The next few years of e-commerce growth are going to fundamentally change the way soft-goods retail works today.

E-commerce has been growing rapidly for the last 6 years with equally rapid projected future growth. To date the growth has been mostly powered by existing brands moving rapidly online. Great direct-to-consumer brands like J. Crew realized this early, got out ahead of the curve, and are reaping the benefits. New companies selling other brands (e.g. Zappos) were notable as well. For the most part these companies built revenues through leveraging existing audiences (in the case of existing direct-to-consumer brands) or taking advantage of SEO and paid acquisition opportunities (in the case of wholesale retail). There is still some growth left to be had in this area, but there is one segment in particular that will drive e-commerce growth over the next few years: existing designer brands who previously only sold wholesale moving into direct-to-consumer online.

How Retail Works Today

While direct-to-consumer retail on the internet has been an opportunity for a long time, small-to-midsize designer brands that have traditionally sold wholesale have been behind the curve. Brands that distribute wholesale have not historically had core competencies in direct-to-consumer. This stems out of the structure of a pre-internet retail industry where direct-to-consumer was a large investment either for store build-outs or catalog operations. Recently designer brands have realized the opportunity to increase their top line with direct-to-consumer retail and have been exploring investments there. The average markup of a designer apparel brand from the wholesale retailer to the consumer is around 3x. If a designer brand produces a product for $50, they may sell it to a retailer at wholesale for $100 now. The retailer will turn around and sell this product for $300. Prior to e-commerce, the effort required to capture this extra $200 margin at scale didn’t justify the investment, but now brands are starting to realize that consumers’ increasing willingness to purchase online makes these investments feasible. Many of the brands are doing this poorly, but at least they are making an effort.

Explaining why this shift is such a big deal first requires a brief background on how these designer brands that sell wholesale work. Designer brands create lines usually 4 times a year with 2 major lines, Autumn/Winter and Spring/Summer. They show these collections to buyers from boutiques and large retailers throughout the year via showrooms (mostly based in LA or NY) and at the major trade shows (Project, Capsule, ENK) that occur bi-annually in both Las Vegas and New York. Most buying is done around 5-6 months before product ships. At the trade shows or in the showrooms brands are showing production samples from the factory; the clothes are not actually produced yet. After putting in their buys, the buyers wait for ship-dates to arrive They don’t actually pay for the product up-front, but rather upon receiving it, or with financing terms depending on the brand and the buyer’s history with the brand. For the Autumn/Winter tradeshow occurring in February a buyer would probably be placing orders that would ship on 7/1, 8/1, and 9/1. The product here is generally spaced out seasonally with the 7/1 shipment being late summer/early fall styles and 9/1 being winter styles. This is why you often see clothes at retailers that seem way ahead of the weather.

Once the brand has their orders for the season (they generally have a hard cutoff date that is around 4 months before delivery) they take those orders to the factory and produce them. Some brands will over-produce by some percentage to allow for re-orders or some small amount of direct-to-consumer sales, but many brands will just ‘cut to order’, producing just what the buyers ordered from them. Generally once the orders are filled they are packed up by the factory and shipped directly to the retailer; the brand often never takes possession of the goods.

Outsourcing Like Crazy

There are two reasons why designer brands have been late to the online game: technological competency and operational competency. Until recently brands have not had to know how to build a website, market it, and ship things to consumers. Designer brands are often much smaller operations than most people realize. Many brands operate with just a designer, a couple people managing production, and a couple sales people to represent the brand. Often times even the brand representation is outsourced to different ‘showrooms’ or agencies which operate actual physical showrooms in NYC and LA as well as presenting the product at trade shows. Even the production management is outsourced sometimes. At many brands the only internal core competency is the actual product design. The showrooms/agencies sell the product to consumers, a consultant manages the factories, and the factories make the product and ship bulk orders to retailers. Realistically, given their propensity to outsource, most brands are not going to build e-commerce capabilities in house. However, the complexity of building a direct-to-consumer e-commerce business makes outsourcing this process both expensive and arduous, which is likely why brands have been slow to make the leap.

E-commerce Changes Everything

The brands that succeed in the future will have two major operational differences versus the brands of today. First, these brands will hold inventory. Second, these brands will control fulfillment. As designer brands come online and build out their direct-to-consumer presence they are going to have to do a lot of things they have never done before. Successful brands in the future will need to forecast direct-to-consumer sales, produce additional product, manage shipping to customers, manage returns, and more. It is likely that more than a few smaller brands will mis-manage this process and end up either shuttering all direct-to-consumer operations or simply going out of business. However, the brands that succeed at running direct-to-consumer operations will be in an unprecedented strategic position.

Historically retailers have had very inflexible relationships with designer brands. Retailers have been required to forecast their buys far in advance of when they’re buying inventory, they have had to take deliveries (and pay for them) at specific times, and they’ve been unable to re-order styles that were working due to ‘cut-to-order’ policies. All of this equates to a lot of risk on the retailer side, for which they have been compensated with very high (from a consumer’s perspective) markups of around 3x on average.

This is a hidden issue for the brands as well: it means that to avoid channel conflict – retailers don’t like it when the brand undercuts them on price and vice versa – designer brands must sell their product at the same price that the retailer would regardless of whether the purchase is direct-to-consumer from the brand itself or not. This initially sounds great from a brand perspective, but in a world where it is now possible to launch a new ‘designer’ brand direct-to-consumer online these brands must be cognizant of upstarts undercutting them with new brands that have cachet, while still providing a strong price/value component. It’s the innovator’s dilemma at work: in this case the thing that is better is price/value and the thing that is worse but will improve over time is brand equity.

Goodbye Wholesale Brands

These disadvantages are just byproducts of the old model of how brands were run. If the old brands want to survive they will need to re-imagine the wholesale/retail model. In a new world where brands hold and ship inventory the existing wholesale/retail model will collapse.

Right now inventory risk is pooled across all the retailers, each of who hold a piece of liability for the goods they have taken in. This model doesn’t make any sense in the new world. Just as insurance companies pool individual health risk for a large profit, smart brands will bring inventory risk in-house and take the risk premium off the top.

In a new world where brands manage inventory retailers should be able to commit to a partial buy with more availability for re-orders instead of an entire buy up-front like they are required to now. Retailers should receive part of their order, but have the rest available on demand, with fulfillment enabled by the brand’s newfound shipping capabilities. In exchange for offsetting this risk the brand should be able to sell at higher prices to retailers. This is a good deal for both parties. Each retailer gets less risk and the brand gets more revenue.

Who Will Win?

This model shift will give brands more price control. They can either capture the additional margin or give it back to consumers in the form of lower prices and/or higher value. With the growing prevalence of online-first brands who sell direct-to-consumer, providing value will become increasingly important consideration for brands. The tradeoff between designer brand and price/value is falling away and increasingly consumers will have the option of choosing to buy brands with both a strong brand and strong value. The new world will increasingly favor brands that are not price constrained by wholesale model channel conflicts. The brands that aggressively shift to direct-to-consumer retail and agile wholesale relationships and pass the benefits back to the consumer in the form of lower prices or higher value are the ones that will win.