The Business Times' Column | Demystifying direct-to-consumer brands

Jessica KOH | 16 Oct 2023

This column was first published on The Business Times

While early drivers of growth supported the meteoric rise of new-age, Internet-first companies, margin compression and a funding drought have led to their swift downfall

THE world’s love affair with direct-to-consumer (DTC) brands first began little over a decade ago.

As real estate costs in physical retail grew increasingly out of reach, new upstarts turned to social media marketing as a place of refuge. The pioneers of DTC brands include Warby Parker, Glossier and Away.

The strategy was sheer ingenuity. Not only were online real estate and consequent customer acquisition costs (CAC) a fraction of offline costs, online advertising also unlocked a fertile catchment of engaged and data-enriched audience that up till then, could not be targeted anytime, anywhere.

The DTC wave permeated the world, including South-east Asia. This paved the rise of a new generation of brands that were characterised as follows:

  • Online-first in distribution, primarily via brand websites;
  • Bypassed middlemen;
  • Cultivated cult-like communities that were fervently loyal;
  • Facilitated online conversations for customer- and data-led product development; and
  • Focused on the “masstige” (mass prestige) segment that often married form and function.

The industry-minted marquee wins included the US$845 million acquisition of Drunk Elephant by Shiseido in 2019.

However, the phenomenon was also plagued with high-profile casualties. Coveted DTC darlings, such as Glossier and Away, reportedly underwent large scale layoffs and chief executive replacements, along with allegations of poor revenues, unsustainable unit economics and toxic work cultures.

This article seeks to first unpack drivers of growth that lasted till early 2022, before shedding light on the causes of decline, and the corresponding best practices in building resilient, winning brands amid challenging market conditions.

Growth drivers that fuelled DTC brands

Lowered CAC online: The fundamental winning formula for any DTC brand lies in its ability to build brand equity, sustainably and cost-efficiently, thereby closely impacting what is arguably the most critical cost lever in consumer brands – marketing costs.

Therefore, the race for eyeballs and mindshare disproportionately tipped in favour of DTC brands in the early 2010s. With the advent of social media marketing, DTCs promised the best of both worlds – growth at breakneck speed and unrivalled net margins.

Due to the nascency of social media marketing, customers were not only less discerning, but also trusting with personal data, thereby propelling DTC brands’ ability to scale at unprecedented speed and cost efficiency.

The Covid-induced online retail boom was the cherry on the cake, as consumers diverted both mindshare and wallet share to online shopping.

Access to China’s manufacturing hub: China’s manufacturing capabilities reaching new heights – coupled with more efficient cross-border logistics – made its factories the manufacturing hub for the world.

Low minimum order quantities and agile manufacturing not only reduced working capital burden, but also levelled the playing field between large, traditional brands and small upstarts.

These developments quickly eroded traditional brands’ supply-chain moat, turning what used to be a fixed cost requirement and proprietary in-house capability into a variable cost structure that became increasingly on-demand and commoditised.

Amping up customer love: DTCs were particularly community-centric throughout customer touchpoints. In fact, Glossier was first built upon Into The Gloss (ITG), the personal blog of its chief executive and founder Emily Weiss.

She did almost the opposite of what traditional beauty brands did – build a cult-like following via ITG, then an Instagram for Glossier, before launching its first product. Only after Glossier had about 15,000 excited customers waiting did they then launch their first product.

Weiss was on point; she was distribution-first, product-second. By doing so, Glossier nailed CAC and customer lifetime value (CLTV) economics in its very early days.

More crucially, the DNA of DTC companies is steeped in the belief that customers should be empowered to co-create products, thereby building near-guaranteed “holy grail” products consistently, and with minimal trial and error.

Finally, DTCs were particularly refreshing in marketing speak. Not only did DTCs seek to build authenticity and accessibility through informal lingo, they embedded deeply relatable values such as sustainability into their brand ethos that deeply shaped brand communication and operations.

What led to DTCs’ nosedive in the last 24 months?

Margin compression: The early successes of social media marketers led many brands to follow suit, quickly saturating online channels and causing online CAC to skyrocket.

For instance, Google ads’ cost per lead (CPL) has increased significantly, with 21 out of 23 industries seeing an increase in CPL year on year. There was an average overall increase of 19 per cent from 2022 to 2023.

Furthermore, targeting efficiency has decreased considerably due to several factors: increased customer discernment and savviness and tightened privacy controls – such as Apple’s iOS14 update – that have crippled these once formidable content marketers.

Increasingly inefficient and unsustainable online targeting have upended the viability of social media as a distribution channel. Furthermore, inflationary pressures have rapidly increased manufacturing cost, thereby further thinning gross margins and reducing DTC companies’ margin of error.

The end of Covid delivered the final blow as physical retail started to wrestle and regain grounds, coupled with the redirection of online shopping spending to post-Covid revenge-spending categories, particularly travel and dining.

Drying up of funding: Record rate venture capital (VC) funding lasted up till early 2022, coupled with a low interest rate environment. The easy access to capital spurred a growth-at-all-costs frenzy, where topline growth – often at the expense of bottom-line metrics – single-handedly mattered.

According to the World Intellectual Property Organisation, the number of VC deals grew by 46 per cent between 2020 and 2021, compared to 7 per cent between 2019 and 2020. In total, US$618 billion flowed into VC deals across the globe in 2021, with a growth rate of 125 per cent – a magnitude last seen just before the dotcom bubble burst.

While the deal numbers and values remain strong in 2022, VC growth will decline severely relative to the exceptional 2021 VC boom year.

In 2020, the US Federal Reserve dropped its benchmark interest rate to zero and launched a new round of quantitative easing to stimulate economic growth following the onset of the Covid-19 pandemic. The Fed had a target of 0 per cent to 0.25 per cent, setting an unprecedentedly low interest rate environment.

However, as deployments drastically reduced and came to a near halt in the current funding winter, DTCs could no longer depend on VC-sponsored customer acquisition, ushering in an era of renewed emphasis on financial discipline, focus on profitability, and drastic cost-cutting measures.

As a result, companies’ unit economics and business viability were, for the first time in many years, put to the test. Many did not survive.

Opportunities abound in DTC, if done right

That said, we at Vertex Ventures South-east Asia and India continue to be excited about DTC – albeit remaining highly selective when investing into this sector at the Series A stage. Several best practices that we have witnessed across winning brands that work particularly well in the South-east Asia and India markets.

CAC discipline is key: The strongest DTC brands are more obsessed over channel fit than they are over product fit.

As channels mature and evolve overtime, securing strong channel fit is an ongoing, iterative process that needs to be tailored across different markets, product categories and customer segments. After all, channel strategy is the primary lever impacting CAC.

The serviceable market is often smaller than you think: A common myth and misconception in brand-building is the belief that brand equity and CAC are inversely related. However, what rookie brand-builders fail to realise is that on the contrary, CAC counter-intuitively increases once its early-adopter market segment is saturated.

The problem quickly worsens as most DTC brands focus on highly niche propositions to remain relatable to its core loyal base of customers, which in reality, is often a mere small sub-segment of a larger pie.

Focus on increasing CLTV from day one: As CAC continues to soar, the need to increase CLTV becomes ever more pressing.

A solution to mitigate low CLTV is to either launch high average order value products, thereby recouping CAC within first purchases or subscription products with naturally higher retention. At the same time, discount incentives are given to encourage users to return and buy more.

Poor inventory management cripples DTCs’ scalability: This year and 2022 have been characterised by large scale inventory write-offs and inventory clearance in the retail sector globally.

DTCs that are able to reduce cash cycles and debt dependency for working capital needs will emerge winners, especially in today’s high interest rate environment.

Multichannel retailing is the way forward: A DTC’s ability to build a strong, diversified omnichannel strategy – online and offline – that allows it to be “anywhere, anytime” is crucial for lowering blended CAC and building strong brand presence in the long run. In South-east Asia and India, brands also need to consider how they could scale beyond tier-one cities.

Diversified supply-chain sourcing: While China’s manufacturing capabilities continue to be unrivalled, DTCs need to proactively de-risk supply-chain sourcing, given growing geopolitical tensions and the unpredictability of black swan events such as Covid-19. India and Vietnam have risen as popular options in this region.

Going back to first principles

Brand-building fundamentally boils down to the ability to acquire quality mindshare sustainably and efficiently. To do so, DTCs need to remain agile and innovative to tailor strategies in an ever-changing consumer landscape.

More importantly, while building a brand to US$10 million in annual revenues is still considerably within reach, scaling it to the US$100 million mark, sustainably and profitably, is an entirely different feat altogether.

By Jessica Koh

Jessica Koh is a Director at Vertex Ventures Southeast Asia & India

We publish monthly on The Business Times Due Diligence column and we invite you to read our previous articles here.

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