Memo: The Forgotten Middle

The shift to eCommerce has been overstated, according to one common refrain. There’s some evidence to back that up: total eCommerce penetration accounts for an estimated 14.3-16.1% of all retail sales in 2021, a small slice. Anecdotal support of physical retail’s continued prominence is also regularly called to mind. In a well-researched essay by Elena Burger, an investment analyst at Gilder Gagnon Howe & Co, she explains: 

The takeaway shouldn’t be “eCommerce is eating the world” it should be “despite lockdown, store closures, mass layoffs, and global logistics networks that rival militaries in terms of sophistication, eCommerce was less than one-sixth of sales in the US.”

Intelligence, for the moment, is outpacing life. [1]

The essay is tremendous. A number of takeaways will leave you wanting to understand more about the fascinating times of digital agglomeration’s clash with traditional retail. My concern, however, is that it glosses over two larger issues: retail infrastructure is not solely resting on New York’s soil (the city is mentioned 12 times throughout the essay), and throughout the country, pockets of front-office employment has evaporated. As retail store managers and associates have faced furloughs or worse, there is opportunity for lateral movement to other retailers, brands, or comparable industries. This is not so with the tens of thousands who’ve lost their jobs in front-office retail.

One brand’s success in an area like Soho, New York is often held up as the anecdotal argument that retail’s demise isn’t so dramatic, with stories that read, “Retail is not dead, look at what Allbirds is accomplishing in physical stores!” Yet if you zoom out, recent reports from CNBC tell a different story: rents have fallen to $367 per square foot, a 62% decline from the area’s peak in the spring of 2015, and are declining 25% year over year [2]. The average gross margin of a major retailer fell from 28.44% to 16.76% between Q2 and Q4 2020, with EBITDA margin falling nearly 100 basis points over the same period [3]. Meanwhile, foot traffic has yet to return to pre-COVID form.

We built a bubble of physical retail that reflected changes in America’s social fabric. We did not account for what an even a single-digit change in foot traffic could do to those creations. Ms. Burger explains:

In that period, engineering solved the rather unwieldy problem of “how do we bring an unfathomably large number of people together so they can shop, and justify the millions of dollars we just spent building out this department store or mall.” While developers had other tools to ensure profits (mall operators used a 1954 tax change to accelerate their depreciation schedules and, in turn, realize higher tax write-offs) this is something really worth highlighting. [1]

It’s important to note that preceding this 1954 tax change was another major shift in society, taking place earlier that same year.

The U.S. Supreme Court abolished segregation in schools after Brown vs. Board of Education was decided. This meant that urban areas around the country were characterized as unlivable by some. Nowhere was this felt greater than in the midwest, where affluent families and government-funded veterans moved to the suburbs to allow their children to avoid certain schools. […] This massive exodus to the American suburbs corresponded with a construction boom in the outskirts of many metropolitan areas. [4]

We built these new malls as a means to modularize new cities removed from urban centers. We built these malls far too fast and far too often. America is simply over-retailed. Between 1950 and 1990, the aggregate population at the center of American cities declined nearly 17% while population grew by 72% in the suburban areas. Before the 1954 tax change was enacted (accelerated depreciation), there was one regional mall in the United States. By 1956, that number rose to 25. There was 6 million square-feet of retail in 1953 and nearly 31 million square-feet by 1956.

We did not account for a future of re-urbanization. We did not account for a future that saw a decline in car ownership. And we did not account for a future that saw digital means of trade as an alternative to the physical.

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When you learn just how little retail’s physical development is tied to population growth, you begin to understand why so many retailers relied on debt and persisting sales promotion to account for waning interest. eCommerce does not have to exceed 30-40% of total sales to negatively impact the retailers who failed to prepare for a future without the consistently high rates of foot traffic that mall developers advertise. In fact, eCommerce as a percentage of retail only needs to remain where it is to continue disrupting America’s 70 year-old model of mall retail. And eCommerce is not responsible for the “contraction of physical retail.” It’s more complicated than that.

Authentic Brands Group’s recent acquisitions are shaping up to be a bright spot in the mall retail sector (Frye, Nautica, Nine West, Volcom, Barneys New York, Forever 21, Lucky Brand, and Brooks Brothers among them). But there are a number of retailers whose positions are increasingly vulnerable. Foot traffic remains unreliable at many malls across America. A number of major retailers are enduring disruption, some worse than others. Your mall is overwhelmingly represented by one American city that is 560 miles away from Manhattan and 2,800 miles away from Los Angeles. It’s the forgotten middle.

As 2019 came to a close, I was sitting around a table with retail of executives from L Brands (Victoria’s Secret, Bed Bath & Beyond), Designer Brands (DSW), Ascena Retail Group (Justice, Lane Bryant, Ann Taylor), Abercrombie & Fitch, and Express. Each headquartered in Columbus, Ohio, the stakes of the conversation were alarming. According WWD, Columbus is the third-ranked city for fashion designer employment behind New York and Los Angeles. This region of Ohio depends on corporate retail like Pittsburgh once depended on steel mills or Detroit boomed on domestic automotive manufacturing. Even a fractional change in the retail ecosystem can cause seismic damage to the city’s tax base. The city’s economic development website boasts:

The Columbus Region is home to some of the world’s most recognizable retail and apparel brands who drive innovation globally – ranking No. 4 along large U.S. metros for concentration of retail headquarters. A concentration of headquarter operations is joined by businesses focused on market research, analytics, design, technology and omni-channel efficiencies – creating a market that uniquely connects retailers with customers.[4]

Well into the day, eCommerce rose to the forefront of the conversation. While some of the leaders were prepared for an eventual digital-first economy, few were eager to depend on it so heavily and so soon. By the second quarter of 2020, digital and logistical infrastructures would be put to the test as mall foot traffic fell precipitously. That foot traffic has yet to return to its pre-COVID form. And neither have the gross margins that sustain the large corporations that depend on them for the maintenance of five-figure workforces.

Retail is resilient but all retailers are not. Since that conversation, the collective of brands in that room has eschewed thousands of front-office jobs, disrupting suburbs and schools and places of worship that depended on the consistency of enterprise retail. The reality is that the No. 4 metro for retail employment and the No. 3 metro for fashion design has been impacted by the shift to digital agglomeration. And it’s a leading indicator for further disruption, if I have ever seen one. We are talking about a class of corporations that are commonly operated with extraordinary amounts of debt and little room to tolerate disruption. In The Credit Report, I explained:

A number of key retailers are carrying debt-to-EBITDA ratios that are not sustainable under COVID-19’s conditions. For example: JCPenney owes $8.30 for every dollar earned, Office Depot owes $4.60 per dollar earned, and Walgreens owes $5.80.

Perhaps the traditional retailers who’ve relied so heavily on foot traffic will find new ways to build omnichannel successes. It is a matter of margin, room for error, and tolerance for disruption. Retail is on shakier ground than many can understand. Here, in the forgotten middle, I see the struggle to pivot towards a digital-first economy. Digital agglomeration [6] and eCommerce are undeniable factors in this newfound vulnerability. It may be difficult to see at the New York or Los Angeles street levels, where luxury brands and popular stores are still thriving despite it all. But, without considerable changes, the mall retail system is incapable of tolerating further disruption. The shift to eCommerce is actually understated because the old guard will have to adopt the technologies of today just to survive the decade. In a wonderful excerpt, Burger explained:

Because technology made the relationship between the consumer and consumerism more convenient, and because its acceptance was relatively uncontested, shopping itself sponsored the complete alteration of urban and suburban sprawl. [1]

In the 1950s, malls were the retail technology of its time. Seventy years later, you wouldn’t possibly rely on olden technology to power retail for the next seventy. Mall owners will require its retailers becoming great eCommerce practitioners. Without that, these developments will struggle with delinquencies and vacancies, perpetuating a ruinous cycle. Physical retail needs eCommerce more than ever.

By Web Smith | Editor: Hilary Milnes | Art: Alex Remy | About 2PM

Editor’s Note: Elena’s essay is one that is sure to take the retail ecosystem by storm, and rightfully so. Within the hour that it was published, seven different people sent it my way. It is well-researched and well-positioned. The author is a hedge fund analyst, which informs her views. She explains that the narrative around eCommerce’s impact on physical retail is overstated. She and I hopped on a traditional old phone call to discuss what we agreed on as well as what I would contend with or elaborate further on. What I most appreciated about the exchange is that we discussed ideas candidly and constructively without as much as a prior introduction. It’s what I hope happens more often in this era of Substack creators, newsletter operators, and operators-turned-writers. If you’re new to 2PM, read the rest of this week’s Monday Letter here. 

Member Thesis: The Connected Mall

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Long before retail was impacted by social distancing, the American mall was fighting for survival. Early signs of this were everywhere: perpetual discounting and promotion, insufficient staffing, stale inventory, and outdated storefronts. A number of these retailers are highly-leveraged assets, a culprit even a junior financial analyst could identify. As a result, a deluge of layoffs and closures began within two weeks of foot traffic falling. What will a healthy retail ecosystem look like when normalcy returns?

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No. 344: IPO and The “Frontier Thesis”

2PM-Frontier-Democracy

By air and by sea, thousands of would-be gold miners traveled to California in pursuit of wealth. They’d come to be known as 49ers. In March of 1848, 800 non-natives made the trip to California. By the end of 1848, that number ballooned to 20,000. And by 1849, that number reached 100,000. The gold rush was one of America’s earliest examples of the frontier thesis. Historian Frederick Jackson Turner penned an essay in 1893 that explained that the economic strength and vitality of America was tied to moving towards the frontier.

I define ‘frontier’ as the social levelling associated with large numbers of people comprising a broad spectrum of skills, educational levels and class backgrounds, working alongside each other at rough parity in open access, high potential gold mining. [1]

That frontier line, a demarcation that separated the known from the unknown, spurred innovations in: commerce, behavioral economics, government, and social sciences. Of course, there is no longer any physical frontier. Today, that line is figurative. With any new industry, these behaviors repeat in seen and unforeseen ways. Direct-to-consumer brands have begun to reach venture-backed maturity. Like the physical frontier of old, this new line of demarcation bears many of the same traits — uncertainty is one of them.

During the gold rush, it wasn’t the miners that made the real money. It was the toolmakers, the workers that manufactured the implements necessary for the droves of miners to strike it rich.  We remember Levi Strauss & Co but few rarely can recall top gold miners of the time. The toolmakers made riches; the vast majority of the miners went home empty handed. Not even their tools made the trip. As the adage goes: you can mine for gold or you can sell the pickaxes. Like the commerce tools themselves, venture capital eventually flooded brand retail. This not only affected who could scale, but also it affected how companies were scaled.

The problem with all of the tech-enabled customer channels, though, is that they are available to everyone. Indeed, the flipside of tech concentration when it comes to platforms and Aggregators is the democratization and commoditization of basically everyone else in the stack. That is how you end up with, as of August 2019, 175 different online mattress companies. [2]

Seated to my right on a flight from Ohio to Minnesota was a salesman whom we’ll call Dave. “Do you want to start a mattress company?” he utters through a smirk and a light smile. After his third whiskey he opens a laptop to reveal a spreadsheet with nearly 100 rows of data and says, “Look at this.” I’m interested and I immediately recognize several of the companies out of the corner of my eye. Of them, Casper is atop the list. Dave is an employee of a company that manufactures mattresses for many of the the top brands. I was stunned. “Wait. Casper doesn’t make their own mattresses?” I asked. Dave goes on and he asks if I want know how to start. Curious, he lays it out for me.

Start a website and use Spotify [SIC] or something. Pre-sale the mattresses for $800. Buy them from me for $400-$500. We will deliver them to you within three weeks of the sale. Rinse and repeat.

Dave was the proverbial pickaxe seller, and the DTC era was his gold rush. According to him, Casper was one of his company’s many customers. I didn’t believe Dave until I read Casper’s S-1 filing. He was correct, Casper doesn’t manufacture its own mattresses. And neither do the vast majority of its nearly 200 competitors. Instead, the Casper team buys them from a source and marks them up for resale.

While most of our product design is developed in-house, certain foam formulations are currently licensed from certain of our contract manufacturers pursuant to our manufacturing agreements with them, some of which include varying degrees of exclusivity. [3]

And this manufacturer isn’t the only pickaxe seller. While Casper.com is a custom cart build, a majority of digital natives are built within the Shopify ecosystem. This is a reflection of modern retail as a whole, which has been influenced by the greatest pickaxe seller of them all.

Venture capital has disrupted retail in a number of ways. Imagine an entrepreneur raising VC to launch a clothing, shoe, or mattress company in the 1990’s. The thought would have been implausible. But retail brands aren’t new; its tools are. Prior to 2006, these types of businesses pursued other funding sources: private loans, lines of credit, or friends and family rounds. They often began with the idea that unit economics would be at the forefront. Some decided to grow on cash flows. The earlier the profitability, the better.

And if these companies did go public, it would be after a measure of decades and not a measure of years. Take Ralph Lauren Corporation: founded in 1967, it went public 30 years later. Or Nike Inc., a retailer that went public nearly sixteen years after its founding. In Columbus, Ohio, there are a number of specialty retailers that took similarly long paths to becoming public companies: Express, L Brands, DSW, and Abercrombie & Fitch are but a few.

Web Smith on Twitter

On brand ceilings and valuations. 1967: RL was founded. 1994: Goldman acquired 28% of @RalphLauren at a $520 million valuation. 1997: RL IPOs at a $2.4b valuation after 30 years – a number of them in the black. 2020: $8.8b market cap (1.3x revenue) From the S-1:

Like a Cambrian Explosion, venture opened the door to a diversity of platforms, apps, logistics services, and packaging solutions. It also developed a new format for retail, one based on hyper growth. And by extension, venture capitalists began funding the companies that would be built on them. For would-be retail founders, the bar for starting a business reached an historic low. And the ability to raise historic sums of venture capital reached its high in the same period of time: 2014. The last decade of eCommerce was just as much about the tools sold as the nuggets of gold that were mined.

But while venture capital disrupted pickaxes for the better, one could argue that it disrupted the miners for the worst. The DTC era has seen few acquisitions and even fewer public offerings. Even so, Stitch Fix President Mike Smith suggested that staying private is the best bet for many of these brands. He explained to Recode’s Jason Del Rey:

Should you be a public company? In a lot of cases my answer would be no. You have to bring your A-game to the public markets. You can hide in the private markets and spend a lot of your venture capital on Facebook.

For the digitally native brands of today, they’ll have to think and behave a lot less like their contemporary peers as they approach the new frontier line. In this way, Casper’s IPO will serve as a bellwether for this era of digitally-native brands. Can they IPO without a realistic path to profitability? The thought has its headwinds. In these tweets below, I summarized most of the bear argument.

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Casper’s management will have to convince Wall Street that they’re capable of something that few brands aren’t: they must “own the category” and do so profitably. There are two obstacles to this. And this is where it gets a bit technical.

Parallels: Casper and Mattress Firm

Consumer-based corporate valuation. In the company’s S-1, they chose not to report cohorted revenue data. But a few key figures stood out: 14% of customers returned within a year of the original purchase. In the S-1, Casper cites returning customers and not the figure in sales. According to venture capitalist Alex Taussig, the company’s annual dollar retention is just 6%. Their repeat business is nearly non-existent.

Casper’s average order value (AOV) is $867 with a repeat AOV of $87, according to Marketing Professor Daniel McCarthy. This is based on the assumption that 80% of the orders are at the primary AOV and that repeat AOV is $87. The customer acquisition cost (CAC) for that $867 sale is $324. In a fascinating thread of marketing mathematics, Professor McCarthy cites a five year customer value at $455 with a lifetime value (LTV) of $131. But one thought stood out:

Bulls will probably point to stores as a way to bring CAC down, upsell, and supply chain efficiency margin improvement. Bears will point to late adopters being harder to bring in, and competition picking up.

Back where we started. The institution that Casper disrupted with direct-to-consumer delivery is now its best hope — brick and mortar retail. Within the year that Casper launched, there were two separate instances of note. Of course, Casper quickly scaled its direct-to-consumer model. And Mattress Firm invested in a brick and mortar company as Casper’s DTC offering generated nearly $100 million in first year sales.

[Mattress Firm] was constrained by its decision to buy retail chain Sleepy’s in 2015 for $780 million. Instead of investing in digital tools and shipping infrastructure, Mattress Firm expanded its store base at exactly the wrong moment. [4]

Mattress Firm’s retail acquisition left the company over-retailed (by nearly 1,000 stores) at a time when customer acquisition arbitrage for mattress-in-a-box retail was peaking. Just a year later, Steinhoff International acquired Mattress Firm for around 1x gross revenues.

The South African retailer Steinhoff International Holdings will buy Mattress Firm Holding Corporation, the largest specialty bedding retailer in the United States, for $3.8 billion, including debt, both companies said on Sunday. The deal would create the world’s largest mattress retail distribution company. [5]

In 2018, Mattress Firm filed for Chapter 11 Bankruptcy to begin the process of restructuring, closing nearly 700 of its 3,230 company-stores. In effect, the bankruptcy began to offset the poor timing of the 2015 Sleepy acquisition. As Mattress Firm retracts, Casper hopes to gain its share. According to the Casper S-1, physical retail is a major component of their growth.

Our presence in physical retail stores has proven complementary to our e-commerce channel, as we believe interaction with multiple channels has created a synergistic “network effect” that increases system-wide sales as a whole. Driving continued success in our retail store expansions will be an important contributor to our future growth and profitability

The question remains whether or not Casper can convince Wall Street investors that their plan to capture the value that Mattress Firm is a viable one. While Casper’s vision of a sleep economy is grander, Mattress Firm’s annual revenue was $3.2b in 2019 (according to Steinhoff International). To capture this, they may have to rebuild the company from in inside out.

With nearly 700 employees and no in-house product manufacturing, Casper is a very large product company that doesn’t manufacture its own goods. This is evident in its G&A category. Casper’s spend on General and Administration is 5x that of Purple ($106.2m to $19.1m) with similar sales figures. To capture the value of its incumbents and fend off its challengers, Casper can be more competitive. For Casper to become a “category owner”, they’ll have become more like Nike internally. Founding CEO Phil Knight said it best:

Beating the competition is relatively easy. Beating yourself is a never-ending commitment.

A Leaner and Meaner “Nike of Sleep”

 

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Share of online mattress retail | Source: Rakuten Intelligence

The comparison began with a quote in Forbes. In 2016, the same year that Mattress Firm was acquired, Casper Co-Founder Luke Sherwin laid out his vision for the company. In the interview with Ron Rofe, Sherwin explained:

Casper can do for sleep what Nike did for sports. We want to make sleep a lifestyle and build sleep environments that become a major part of your life.

In their securities filings, Casper laid the groundwork to address product commodity by expanding their total addressable market beyond the category of mattresses:

As the wellness equation increasingly evolves to include sleep, the business of sleep is growing and evolving into what we call the Sleep Economy. We are helping to accelerate this transformation. Our mission is to awaken the potential of a well-rested world, and we want Casper to become the top-of-mind brand for best-in-class products and experiences that improve how we sleep.

Nike owns 17.9% of footwear and spends 10% of its gross revenues on marketing and advertising. Casper owns 5% of mattresses and spends upwards of 33% of revenues on marketing. Without capital efficiency and a short-term path to profitability, Casper cannot mimic the brand that it aspires to. To become the Nike of Sleep, Casper must become more like the Nike of marketing and sales. They have to lead the industry in the ability to acquire customers efficiently. What I am suggesting is simple enough: leave the DTC industry behind altogether. With partnerships with Amazon, Target, Walmart, and Costco as a solid foundation, Casper can shift to a leaner and profitable model by:

  • emphasizing relationships with third-party sellers for sales and distribution
  • shifting from short-term performance marketing to a brand marketing strategy

Though Casper has raised at a $1.1 billion valuation, as recently as March 2019, most companies in and around its space are trading for 10-20x EBITDA or 1-2x revenues. For Casper, that means an initial market capitalization of $500-600 million (they’ve raised $339 million). In this report alone, there are two comparables to consider: Ralph Lauren traded at a $2 billion market capitalization on an EBITDA of $140 million. A year after Mattress Firm went public, it was trading at $1.91 billion or 24x EBITDA.

To reach profitability, Casper must “beat themselves” as well as they’ve beat others in the market — challengers and incumbents alike. They’ll have to build their company like the early-stage retailers of old, long before the abundance of venture capital and rising CAC. By reducing General and Administrative by even $50 million, annually, they will be close to break even. By shifting marketing spend from digital-first to third-party partnerships, Casper could be EBITDA positive in its first year.

Casper adopted the tech-adjacent model that’s plagued the DTC industry over the years: incredible sums of money raised, New York or Los Angeles offices, excessive marketing spend (relative to gross revenues), costly executive salaries, prime real estate leases, and startup perks. By reducing these expenses and shifting to third-party sales, Casper can become the publicly-traded brand that it is pitching to Wall Street. Existing competitors like Mattress Firm would welcome Casper’s partnerships alongside Sleepy’s, Purple, and others. With each of the aforementioned retailers, Casper brings a new customer to their stores.

At $50+ million in EBITDA, Casper can become the $1 billion brand that they envision. Like the gold miners on the frontier, Philip Krim and team can be the ones to map the path forward for digitally-native brands like Away and Glossier, two others with IPO intentions. To compete in public markets, these brands will have to operate more traditionally.

The DTC era experienced a decade of grow-by-any-means marketing and often inefficient operations masked by excessive venture capital. As private companies, this can last as long as rounds can be raised. But they’re at the frontier now. And this represents somewhat of a reckoning for the DTC industry. When the miners arrived, they would often choose to set aside what they brought with them. For some, it was valuables and others, it was an inflated sense of self-worth. There, on the frontier – where sacrifice and discomfort are a necessity – it was about what you brought home with that expensive pickaxe.

Research and Report by Web Smith | Edited by Carolyn Penner |  About 2PM

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