreme example I know with respect to monetizing a truly tiny tribe is Daily Harvest. 

 

The brand initially did very well initially selling subscription meals and smoothies because the internet is very good at surfacing tiny tribes of truly rare preferences. This is exactly the same power that social media have in aggregating and recruiting terrorists who otherwise would never meet or dare to meet each other. Tiny nutritional tribes at very prices and routine ordering can scale very large DTC businesses. The problem is that brands like Daily Harvest may have built a nutritional proposition that is so niche it has no real bridge to the next 10% of household penetration. 

 

Or it has to find a way to dilute and mainstream a much less sophisticated core set of UPCs to dominate in chain retail. This is what many, many specialty food brands learned to do before social media-fueled DTC was a thing. They started in catalogs and then spread their conventional wings.

 

The reality is that DTC was ALWAYS oversold as a channel because there aren’t a lot of CPG brands whose ticket price, average purchase volume and purchase frequency accrue enough money to fund the marketing necessary to be your own retailer and manufacturer.

 

It’s easy to under-estimate how much a brick retailer does for brands until you have to do all that traffic accumulating work yourself