Last month, retail analysts at UBS further reduced their ratings for department stores. They declared that it was time for brands, particularly those with premium positioning, to “go it alone” rather than selling through third-party channels like department stores. The analysts also argue that brands can no longer rely on malls to generate walk-by traffic that leads to sales. Instead, they wrote, “Brands have to generate their own audiences and become destinations.”
There are certainly good reasons for brands to rethink their distribution strategies in this fast-evolving market environment. Having a robust direct-to-consumer (DTC) operation is a huge competitive advantage. Nevertheless, for most major brands, the best strategy is to pair a strong DTC business with select third-party distribution channels like department stores.
The Case for Go-It-Alone
The UBS analysts lay out several valid reasons why shifting towards a DTC business model is desirable for brands. Most importantly, a brand that builds up a loyal customer base and markets directly to those individuals can maintain higher gross margins than one that maintains a wholesale model. After all, wholesale prices must be lower than retail prices to enable resellers like department stores to cover their costs and make a profit. (Of course, generating demand for your products at full price is also critical to maintaining gross margin.)
An additional advantage of adopting a DTC distribution strategy is that it helps brands control their inventory and image. (We’ve all seen pictures of department stores overloaded with inventory, with messy racks and merchandise strewn all over the floor!) Tight inventory management helps brands limit markdowns, supporting future pricing power.
Yet despite these advantages, going it alone would be the wrong strategy for most brands. There are real costs to abandoning third-party distribution.
The First Hint
If going it alone were truly a no-brainer, you would expect to see that strategy adopted by all of the most powerful brands. Yet outside of ultra-luxury brands like Hermès and Louis Vuitton, that isn’t the case.
Apple is the most valuable brand on the planet, according to Forbes’ 2020 rankings. Forbes estimates that the Apple name alone is worth an estimated $241.2 billion. It is also one of the most successful retailers in the world. Its stores are magnet destinations with high foot traffic and have routinely posted sales per square foot in excess of $5,000. If any high-volume brand could go it alone, wouldn’t it be Apple?
Instead, Apple products can be found in mass-market electronics stores like Best Buy, discount stores such as Walmart and Target, mobile phone stores operated by the likes of Verizon and AT&T, etc. Clearly, Apple’s leaders don’t think distributing products in mass-market channels will sully the brand, and so far, they have been right. The company is also willing to give up a (small) piece of the MSRP to retail partners that carry its products.
Tech peers Google and Microsoft are #2 and #3 on the Forbes brand value list. They both have plenty of consumer-facing products, yet they too have decided not to adopt a pure DTC strategy. In fact, Microsoft recently announced the permanent closure of all of its stores, meaning it will lean even more on retail partners going forward. Amazon (#4 on the brand value list) also sells products like the Kindle and Echo lines in rivals’ stores despite itself being the second-largest retailer in the world.
The key challenge today is figuring out which retailers have the staying power to serve as good long-term partners and worthy ambassadors for your brand.
Finally, within the apparel world, Nike tops the list with an estimated brand value of $39.1 billion. Its products are widely available at department stores (even lowly J.C. Penney), sporting goods stores, shoe stores, and other merchants.
The Key Challenge of Going It Alone
Creating a compelling brand-owned retail experience is critical for brands looking to build a strong DTC business. Ideally, a brand’s stores offer unique experiences that consumers can’t get anywhere else, in addition to attractive merchandise.
However, unique retail experiences (such as the Nike flagship store in Manhattan that opened two years ago) generally involve some combination of high upfront capital expenditures and high operating costs. That model works extremely well in the biggest cities and the most popular tourist destinations. It doesn’t work outside of the top markets, though. A trade area of 1 million people represents a sizable demand pool but can’t support the kind of investment that might make sense in a global metropolis.
Thus, most midsize cities in the U.S. don’t have a Nike store, other than the local outlet mall’s Nike Factory Store. Even a city as big as Philadelphia (with a metro area population of over 6 million) doesn’t have a non-outlet Nike store.
Brands that create truly excellent but costly retail experiences in the top markets face a big tradeoff. On the one hand, opening smaller, far less impressive stores in midsize markets could confuse customers and damage the brand. On the other hand, forgoing expansion beyond the biggest cities leaves a huge number of customers (and potential customers) without full access to the brand’s products.
Of course, e-commerce allows brands to sell directly to consumers no matter where they live. That said, there’s real value to being able to touch, feel, and try on products. Physical stores also have distinct advantages over e-commerce when it comes to product discovery. By adopting a pure DTC strategy but only putting stores in larger markets, a brand would forfeit what could be billions of dollars a year in sales, constraining its success.
This is why many top-tier brands outside of the luxury space still find it worthwhile to maintain a wholesale business. For example, bed-in-a-box upstart Casper began with a pure DTC model, selling mattresses online. Yet even with a generous return policy, most people want to try a mattress before buying it. Casper opened dozens of stores in high-end malls to address that issue, but that meant paying a lot of rent. More recently, Casper has seen the light, aggressively pursuing growth through wholesale relationships. It’s still paying the price for its earlier hesitancy, though: Casper’s revenue rose just 23 percent in 2019, as DTC revenue growth slowed to 13 percent despite strong organic search interest in the company’s mattresses.
By contrast, rival mattress startup Purple (which launched later but moved more quickly to partner with major mattress retailers) posted a 50 percent increase in revenue last year, nearly overtaking Casper. And while greater reliance on wholesale distribution means that Purple’s gross margin is somewhat lower than Casper’s, Purple reached positive adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) last year, whereas Casper is still unprofitable on that basis.
Broadly speaking, retail partners like department stores give customers a way to experience products in person in markets that might not be able to support a standalone store for a brand. While there is some brand risk from selling through third-party channels, customers don’t have the same expectations as when they walk into a brand’s own store. There’s far greater risk from opening a subpar store under your own brand in an attempt to serve a small or midsize city.
The calculus is different for ultra-luxury brands. Scarcity adds to the cachet of a brand like Hermès. As a result, expanding the sales base significantly could backfire in the long run by eroding the brand’s value. It is far more important to control sales levels, maximize margins, and ensure that each customer has an excellent experience. A pure DTC strategy has enabled Hermès to grow sales, earnings, and cash flow at a steady (if not extraordinary) pace of about 10 percent annually in recent years.
Some Things Have Changed
None of this is to say that brands should operate as if the retail environment is the same as it was two or three decades ago. Before e-commerce became mainstream, it often made sense for brands to maximize the number of distribution points for their merchandise. Adding more retail partners enabled you to put your products in front of more shoppers and ensured that customers wouldn’t have to go far out of their way to make purchases.
Today, e-commerce represents a convenient and efficient distribution channel. Consumers don’t need to go to a store every time they want to buy something. Instead, they visit less frequently, using stores for product discovery and perhaps order pickup and returns.
Meanwhile, many chains that have been powerhouse third-party retailers of branded goods in the past are quite unhealthy today. Some no longer represent appropriate selling venues for strong brands. However, if brands are selective in choosing retail partners, they can opt-out of stores that don’t meet their brand standards, while giving remaining channel partners a strong incentive to protect the brand (or otherwise risk being cut out of the distribution ecosystem in the future).
In short, having the most distribution points is no longer a strategic goal. But there is still value to choosing retail partners that can provide an in-store shopping option convenient to customers (and potential customers) who could otherwise be served only via e-commerce. The key challenge today is figuring out which retailers have the staying power to serve as good long-term partners and worthy ambassadors for your brand.