This post was originally included in our Quarterly Letter to our LPs in Q1 2017.
The Changing Retail and E-Commerce Landscape
The team at Lead Edge often thinks about the changing structural dynamics of industries relevant to our business. One of the industries we’ve followed closely ever since the mid-2000s is the retail sector and the growing importance of e-commerce. From 2005-2007 at Bessemer Venture Partners, Brian and I cold called and built relationships with pretty much every e-commerce company at scale. Most investors thought we were nuts since they had seen the results of the dot.com blowup (we were just too naive to know any different). Some of these companies have disappeared, some are still independent businesses (RevolveClothing.com) yet many have successfully gone public or been acquired (Backcountry.com, FootballFanatics.com, eBags.com, ImprovementDirect.com, Wayfair.com, Net-a-porter.com, Yoox.com, Shopbop.com, Zappos, Diapers.com among others). Our first investment in e-commerce at Lead Edge was in Bazaarvoice in 2008, which was an acknowledgement of the fortitude of online commerce and the importance of customer reviews in enhancing that experience. In 2011, we made our first direct e-commerce investment into Alibaba and our thesis was simple, Alibaba was the e-commerce leader in China and what happened in the US with e-commerce penetration would happen in China. Even more so in China since there were no big box retailers across most cities in China so consumer selection was limited and the internet would vastly open-up vast amounts of goods that consumers across China never had access to. Fast forward to today, we see many trends affecting the retail and e-commerce landscape, and most notably in the U.S., the rise of Amazon as a powerhouse that has reshaped both customer experience and the retail industry as a whole. We think it is worth discussing these developments and the areas of interest that still exist. While we have not been as active in the e-commerce category as of late, we have continued to notice pockets of opportunity, which we will discuss further in this letter.
Disruption within the retail industry is nothing entirely new. Back in the ‘80s and ‘90s across suburban America, big-box stores began to replace mom and pop specialty shops. Instead of making multiple stops to complete errands, consumers could go to one large general merchandise store, such as Walmart, Target, or Kmart and could satisfy all their paper shopping list needs. The local knowledge and service layer of a mom and pop was replaced by the convenience and cost effectiveness of shopping at one of these large retailers. This trend was not confined to general stores, but also to sector specific outlets in large consumer categories such as Electronics (Best Buy, Circuit City), Sporting Goods (The Sports Authority, Dick’s), Home Improvement (Home Depot, Lowe’s), Home Soft Goods (Bed Bath & Beyond, Linens & Things), and Apparel (Macy’s, Bloomingdales, Saks, Neiman Marcus, Dillard’s). During the late ‘80s many venture capitalists made lucrative investments in the big box field, and our former firm Bessemer Venture Partners was one of them.
Today, these disruptors are being disrupted. Online retail has continued to grow rapidly around the globe. No longer do consumers need to make a stop at all, being able to browse the internet from the comfort of their home computer or more importantly from anywhere via a mobile device. Today, physical retailers are being forced to add “live experiences” to their offerings, as indicated by the rising importance of food halls at malls and the emergence of in-store services, like a new Bed, Bath, and Beyond in Brooklyn offering cooking classes and a hair salon. Retailers who cannot innovate are shutting down stores or even declaring bankruptcy, causing a further decline in suburban malls. It seems like every week there is another news story of a legacy retailer closing down. In April, Payless Inc. shoe chain filed for bankruptcy, while Ralph Lauren announced the closure of its flagship Fifth Avenue Polo store. In the last two months alone, clothing company, Vince, and mass merchant, Sears have rung the so-called going concern alarm, warning investors that there is “substantial doubt” that they can continue to stay in business over the next year. Just this week, Rue21 filed for bankruptcy. These retailers join a long list of retailers who have gone bust and the list is going to get much longer. JCPenny, Macy’s, Dillard’s are all down-sizing their store footprint this year and we’re sure stores such as Bed Bath and Beyond, Saks, Neiman Marcus, J.Crew, Nordstrom and countless others are not far behind. In our view, it’s a matter of time before these go bankrupt as well and the retail graveyard will be filling up over the next 5 years. An economic downturn will accelerate the brick and mortar bust as well.
The emergence of online retailers has not only changed the shopping experience but also customer expectations. Retail stores in many cases have become showrooms for customers to demo a product or try an outfit on for size. Even in the store, you can see consumers searching online to compare prices and feature sets. This layer of transparency that has brought about the informed consumer means that customers will not settle for over-paying and will rarely miss a nearby discount. Amazon has pushed the customer expectation even further, adding speed and reliability into the equation. Instead of carrying boxes or bags to their trunk, customers can expect items to arrive on their doorstep – and now thanks to Amazon, in two days or less, and in some cities, the very same day. The emergence of Amazon Prime, offering subscribers free two-day shipping for $99/year, has completely changed the convenience equation for consumers. Next-day and even 2-hour options will continue to reinforce the immediacy of the online purchase, further replacing the need to step into physical stores. It wouldn’t surprise us to see delivery get faster and faster and we think it’s only a matter of time before companies such as Uber and Lyft are delivering same day purchases to consumers.
Growing well beyond its beginning as an online bookstore, Amazon is now the true everything store, making it extremely hard for other e-commerce players to compete. I like to say, if you sell an unbranded good, good luck! Amazon will crush you. Similar to the rise in general merchandising stores and big box retail replacing local specialty stores, Amazon and the customer expectation that comes with it has made it very hard for other e-commerce businesses to find meaningful growth and more importantly sustainable profitability. The scale required to be able to rapidly fulfill orders across the country and the marketing dollars required to get in front of customers has made it prohibitively expensive to compete. According to a recent Fortune article, Amazon now accounts for 34% of U.S. online sales and is likely to see this market share grow to 50% by 2021. We think it even goes higher. As more consumer buying behavior shifts from retail to online, with the percentage of online retail in the US growing from ~3% to ~8% of total sales from 2007 to 2016, Amazon continues to capture the majority of this growth.
There are many examples of the challenge of competing with Amazon and the difficulty of building a standalone e-commerce company. Quidsi, the company behind Diapers.com, which I sourced while at Bessemer, saw an impressive growth trajectory for years. Once they were big enough to be on Amazon’s radar, they suffered a meaningful hit when Amazon undercut prices and soon thereafter Quidsi.com agreed to be acquired for $545 million. Marc Lore, the founder of Quidsi, came back years later targeting Amazon directly with Jet.com, yet another everything store focused on optimizing prices based on shipping distance and box size. While Jet.com raised hundreds of millions of dollars to take on the giant of Amazon, they were burning large sums of money and suffering some financing difficulties before agreeing to sell to Walmart last August for $3.3 billion. In many ways, Walmart’s acquisition of Jet.com was a very expensive acqui-hire of Marc Lore, who is now overseeing the company’s e-commerce division as they try to reinvent their supply chain and omni-channel offering to be more competitive. In a recent showing of bravado, Amazon shut down Quidsi.com a couple months ago and rolled the websites to redirect to Amazon, explaining that the company was never able to earn a profit.
Walmart has historically been extremely ROI focused whenever deciding on new store builds, geographic expansion and e-commerce. The fact that they spent over $3 billion dollars to acquire Jet, a business which many would argue was categorically failing, shows just how desperate they are in e-commerce. It’s important to keep mind that Walmart has a large credit card business and we suspect they have been watching Amazon literally steal their core customers. They realize they need to do whatever they can to stop the freight train (Amazon) from running them over. We think this also explains recently moves like Walmart buying Bonobos and Modcloth, which we do not believe have very attractive unit economics. We just hope for Walmart’s sake it’s not too late and that the train hasn’t completely left the station.
Most other US-based standalone e-commerce companies have not fared so well either. Zulily, a e-retailer of toys and children’s clothes founded in 2010, grew rapidly to $1.2 billion of annual sales in 2014. Zulily had raised $253 million in an IPO in November 2013, pricing at $22 per share and rising to a high of over $72 by March 2014. From there Zulily stock continued to decline significantly even while the company’s sales nearly doubled. The company ultimately got bought for $2.4B by QVC in August 2015. While that is certainly a remarkable outcome and a great growth story, Zulily was acquired at roughly $18.75 a share, below its IPO price, and once again confirmed the challenge of competing as a standalone vendor in large horizontal categories against Amazon. Etsy, a peer-to-peer marketplace for handmade or vintage items, has had its own challenges as a public company. Wayfair, founded by one of our Limited Partners, Niraj Shah, has been a notable name in vertical e-commerce, building a fast-growing multi-billion-dollar business in the furniture and home goods category, with a very successful IPO in 2014. (On May 15th, Wayfair stock closed at $61.09 per share versus $29.00 at IPO.) Yet, even Wayfair stock moves from announcements that Amazon may encroach on its territory. We are big believers in Niraj and his team at Wayfair and remain impressed with their growth, especially considering the 1,000 pound gorilla in the room.
Many entrepreneurs have tried to innovate in the e-commerce category in the last decade but have failed. Andy Dunn, the founder of Bonobos, wrote a thoughtful perspective in his May 2013 blog post called E-Commerce is a Bear in which he acknowledged the e-commerce challenge and described four strategies to deal with Amazon incumbency including proprietary pricing (flash sales), proprietary selection (niche audience), proprietary experience (stuff in a box/celebrity endorsement), and proprietary merchandise (vertically integrated). Sadly, these strategies in pricing, selection, and experience include businesses he highlighted like Gilt, Fab, Zulily, One King’s Lane, Ideeli, ModCloth, Beachmint, and Nastygal, which have all been acquired for less money than they raised or shut down completely. However, this last strategy in proprietary merchandising (i.e. making your own goods and selling direct to consumer through e-commerce) has seen some levels of success. What that is also called is building a consumer products company and distributing via the internet, which is very different than a standard e-retailer. Warby Parker saw the immense margin of the glasses conglomerate Luxottica and decided to make their own brand, selling online initially. They continue to have a large footprint, now both in retail stores and online, and are seen as a pioneer in new age commerce. Dunn’s company Bonobos has built a notable men’s apparel brand as well, but it is likely that will be acquired for a rumored $300 million to join the confederation of brands that Lore is building at Walmart.
Even with the entrenched market dominating position of Amazon and its ferocious competitive nature, there have continued to be pockets of interesting opportunities in the e-commerce space. In particular, subscription commerce has seen success in the past couple years, especially in companies that serve a specific need by offering a service or a proprietary product as discussed above. Likely IPO candidate, Stitch Fix has built a large business offering women stylist curated outfits delivered monthly, where users only pay for what they keep. This membership model enabled more predictability to the revenue and allowed Stitch Fix to rapidly scale its team of stylists and data scientists to keep improving the customer experience. Similar to Warby Parker, Dollar Shave Club (DSC) went after the market dominance of Gillette in the razor category and offered a cheaper high-quality razor blade subscription product that was on a path to success after a viral video launched the company in 2012. The business was acquired for $1 billion last year by Unilever, which needed an answer to P&G’s Gillette offering. Like Stitch Fix, DSC’s base of subscribers offers more predictability to revenue and allows for a more direct relationship with customers than these large conglomerates experience when they sell through a retail chain without any knowledge of who is buying on the other side.
More of these non-traditional tech buyers are getting acquisitive in these tech-enabled commerce categories. Like Walmart and Unilever discussed above, Petsmart recently acquired Chewy.com for $3.35 billion, making for one of the largest e-commerce acquisitions in history. Chewy offers subscription (“autoship”) pet food and supplies and has scaled to over $1 billion in sales. This is a rare occasion where Amazon let a vendor reach meaningful scale, but Chewy was able to win based on its deep sector expertise, customer service, and the community it built around users. Essentially Petsmart is betting the future of the company on this acquisition and are putting themselves in a better position to outlast their rival Petco, which I recently spoke about on CNBC. Our guess is this acquisition will eventually cause Petco to end up in the retail graveyard.
So based upon all of these factors leading to complex competitive dynamics within the retail and consumer sector, what are the avenues that Lead Edge might pursue?
- Public Markets – We are long term investors who do not believe in the ups and downs of trading stocks based upon quarterly earnings. Part of our third fund can be invested in public stocks. When we have a thesis around a company, and we believe the thesis will play out, we’re not shy about holding the stock in size and heavy concentration and tuning out the noise. For instance, we have been long term holders of Alibaba, who we believe is the juggernaut in China. Their core retail operation continues to grow materially and there is growing material option value on the stock given their other growth business units. In our third fund, we recently swapped much of our equity in Alibaba into a public convertible debt instrument, which could heavily reward us for holding the equity until 2020 with not a lot of downside. We thought this was a no brainer given that we don’t plan on selling anytime soon. We will also continue to monitor other e-commerce players such as Amazon to see if they make sense to add to our public portfolio.
- In regards to Amazon, it’s a company we regularly get asked about. It’s an AMAZING company that’s going to be way bigger in 10-15 years than it is today. Usage rates are astronomical. Case in point: since January 1, 2016, the Green Family has placed 392 orders and the Neider family has placed 344 orders. In 2013, the Green family placed 85 orders and the Neiders placed 134 orders. In 2011, the Greens placed 16 orders and the Neiders placed 8 orders. These numbers would be larger if they included the diapers.com, soap.com, and digital goods orders. These numbers are just going to get bigger for anyone who uses Amazon. It’s just so darn easy and convenient, especially with the proliferation of mobile device. Most importantly, Amazon has an upward sloping cohort curve. In other words, the longer consumers are on Amazon the more they spend over time. Two other companies that have this include Alibaba and Uber. Most consumer companies have the opposite effect. The longer a consumer is on it the less money they spend. This shouldn’t be understated, as it’s an extremely important and powerful driver of a business. A company with an update sloping cohort curve does not need to continue spending money to reacquire customers, since its customers just come back and spend more and more money generating lots of profits! We believe we are still in the early stages of Amazon’s e-commerce and cloud computing domination, and we believe it’s one of the most no brainer long term investments on the planet. With that said, we believe timing is important as it’s also one of the most crowded public hedge fund names. We plan to be buyers on a market correction; the only problem being is that we have been waiting for 18 months, and the stock has doubled! So we remain patient (and a bit frustrated!) 🙂
- The Pipes – The e-commerce machine doesn’t work without companies who power their infrastructure. We have been impressed by the growth that Shopify has accomplished over the past several years by building the software and back-end infrastructure to help power millions of online sellers. We will continue to look for companies that are taking innovative approaches to e-commerce enablement and who can insert themselves into the ecosystem while generating multiple revenue streams.
- Direct-to-Consumer – There are other vertical e-commerce brands that have seen success using the subscription and direct to consumer models. In the daily contacts space, there is an early stage but rapidly growing company called Hubble. Hubble is able to fulfill a specific need like daily contacts in an affordable and reliable way with a subscription. Similar to Chewy, the annual spending in a category like contact lenses is very consistent and so these customers are very valuable and sticky once you get them signed up. We’ve seen rapidly growing online companies in the home as well as apparel spaces. Companies such as Brooklinen, Boll & Branch, Parachute Home, Knixwear, Rhone, MeUndies, and several others.
In our own portfolio, we have made a few investments in some e-commerce companies over the past few years. We invested in companies such as Boxed, Thrive Market, and Carbon38, which are all marketplace models in that they sell third party items but they all also make private label goods and sell their own branded products. While all three continue to scale topline rapidly, it is important for them to continue focusing on gross margin. This will continue as the shift of sales moves toward their higher margin private label items. This once again confirms the importance of having proprietary merchandising in order to compete with Amazon.
In 2015, we made a $60 million USD investment into Catawiki in Europe. We believe that Catawiki’s strategy is highly unique and differentiated. They are pursuing a marketplace framework and extracting a high take rate (nearly 20%) from each item sold. We believe, however, that their model is defensible because they are primarily selling unique collectibles that are vetted and merchandised by a specialized and trained team of people. While this requires slightly higher touch, they have proven their ability to scale over the past few years and are growing at a healthy clip with exciting unit economics. They are not selling commodity goods, which we believe is a good area to pursue.
It is clear that the retail and e-commerce landscapes are evolving, and today it is happening at a faster rate than ever. Reliable delivery services, mobile phones, and urbanization are all elements that contribute to these changes in experience and expectation. We continue to watch the category and will look for sustainable, interesting models that can innovate in this new age of commerce.