Brick and Mortar Strikes Back

Earlier this month I wrote about how many people are worried that the direct-to-consumer ('DTC') e-commerce business model may be broken... As reminder, three factors are driving a stake into the heart of DTC e-commerce profitability. First, soaring supply chain costs are making it more expensive to get products to the shores of the U.S., […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] Brick and Mortar Strikes Back By Berna Barshay --------------------------------------------------------------- [It's the end of an era]( Whitney Tilson just made a huge announcement regarding the future of Empire Financial Research. As he says in this short video message, "It's the end of an era for Empire." [Click here to see the full message](. --------------------------------------------------------------- Earlier this month I wrote about how many people are worried [that the direct-to-consumer ('DTC') e-commerce business model may be broken](... As reminder, three factors are driving a stake into the heart of DTC e-commerce profitability. First, [soaring supply chain costs]( are making it more expensive to get products to the shores of the U.S., and once here, getting them to distribution centers and to your home is costlier as well. Inflation for shipping, air freight, rail, trucking, and third-party carriers like FedEx (FDX) and UPS (UPS) has been high, on top of soaring costs to buy the materials needed to make most products. Inflation is a problem for pretty much every player and consumer in this economy... but DTC e-commerce is particularly exposed to a specific area of inflation: the rising price of digital advertising. And not only are digital ads getting more expensive and the cost of buying search words soaring... these ads are also getting less reliably productive. Apple's (AAPL) [App Tracking Transparency ("ATT")]( initiative led to many ads packing less of a punch now that so many users, given the choice, are opting out of tracking. Soaring digital advertising prices and lower click-through rates cause the cost of acquiring a new customer to soar... But young companies that aren't profitably operating at scale are desperate to keep their toplines growing, especially if they have already come public and are under the eye of skeptical shareholders. Smaller, private e-commerce companies are under a different kind of pressure. Many have venture capitalist overlords to please... and even the companies that lack demanding private or public shareholders are trying to pump up their bottom lines. This is extremely tough when one of the bigger costs, marketing, is growing so fast. When the old tricks aren't working, it's time to find some new tricks. For an increasing number of digitally native (born on the Internet) brands, that means going back to an old-world business model for reaching consumers: opening physical stores. Everything old is new again! Digital-native brands opening brick-and-mortar retail locations isn't a totally new concept... Many of the early digital-native breakout brands had a few stores as part of their business plans from the beginning, recognizing that a flashy store located in a highly-trafficked downtown retail location in a major city – especially one that draws both tourists and locals – can be a powerful advertising tool, as well as a place to ring up sales. But as things have gotten incrementally more difficult in the DTC e-commerce business, more online retailers are turning to good, old-fashioned stores. In an article last month, the New York Times explained the emerging trend... Business owners are motivated by multiple factors. Some have always included brick-and-mortar outposts as part of their strategy, adopting what's known as an omnichannel approach, which provides a seamless shopping experience across desktop, mobile and physical platforms. For others, renting a store has become more attractive because the cost of acquiring customers through social media advertising "has become prohibitive," said Michael Brown, a partner in the consumer products and retail practice at Kearney, a consulting firm. The tipping point varies, he added, but it "typically occurs where growth has slowed and the cost of acquiring new customers has increased." "Growth has slowed and the cost of acquiring new customers has increased" pretty much describes every DTC e-commerce player that I can think of, so I'm not surprised we are seeing so many of them turn to physical space. Ben Soleimani, whose site sells high-end rugs and furniture, started his online business in 2019 and opened a store in Los Angeles later that year. When a 9,000-square-foot space opened up on a busy corner on Madison Avenue in Manhattan, he jumped at the opportunity, explaining to the Times... "When you open stores, your business gets much stronger in that region because people are passing by and can just walk in," he said, adding that his clientele likes to "feel and touch our offerings and get that experience." What a novel concept – people might want to feel fabrics on sofas or clothes before they buy them. Who would have thought...? Plus ça change, plus c'est la même (the more things change, the more they stay the same)! --------------------------------------------------------------- Recommended Link: [Bombshell opportunity: 'America's Next Big Monopoly']( A little-known company is making all the right moves to destroy the competition in today's hottest industry. The media is already comparing it to the biggest success stories of our times. While Forbes says this company could be the next Apple or Microsoft, Barron's says this could be the "next big thing." Bill Gates has already invested millions into this company. So has tech investor Cathie Wood. If you're looking for massive gains... [this could well be the biggest opportunity of your lifetime](. --------------------------------------------------------------- One thing making this shift to physical space possible is the fact that there is a lot of space available... Long before the pandemic, empty storefronts were on the rise because of the "retail apocalypse" – the rise of shopping online was reducing demand for shopping in stores. In some sectors, like apparel or home furnishings, the Internet really chipped away at in-store demand on the margin. In other more commoditized consumer product areas, like toys and consumer electronics, the impact was more catastrophic. Then COVID-19 rolled into town, leading to even more store closures. Many major cities where online brands want to access affluent local consumers and get their brand in front of tourists suddenly have tons of empty storefronts. One thing that was shocking in the Times article was the number of industry players citing that not only have retail rents recovered since the pandemic in New York, in many cases they exceed pre-pandemic levels. This is surprising to me as the number of retail vacancies is visibly up... Usually the laws of supply and demand would dictate when there is more supply than demand, prices should drop – not go up! This makes me wonder if there is something very wrong in the tax code or commercial real estate regulations... Landlords should want to lease this empty space – and lower the rent so it fills. The fact they are keeping their asking price so high when there is so much empty space doesn't make sense... and if I could figure out what's going on, that would be a great topic for another essay! So while there aren't many rent bargains to be had right now in New York, and probably other big cities as well, landlords have gotten a lot more flexible about offering shorter-term leases and tenant improvement (renovation) budgets on these shorter-term leases. No young brand wants to commit to a five-year lease for a store which is essentially an experiment – and right now it seems like they don't have to. Naveen Jaggi, the president of retail advisory services at real estate company JLL told the Times... "The big trend line we have seen during the pandemic is that many landlords are starting to recognize that in order to attract different brands that can make their property stand out, they will have to go to shorter lease terms," he said... In addition to shorter leases, some landlords are offering more generous tenant improvement allowances. And taking a percentage of store revenue in lieu of a fixed rent, while not a new strategy, has become more common. Aside from signing up for short leases – some as little as two years – other brands are taking advantage of the ample availability of space by dipping their toes into the brick-and-mortar water through pop-up stores, which can require lease commitments of as little as a few months or even weeks. Meanwhile, others are taking advantage of emerging real estate models that lump together lots of small brands into a common shopping space, kind of like an upscale bazaar. Neighborhood Goods and Showfields are examples of this new breed of brand aggregator, where they rent the space on a fixed lease and then offer out short-term leases to brands, offering them technology and marketing support as well. For companies with deep roots in the online world but a hesitancy to jump into physical stores because of a lack of in-house brick-and-mortar experience, a cottage industry is popping up to help them. As the Times explains... Leap, one of several start-ups that operate a "retail as a service" model, offering help in leasing and expanding stores and gathering data on shoppers. Leap leases locations in clusters and then subleases them to retailers, said Jared Golden, a co-founder and co-chief executive of Leap. In turn, the brands pay a fee that covers rent, labor and insurance, as well as a percentage fee based on the store's sales, he said. At the end of 2021, the company had about 50 stores in Arizona, California, Florida, Illinois, New York, and Texas. There's probably no better example of this pivot to physical retail by digital-native brands than eyewear company Warby Parker (WRBY)... Launched with the premise of selling its own brand of eyewear directly online to consumers, creating a cheaper product by cutting out the middleman and getting rid of real estate, Warby Parker has pivoted to a physical retail-driven model. The company plans to open 40 stores this year, which will take its total to 201 locations. The company sees the potential to grow to 900 stores in the U.S. over time. Warby Parker gets the majority of its revenue from its physical stores and plans to grow by taking share from other chains and independent eyewear shops that are more expensive or offer an inferior customer experience. Founded in 2010, Warby Parker has always had physical retail as part of its business plan – or at least since 2013, when it opened its first store in New York City. But it has shifted its emphasis from online to stores over the years, and on the last earnings call, its CEO Neil Blumenthal stated, "We expect most of our 2022 growth to be driven by our retail channel." Not only are its stores more profitable than its website, but the pace of consumer adoption for buying glasses online has been much slower than the company expected 10 years ago. Among the brands born on the Internet, Warby Parker's pivot has probably been the most dramatic. But as long as digital advertising prices stay in the stratosphere, bringing the cost of customer acquisition ("CAC") along, we'll probably see more of this. One Times reader summed it up best in the article's comment section... Source: The New York Times In the mailbox, lots of thoughtful reader feedback about Netflix (NFLX)... Do you shop for any online brands in the offline world? Are there certain categories of goods – like eyeglasses, for example – that you want to buy only in person, so you can try them on or touch and feel them? Does anyone have any insight into why retail landlords are keeping their asking prices sky-high when there are so many empty spaces? Is it actually possible that the tax write-offs on losses (including non-cash expense depreciation) are so valuable that it is better not to rent out the spaces for less money? Has anyone heard of novel regulatory incentives that have worked in filling these empty storefronts? If anyone has insight on this, I would love to hear it! Send an e-mail and let me know by [clicking here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). "Berna, thanks for addressing your failed trade – we all have them – but too many analysts get it wrong and then just pretend it never happened, or they shamelessly hype their winners and somehow forget to mention the losers. Your honesty is refreshing. "I also appreciate you calling out the unnamed analyst with the ridiculous price target on Netflix. I came out of the industry on the research side with many frustrations about how things are done – for example, earnings-related blow-ups that are quickly papered over with a rating cut and a huge price target reduction, and the analyst playing it up as if he/she was right all along -- and somehow managing to ignore the extensive collateral damage the firm's clients just suffered. "Regarding Netflix and the streaming world, I still think Netflix is a great service, but so is Amazon Prime and YouTube TV and Apple TV+ and Disney, etc. etc. etc. There's plenty of great content out there now, so my concern has more to do with pricing power, or should I say, lack thereof. But you already covered those bases, and this is just my vote." – Mark S. Berna comment: Thanks for your kind words, Mark. I strive for accountability... and I also think any honest market participant has to acknowledge that they will be wrong almost as much as they will be right. If you can be right just 60% of the time and size your positions correctly, you will beat the market handily! "Hi Berna, what is stopping Netflix and their competitors from eventually incorporating ads to the full-priced tier? Since Netflix's inception, there has been speculation that this would happen in time. I'm too young to know cable TV without ads, but I have heard and read that cable networks began ad-free. "If streamers do end up eliminating ad-free services, will this put their economics more in line with what the cable companies enjoyed in their prime? Either way, I do agree that Netflix is probably a great buy here. I think many customers will prove to be sticky (even if ad-free services disappear) due to the benefit of being on demand." – Roland D. Regards, Berna Barshay April 27, 2022 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2022 Empire Financial Research. 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