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Companies buying brands that sell primarily through ecommerce channels recently raised $16 billion in new capital. Most of that was in debt and a significant part of that debt is in technical default. It’s reasonable to ask if this business model is viable and could be successful long term. We try to unpack that question here.
First some background.
The state of things
The first companies dedicated to buying and operating niche online brands appeared about 10 years ago. But the activity didn’t take off until the pandemic. A covid induced surge in online sales created the appearance of an invincible business model: rapid revenue growth, together with low capital intensity and good margins created very high returns on invested capital.
This backdrop attracted plenty of capital and talent in the 2020-2021 period. And things worked for a while. Until they didn’t.
A fatal combination hit most industry participants: high leverage, variable interest rates, a significant revenue downturn and underdeveloped operating capabilities. Profits got significantly eroded or disappeared, leading to a breach in the financial covenants that were included in debt financings.
In summary, leverage and speed were a bad combination for a sector that was more volatile than anticipated.
We’re now deep in the fog of war, which makes it hard to understand if the problems that are hitting the industry can be solved with a different approach.
Our View
Taking a step back, we see two things: rollups work and brand aggregation works. The table below shows some successful examples in both categories.
An important clarification is that finding examples of success in a given strategy doesn’t mean it will work for everyone who tries it. That is not what we’re saying here. What we are saying is that it is not hard to find examples of successful brand aggregators and rollup companies. There is proof that success is possible. That’s all.
If we accept the premise that rollup strategies and brand aggregation can be effectively implemented, then an interesting question emerges: what conditions are necessary for success?
We think that five conditions must exist for brands to be successfully aggregated via a rollup strategy:
Long term mindset: from acquisition discipline to product innovation, this business requires a long term mentality, there are no shortcuts to success.
Viable business model: the margin structure of small brands distributed digitally and globally demands a new business model. Adopting what works elsewhere is not enough.
Operating efficiency: the highly competitive nature of this industry requires structural advantages in operating efficiency, simply trying to run faster than others will not work.
Top global talent: the ability to attract global talent is central to developing sustainable competitive advantages.
Strong capital structure: the cyclical nature of acquisitions and operations means that survival and opportunity depend on having a strong balance sheet that works throughout the cycle.
Of these conditions, the second is probably the trickiest to achieve. A combination of people and technology support the brands that are acquired. This overhead should be seen as the investment that makes or breaks the model. Growth and profitability at the brand level are almost entirely dependent on the quality of the teams and the technology that guide them. Creating a repeatable growth playbook and making effective use of data seem to be the two key institutional skills that need to be developed to make this an attractive business in the long term.
Long Term Fundamentals
Assuming an ecommerce aggregator can excel at the conditions described above, what does the business look like? In other words, is this worth the effort?
The cyclical and financial challenges that the industry faces today make it hard to understand the long term fundamentals. We would break down the answer in three components, two favorable and one uncertain:
The adoption of ecommerce as a distribution channel still has room to grow, both in the US and in some regions like Latin America. This implies a strong tail wind for revenue growth that should last for a decade or more.
The returns on capital achieved by successful brands, before overhead, are very attractive, usually exceeding 50%. This results from low capital intensity, a favorable working capital cycle and brand profit margins in the 10% to 20% range.(1)
The big question mark is overhead. If this line of the income statement can be kept at 5% or less, then ROIC stays at healthy levels. Once that threshold is breached it can quickly turn an attractive business into a poor one.
We think that successful aggregators will be those that have a clear idea of how they will achieve and sustain attractive margins. And more importantly, how they will maintain a competitive edge that allows them to keep earning high returns on their invested capital.
Short term opportunity
If the long term fundamentals are potentially attractive, what is the opportunity now? For those with skills and capital, investing now could be quite attractive. Valuations are modest, with multiples in the low single digits. Given the revenue downturn, this could mean low multiples on cyclically low profits.
Additionally, some distressed situations and strategically motivated asset sales are starting to take place. In these instances finding a resolution and moving on is the priority.
In Conclusion
Brand aggregation is viable under certain conditions. The first generation of high speed, high leverage companies entering the space did not work out as planned. There’s an opportunity now for a second generation to emerge, in some cases from combinations of existing players and in other cases from newly formed companies. This new generation has the chance to incorporate lessons learned and approach the business with a long term mentality.
If the adoption of ecommerce as a distribution channel still has years to run, as we expect, and successful niche brands can grow while achieving high returns on invested capital, then this is a great moment to invest. Pessimism is high, asset prices are low and prospective competition from new capital and talent entering the space has declined to almost a halt.
Of course it doesn’t feel like a great moment to invest. There’s blood on the streets and no end in sight to operating and financial challenges. These are the types of conditions that can lead to materially mispriced assets. Our prediction is that decisive teams with operating skills, defensible competitive advantages and ample capital, will produce outstanding long term returns from this point forward.
(1) Someone could argue that marketplaces like Amazon and ad platforms like Meta will ultimately capture most of this margin. This argument only goes so far. Kill your clients in a systematic and comprehensive way, and you kill your business.