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Down and Dirty with DTC

Updated: Jul 22, 2021

An investor in a promising consumer packaged goods startup going to market through conventional grocery retail distribution recently asked me, "Should I push the CEO to go for a DTC model?" They were frustrated by the positive but relatively slow growth rate for the new brand -- negotiating shelf space for a new CPG product in grocery isn't easy or fast -- and they wanted to speed things along.

My first response to this investor: "DTC to accelerate growth? Completely do-able. But by the way, how much capital do you have?"

You Are Not Nike

Direct-To-Consumer (DTC) models are all the rage. They're disruptive, and disruptive is cool, right? Plus, there are prime examples of brands that are cutting out the retail middleman and focusing more on direct. Nike, for example, recently eliminated distribution through DSW, Urban Outfitters, and Macy's as it focuses on DTC both online and in its own highly experiential, differentiated retail stores.

The problem is, you are not Nike.

At least most probably you are not like Nike, in the sense that they already have a dominant category position, global brand recognition, emotional appeal to multiple demographic segments, and generate billions in cash every year. (And if you are, more power to you!)

But assuming you are not, you'll have to look carefully at the dynamics and economics that your own brand will face with DTC.

$ Get Out Your Checkbook $

In considering DTC, there are four basic approaches you could take:

  1. Physical retail: Your own bricks & mortar stores

  2. Digital DTC: E-commerce sites and apps

  3. Multichannel retail: Physical + digital + others (catalogs, etc.)

  4. Subscription models: Box-of-the-month club and similar models

Implementing any of these four approaches will require capital. Depending on your target customer segments and the nature of competition in your product category, potentially a whole lot of both CapEx and working capital. And also, likely a chunk of incremental SG&A hitting the P&L to manage the new channels. So the economics of DTC can be quite punishing.

Let's peel away the high-level economics of just one of these for fun, the Subscription Box model. (If you think peeling away the economics of a DTC model doesn't sound like fun, perhaps running a DTC business just might not be your thing.)

Customer Acquisition Costs: The CAC Can Kill Ya

Even if you have a terrific product offering, you still need to acquire customers to become subscribers so they can experience all that wonderful stuff-in-the-box.

To build your subscriber base, you can leverage traditional channels of promotion: TV, radio, direct mail, event marketing, etc. This can be costly and, generally speaking, these channels are becoming less cost-effective over time as audiences fragment and consumer attention shifts online.

You could therefore instead go for digital channels. But these are also getting increasingly expensive as DTC competition heats up and digital channel operators consolidate their market power.

In addition to not being Nike, you are also not Google or Facebook.

Plus, digital marketing tools and talent are expensive! Not to mention the cost of building and maintaining your e-commerce site, apps, etc. Minimum efficient scale in your category may be a higher economic mountain than you'd like to climb.

Either way, it's going to cost you something to acquire a subscriber. Now hopefully you have positive unit economics, i.e. you aren't losing money and hoping to "make it up on volume!" Oh, and that's positive unit economics as in a profitable landed variable margin AFTER shipping costs, chargebacks, and return credits of course.

So if you gain a subscriber at some average cost, each month they pay their subscription fee and you are sending them a box of goodies at a profit, your positive margin $ that month are earning back a portion of your original acquisition cost for that customer.

The Churn That Burns

Let's say you earn back your CAC expense after four months of paid subscription (five or more months in calendar time if you had to offer a free trial to get the subscriber -- with the cost of the freebies tacked onto your CAC). But at four months you have now broken even on that CAC investment, and you are profitable, so great! It's all gravy from there, right?

True, but what if, on average, your subscribers cancel after seven months? They get bored with the boxes as the novelty wears off, they fill their pantry with your items and don't need any more, they defect and switch to a competitive offering, etc.

In that hypothetical, you are getting exactly three months of profit from your average subscriber, for a likely not-very-exciting total customer lifetime value. Customer churn can really burn your economics.

The Sky Is Not That High

There's another problem with subscription models: they are self-limiting. Because of the churn factor, at some point your new subscriber acquisition is mostly going to be replacing existing customers who cancel, not generating net incremental subscribers. At that point, revenue growth slows to a crawl.

There are then four basic ways to get revenue growth jump-started again:

A) Improve the Value -- You can try to upgrade the value proposition of your offering in the box or improve your customer service and subscriber communications to increase longevity and decrease churn rate. But these are likely to increase product costs and/or SG&A and thus decrease your net margins. If you can do these things and NOT increase COGS or SG&A, go for it of course, but such feats will be difficult to accomplish repeatedly.

B) Increase Traffic -- You can try to increase your subscriber acquisition rate by getting more prospects to visit your site / app and thus increase the rate you add new subscribers. This will indeed raise your net active subscriber ceiling, but will usually drive up your average CAC, with more of that new subscriber volume coming through less cost-efficient acquisition channels. Your time-to-profit for new subscribers therefore becomes less favorable. So you are going to run out of room with this tactic.

C) Acquire Smarter -- You can try to reduce your existing CAC by optimizing your channel costs and/or raising your conversion rate -- the % of leads / visitors / free trial prospects who turn into paying subscribers. There are lots of tactical options to try here; usually these require tools, IT integrations, or marketing and analytics specialists to get it done, so you have to carefully watch the tradeoffs against other SG&A categories. At some point, you will hit diminishing marginal returns with this approach as well.

D) Raise/Cut Prices -- A price increase may be great in theory to improve your margin, but typically this will not only hurt your conversion rate but also increase your churn rate, thus making all the other approaches less effective. Cutting prices will have the opposite effects, but worsen your unit economics. So again there's a self-limiter here as your customers' price elasticity or your COGS catches up to you.

Bottom line: Even with all this tinkering and optimizing, you eventually hit an overall ceiling. Your X-in-the-box offering can grow no more. At least, not profitably. So you'll need to diversify into new product categories or the other DTC models to maintain top line growth. Which requires, yes, even more capital....

DTC: Doom and Gloom?

There are parallel economic challenges for the other three direct to consumer models. Does this mean it's all DTC Doom and Gloom? Not necessarily; for example the subscription model might be a net positive -- if niche -- add-on to your core business.

And the other DTC models can be amenable to profitable growth, particularly if your product category features a high repeat purchase rate, strong customer loyalty/longevity, rich variable margins, minimal competitive intensity, or some combination thereof.

But even so you're likely to need a truckload of capital to make it happen. So DTC to accelerate growth? Sure! Just be ready to get out that checkbook.


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