How to Achieve Durable Profit Margins in DTC eCommerce
October 21, 2021
May 10, 2023
min read

How to Achieve Durable Profit Margins in DTC eCommerce

We talk a lot about margins in the world of DTC — from gross margin to contribution margin and profit margins. Ultimately, the only margin that really counts is profit margin. After all, you’re in business to make money. It’s the size, growth, and especially the durability of that profit margin that investors and acquirers consider.

Even if you are currently unprofitable, it’s the potential for profit that investors and buyers are weighing. Investors recognize your current unprofitable status, but get excited thinking about what will happen when you turn profitable. The best all time example of this is Jeff Bezos and Amazon. For decades, Bezos sold investors on the exciting future of Amazon and the potential for massive profits. And it worked. Capital providers held Bezos and Amazon to a different and better set of standards which enabled Amazon to access cheap capital. With that capital, the company was able to grow quickly and actually build the foundation to realize those promised profits.

Not All Profit Margins Are Equal

There is no doubt that profits are important. But the quality of a profit margin varies depending on size, growth, and durability.

  • Size: A big profit in a single quarter is awesome. But if you have no idea if it will happen again, investors and acquirers are going to discount it.
  • Growth: Profit paired with slow growth is not ideal. That’s because slow growth will prevent you from getting outsized multiples, as your pricing negotiations will be around small differences in growth rates. In other words, your future is relatively certain. It’s hard to argue that you’ll all of a sudden see a massive growth boom after periods of slow and steady growth. Fast profit growth gets people excited. Larger growth rates create a wider gap between possible outcomes, thus giving you more leverage in your negotiations. This is why you see dramatic differences in valuations of companies. 
  • Durability: Durability is the idea that your company will reproduce similar margins quarter after quarter — regardless of competition. Size and growth mean nothing without durability. But size and growth combined with durability? That’s the jackpot for any investor and acquirer.
💡 Durability is the idea that your company will reproduce similar margins quarter after quarter — regardless of competition. Size and growth mean nothing without durability. But size and growth combined with durability? That’s the jackpot for any investor or acquirer. 

How to Drive Profit Durability

“Moats” or “Defensibilities” are other ways to describe the concept of durability. There are some great books and resources for the study of defensibility, but my favorite is 7 Powers: The Foundations of Business Strategy. The framework within this book states that there are only seven real routes to gain and maintain power in significant markets: 

  1. Scale Economies: This is how Wal-Mart grew to dominance. When you have so many stores that you can buy Tide from Procter & Gamble at a price your rivals can’t imagine, you have Scale Economies. Play that out across everything Wal-Mart does and you get real, lasting defensibility. Amazon also uses Scale Economies in sourcing, delivery, data processing, human resources, and payments to crush rivals.

  1. Network Economies (Network Effects): eBay is a great example of a company who used Network Effects. A Network Effect exists when each additional entity in the network makes the network more valuable for everyone else. There are various types of network effects, but for eBay, the company’s use of a two-sided marketplace enabled massive growth and generated lock-in (NfX has a nice explanation for marketplace network effects). Sellers knew there were buyers on the platform and buyers knew there were sellers. All the marketplace DTC companies are predicated on this model. Companies like Rent The Runway and Poshmark know that once they build the marketplace, they have a strong moat. Of course, the type of marketplace they build is important too. Check out these summaries from NfX about building iconic marketplaces.

  1. Counter Positioning: This is when companies use a different business model or delivery mechanism (or a combination of factors) to create a market position competitors can’t or won’t copy. Dollar Shave Club is an excellent example of Counter Positioning.  The dominant player way back when was Gillette, a company that was busy selling relatively cheap razors and expensive blades through retailers. Dollar Shave Club offered cheap blades and a direct-to-consumer model that Gillette couldn’t quickly copy. For a time, Dollar Shave Club had that game to themselves — hence their nice exit. You could say that much of DTC 1.0 and 2.0 were built on counter positioning. The problem obviously is that if everyone is counter positioning, it becomes less defensible and the innovations become small enough to be nearly meaningless to the consumer.

  1. Switching Costs: Big enterprise software companies like SAP are built on this strategy. In DTC, subscription models are great examples of companies dependent on Switching Costs. For example, you are unlikely to sign up for multiple dog food subscriptions. But, there’s nothing stopping you from trying new vendors and canceling your subscription, which makes Switching Costs a weaker strategy in DTC than in enterprise software.

  1. Cornered Resource: This is basically a fancy way of saying monopoly. Can you imagine a world where you could choose among multiple cable companies for your internet? Neither can I. That’s why we grit our teeth and deal with the local provider.  They paid the government for their monopoly and are extracting their profits from us at their leisurely pace into eternity. I would argue that celebrity / influencer-focused brands are also Cornered Resources. There’s only one Ryan Reynolds — and you only have one way to get his products. A second type of Cornered Resource in DTC can be exclusivity of materials or manufacturers (example: “We are the only brand made with XYZ fabric!”). These Cornered Resources are dependent on the underlying demand for that particular material.

  1. Process Power: This is the idea that a company can develop and master a process that is so complex, yet so effective, that rivals can’t master it even when freely given to them. Toyota is the shining example here. The Toyota Way is legendary in the auto industry, but extremely hard for others to copy. I would argue that Amazon and Wayfair have significant Process Power. Their use of data and systems is unrivaled in e-commerce.

⚠️   In DTC, you will usually hear false claims of Process Power around customer acquisition (example: “We have cracked Facebook!”) These processes are temporary and don’t lead to lasting advantages. Cracking Facebook helps your growth, but you can’t build a business with fat, durable margins around long-term Facebook domination.  

  1. Brand: This is where most DTC companies hang their hats — and rightly so. Brand is the collection of ideas customers have about your company. Most times, your brand is only powerful if it drives repeat purchases from customers. With strong branding, customers not only like your product. They like your service, ease of ordering, cheap shipping, subscription options, educational videos, and more. That holistic love for the brand keeps them ordering more. Brand is the first line of defense for virtually all DTC companies when they start off. Some scale or are able to achieve one or more of the other six powers, but Brand is your first and likely your best creator of durable profit margins.

Combining Multiple Defensibilities in DTC

Chewy is a great example of a DTC company with multiple defensibilities. When Ryan Cohen sold Chewy to PetSmart in 2017 for $3.5 billion, it was the largest e-commerce acquisition ever.  To grow his business, Ryan started with Brand. Chewy leaned into incredible customer service, personalized pet portraits, and handwritten holiday notes with a focus on finding fanatical pet parents and making them happy. He implanted powerful ideas about Chewy in each customers’ mind, leading to brand love and loyalty. 

He then employed Process Power to hire great people and develop the supply chain and machine to support his vision. As Chewy grew, the company leveraged Scale Economies — which the company was able to achieve by focusing on a specific segment and building the sales volume to get the supplier pricing to compete with Amazon and the biggest competitors in the market. You could also argue that Chewy created some nice Switching Costs with great subscription services and maybe even some Network Effects with positive customer reviews and social proof from happy pet parents. 

💡  Just as Chewy did, most DTC companies need to start their journey to defensibility with Brand. This is especially important in smaller markets, where other tactics like Scale Economies and Cornered Resources are difficult to achieve. From there, it’s easier to add defensibilities as you scale your business.

How to Prove DTC Profit Durability

Looking for a way to prove defensibility and durability? It’s all in the numbers. Month-over-month and quarter-over-quarter performance is hard to ignore. 

As you work to build that track record, you’ll need to help investors and acquirers understand how and why your defensibilities work. To do so, focus on key metrics around repeat purchase behavior. Look at the percentage of each customer cohort that is coming back to purchase more products in subsequent months, and how that impacts revenue. You’ll also want to analyze your trendline of repeat purchases to understand how it varies. Do repeat purchases decline and then stabilize, or move up and down at random? Are cohorts spending more money over time? 

The better you are at understanding and monetizing cohorts over time, the better equipped you’ll be to prove durability to investors. At Drivepoint, our platform prioritizes these analytics with easy-to-read summaries and models to help better understand your business, and make a case for your long-term potential.

Interested in learning more? Sign up for a demo of the Drivepoint platform.

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