A new study from BMO Capital Markets found that although many brands are aggressively shifting towards direct-to-consumer (DTC), underlying profitability may be better selling through wholesale channels.

“Over a decade ago, when e-commerce began its meaningful ascent, the world expected the channel to pose a boon to retail margins,” wrote Simeon Siegel, lead author and analyst at BMO, in the report. “There was no rent, after all. That was until it became clear that e-commerce costs were variable and ended up driving a material company-level profit drag.”
Siegel added, “We worry a similar issue is unfolding again with a broad-based push across the largest wholesale-dependent brands to DTC (both via company-owned stores and e-commerce), away from the wholesale channels upon which they healthily built their retail empires.”

Although BMO agreed that a company could better control and elevate its brand at DTC, capture more data from customers and achieve higher revenue per item sold and presumably a material gross margin lift, the investment firm’s analysis shows that almost every time a company has reported margins by channel, its DTC EBIT (earnings before interest and taxes) margin has been “meaningfully below” wholesale EBIT.

Overall, BMO’s analysis showed that expanding DTC has not raised company-level revenues, gross margins, merchandise margins, EBIT margins, and EBIT dollars.

BMO’s findings are based on a working template it created that explores the dollar and margin implications of a brand opting to sell units via wholesale or DTC. Vendor companies analyzed in the report include Vera Bradley, Tempur Sealy, Ralph Lauren, Nike, Skechers, Columbia Sportswear, Canada Goose, Carter’s, Under Armour, Puma, Urban Outfitters, Deckers Outdoor, Tapestry, Canada Goose, and Levi’s as well as several third-party retailers.

On revenues, BMO’s analysis found that when companies shift revenues to DTC, a greater portion of the selling price per item is captured. However, where measurable over the last five years, companies in most cases have shown slower growth as they’ve increased DTC penetration. The report noted, for example, Skechers showed “meaningful sales” expansion even though its DTC penetration declined. Conversely, Vera Bradley and Michael Kors, with major DTC penetration expansion, have seen flattish revenues.

Siegel wrote, “As such, and potentially falling prey to our over-generalization, this appears to suggest that although revenue per item grows at DTC, the units lost by abandoning wholesale generally overwhelm the unit price lifts at DTC. Said another way, revenue per unit may grow, but total company revenue does not.” However, the report’s primary focus was exploring the widespread belief that DTC is more profitable than wholesale for brands.

Among the findings around profitability was that almost every company that reports (or has previously reported) EBIT margins by channel showed meaningfully higher EBIT rates at wholesale versus DTC. BMO’s analysis shows that the costs to run DTC operations, in most cases, offset the gross margin gains that come from DTC, “a fact which we believe is commonly ignored,” wrote Siegel.

In an analysis of nine vendor companies that broke out their wholesale versus DTC margins in the past, only Canada Goose and Deckers Outdoor, the parent of Ugg and Hoka One One, showed higher DTC margins.

The report further found that only four of the seven companies reporting DTC penetration growth saw gross margin expansion over the last five years. Michael Kors and Nike, two companies that have accelerated DTC growth, saw gross margins erode while several firms with a slower shift to or reduced DTC penetration showed strong improvements, including Ralph Lauren, Skechers and PVH.

A major surprise was that despite the overall finding that DTC gross margins average 2,350 basis points above wholesale, many DTC-only businesses had merchandise margins well below companies that derive as much as 50 percent of their revenues through the much-lower gross margin wholesale segment. For example, American Eagle and Gap’s merchandise margins were below Ralph Lauren and PVH that rely heavily on wholesale selling.

BMO offered several hypotheses on why DTC-only merchandise margins are lower despite the gross margin benefit. These include international gross margins generally landing above domestic margins for many of the largest wholesale brands, the benefits of strong margins coming from factory outlet stores that feature many of the wholesale’s biggest brands, and some scale derived from a larger wholesale business. However, BMO admitted the finding “remains puzzling to us” and planned further studies around the phenomenon.

BMO also explored profitability from online operations given the shift to digital that’s been accelerated by the pandemic. BMO found that although e-commerce profitability benefits from reduced rent and labor costs versus brick and mortal selling, e-commerce “comes with its own set of expenses that are absent from wholesale,” including fulfillment, logistics, heavier marketing, technology, and heightened returns. These expenses can “quickly erode” any benefits from not having to operate physical stores. BMO said that given that the online shift has been ongoing well before the pandemic, the DTC margin erosion overall might reflect online’s oversized growth for many firms.

Siegel wrote, “What’s more, it seems a matter of public record by now that e-commerce has been a margin pressure to the sector, not a boost. A fact shown well through the recent filings of digitally native disruptors.”

Nonetheless, the report highlighted other reasons why DTC channels are beneficial. For instance, companies can gain a higher level of control over the brand image, distribution and pricing. According to Siegel, these benefits are “perhaps reason enough to pivot from wholesale to DTC” despite the margin risks. Siegel wrote, “Brand perception remains key to brand equity; where and how a product is sold can be as important as the quality of the product itself.

Photo courtesy Nike/Business Of Fashion