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How Investors Evaluate DTCs Versus Department Stores in Retail

In an era of constant change, it’s hard to predict which paths reflect promising new directions and which are headed toward dead ends—but investors are charged with determining just that. As the financial market evaluates both new and established retail channels, it must rely on existing metrics while deciding which new indicators have the most value, according to John Kernan, managing director, retail and consumer brands for Cowen and Company.

Determining which struggling sectors will turn around and which promising business models will pan out will be an ongoing challenge as the industry continues to evolve.

Sourcing Journal: When we’re talking about apparel brands, what have investors historically been concerned with?

John Kernan: The first thing you’re going to look at is the management team. There’s still a lot of smart management teams in this space, but the industry has evolved tremendously over the past three years.

Then, you’re going to look at the durability of the company’s growth profile, the durability of the brand, the strength of the brand. At a high level, you’re going to drill into what you think the company’s margin potential and earnings potential is. These are the most important financial metrics.

SJ: If it’s that clear cut, why have valuations been all over the place?

JK: The cash flow model across retail, particularly with apparel and accessories, became very leveraged to a very slow-moving department store channel. The inventory just doesn’t turn. It’s a very inefficient capital model. And you have inventory turns that are declining almost every year at this point. So the problem is you have slow-moving inventory, you have a lot of markdowns associated with that, and that is a major drag on your cash flow and your return on capital.

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On the one hand, you have a Lululemon, a Nike, a VF Corp. and an Adidas that traded very high capital multiples. Then you look at what’s not trading at high capital multiples, mid-tier apparel businesses that are using the department store channels and outlet channels as their major channels of distribution.

SJ: Where do digitally native brands fit into this?

JK: The digital commerce revolution brought down barriers of entry in the space. It enables competition like DTC brands to scale at incredibly rapid rates. I don’t think there’s that many of them that are profitable yet. They have very high customer acquisition costs, but they are building loyalty and taking market share.

The consumer is gradually buying into a mindset of: “I’ve bought too much cheap, disposable clothing, and it’s filling up my closet. I don’t need it.” So the volume-based companies that are based on marketing 40, 50 or 60 percent off to drive a unit sale, that model has been disrupted permanently.

SJ: You mentioned one major benefit of DTCs is they’re building loyalty. The legacy players are trying to find new ways to do that too with revamped loyalty programs, etc. Will that be enough?

JK: The legacy players built loyalty that was just transactional—“Buy this and we will give you 25 percent more off”—which was the wrong way to build loyalty. You have to come at consumers in a more authentic way. Retailers are still hooked on the transactional promotions and loyalty cards. And that’s not true loyalty. That’s really just a promotion at heart. Look at the Louis Vuittons and all those luxury brands; there are fanatical consumers attached to those brands and people willing to pay seemingly irrational price points for their product. That’s loyalty—not getting somebody to charge something to a credit card and earn points.

SJ: What will investor metrics look like in five years?

JK: Investors are really trying to understand what’s durable in the space, because the barriers to entry have fallen so much. And they don’t really know. Nothing is proven to be totally predictable at this point in retail, and I think it’ll stay that way. There will be new forms of digital commerce that pop up, new forms of resale. Investors are really trying to gauge the durability of the margin structure.

SJ: And what about the legacy players in the future? Can they hold on?

JK: Brands still need wholesale channel exposure, for sure. I think the wholesale channel has to figure out a more sustainable financial capital model, whether or not they can move inventory faster and have a much more efficient working capital structure. I just expect a lot more of the evolution and the disruption to continue. Digital commerce has remade the space and reset consumer expectations, and companies are trying to reinvent themselves in the face of that.

This interview was one of several in The New Fundamentals, an examination of how the industry is writing a new rule book. Click to read the full report.