One of the realities of business today is that retail in 2017 little resembles retail of a decade ago. Product companies used to succeed or fail based on their distribution power and the shelf space retailers gave them, and retailers succeeded or failed by having the right product at the best price for consumers. Scale in retail mattered and that's how retailers became power brokers in the product world.
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Retail today has been completely flipped on its head. A great product from a small business can be a hit because its customers share their experience online. Going viral can be more important than being in the right retailers in 2017. Today, anyone can open a store online or on Amazon(NASDAQ: AMZN), Etsy, eBay, or any number of other platforms.
The product development landscape that used to rely on large companies to succeed has been flattened in a way that allows someone in a garage to create a great product and get it out to the world. All of this seems logical today, but so many companies are still built as if the old retail model still exists. Product companies like GoPro (NASDAQ: GPRO), Fitbit (NYSE: FIT), and Garmin (NASDAQ: GRMN) are a great example of this -- and if they're going to succeed, they may have to rethink their business models to incorporate the retail realities of 2017.
Drones are growing in popularity, but are they really a retail impulse purchase in 2017? Image source: GoPro.
The old retail model is ancient history
The old retail model for a product company essentially had three to four layers, depending on the channel. There was manufacturing, the product company would then have inventory on hand to fill orders, there may be a distributor who sells multiple product lines, and then there's the retailer themselves. Manufacturing has to line up with end user demand, but in between is two to three layers of channel inventory that's incredibly complex to get exactly right, particularly if you're a holiday-based business.
This model creates two challenges for companies like GoPro, Fitbit, and Garmin. First is that they have to get their product inventory build right so they don't miss the critical holiday season, but can't build too much or there's excess inventory. The second problem is that retailers have to make money, so they're cutting into margin compared to if products were directly sold to customers. Why not cut out the middleman?
The inventory problem
I don't think I can overstate how much of a problem inventory is for product companies or how quickly it can erase years' worth of profits. Companies have to try to guess what demand will be months in advance, build product to ship to stores, and then if demand isn't as strong as they predicted, they usually have to take product back from retailers.
Image source: Garmin.
In the fourth quarter of 2016, Fitbit says it will take a one-time writedown of $68 million for "tooling equipment and component inventory," increase return reserves by $41 million because of "greater channel inventory," and take another $37 million charge for "increased rebates and channel pricing promotions". That's $146 million in charges during a single quarter that was driven by too much inventory in the retail channel. That quickly erased most of the $176 million in net income from 2015, which was a record for the company.
Something similar happened at GoPro in 2015. Fourth-quarter 2015 results included $21 million in lost revenue from "price protection related charges" and $57 million in costs associated with "excess purchase order commitments, excess inventory and obsolete tooling." The $78 million in charges didn't quite offset 2014's full-year net income of $128 million, but it took a big chunk out of past success.
Building the right amount of inventory is tough for companies like this, especially when they're selling into a channel with multiple layers of distribution inventory. Maybe it would be better to do a 100% direct business model, especially when you consider the value retailers are taking out of potential profits.
Direct sales are the product cash cow
Retailers can bring products to millions of potential customers, but they need to make money to do so. And that makes retail sales far less profitable for product companies than going direct to consumers. Here's an example of how the trade-off looks.
Let's assume a retailer has a gross margin of 30%. So, GoPro would only make $279 on a Hero 5 Black that retails for $399. And that's before any promotion or volume discounts a retailer may be given that are then passed on to customers (think Black Friday deals on GoPro cameras this year).
If we assume that it costs $200 to make a Hero 5 Black (based on margins for the company), then GoPro makes about $79 per product sold at retail. But if GoPro sold the exact same camera directly to a customer on its website it would get the entire $399 and have a $199 margin. On the bottom line, a direct sale is worth 2.5 times that of each retail camera sale.
GoPro sold 2.28 million GoPro units last quarter and a little over half went through a distribution channel. But if GoPro would have sold every camera directly to customers, it could have sold at least 25% fewer units and actually made more money. And this is before we even consider the sales staff and inventory that could be eliminated if a company only sold directly to customers.
This is a hypothetical example, but it should be directionally accurate for product companies. Selling in retail isn't the highest-margin business any of these companies have, and it may not be worth the effort at all when you consider the charges a company has to take if they get their inventory buildout wrong.
Less risk, more profit
When I look at companies like GoPro, Fitbit, and Garmin, I see a businesses that could survive very easily without any retail presence at all. A $400 action camera or $500 triathlon watch isn't exactly an impulse purchase, so customers will find your products if they're the very best. And if these companies went with a more direct model, they may generate significantly higher profits even if sales fall. On top of that, a simpler distribution model means they could take less inventory risk.
Changing business models may be hard, but the retail business isn't what it once was, and if it's not a huge benefit to a business, then why pursue it at all? As traditional retail slowly dies, I think it's time for product companies to look for better strategic alternatives. GoPro, Fitbit, and Garmin may be better off building on top of their brands with a direct model rather than trying to reach everyone in retail.
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Travis Hoium owns shares of GoPro. The Motley Fool owns shares of and recommends Amazon, eBay, Etsy, Fitbit, and GoPro. The Motley Fool has the following options: short January 2019 $12 calls on GoPro and long January 2019 $12 puts on GoPro. The Motley Fool has a disclosure policy.