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Three Easy Clues for Buying Distressed Ecommerce Companies

Three Easy Clues for Buying Distressed Ecommerce Companies

The past three years of ecommerce have been nothing short of a whipsaw for investors and entrepreneurs.

Over the past 20 years the Federal Reserve Board reports that ecommerce, as a percentage of retail sales, enjoyed a predictable compounded annual rate of change of 12% to15 from 2010 to 2019. This gave way to a growth stampede of 42% in 2020 only to come back down to 18% in 2021 and 2022 finished the year at 7% - its lowest recording since the Great Recession and the third lowest in almost the past quarter century. 

Source: FRED Economic Data - U.S. Census Bureau
Amidst all this chaos, lies a once in a decade opportunity for those in the investor sector to find undervalued ecommerce properties. 

But placing smart bets requires analyzing a few key variables.

1. Unpacking the Ecommerce Pandemic Panic

There are three key clues for assessing the value and future opportunities of a post-pandemic ecommerce business: core offerings, supply chain surge, and acquisition costs.

Core Offering Over Time: By now it’s fairly easy to tell if the company’s core offerings are inline with a true shift in consumer behavior. Ancillary industries, such as the pet industry, enjoyed skyrocketing growth but follow the general trends mentioned above for growth reverting to the historical averages.

Quick due diligence tip: When investigating core offerings over time, you can use the Google Trends function via the Google Shopping option. To get a proxy for market demand you can drop in general keywords to get an idea of  what advertisers were (and still are) spending money on. Try and describe what a user would search in two or three keywords and rewind the clock to 2017 if possible. (We’ve learned that time-series data is most accurate with at least three years of data).

Here’s an extremely obvious example for “N95 masks,”  which follows the three waves of the coronavirus and then settles right back down to pre-pandemic search volumes.  

Takeaway: Spending 20 minutes on a simple Google Trends exercise can yield remarkable directional clues on where a category is headed by extrapolating out basic trend lines. It’s also a ton of fun to  guess and test your assumptions which  often can be completely wrong.

2. Supply Chain Surge and Slack

 The supply chain “rocket ship” of spring 2020 left many ecommerce companies scrambling to get products onsite. Cash was forked over to buy inventory at historic levels only to find either the product was slow to show up or when it did finally ship it was exorbitantly expensive to land stateside due to container costs.

The global container rate index from Jan ‘19 through Nov ‘22. Buying inventory to meet demand during this ramp up from May ‘20 to March ‘22 led many ecommerce brands to end up under water as margins were wiped out due to unforeseen freight costs with rising ad costs. (Source: Statista)

Those that could source products grew tremendously only to find out they were upside down on their P&L due to these unforeseen variable costs and lead times. To cover and keep up, they voraciously ate up cash reserves. The historic low cost of borrowing capital meant that some could keep going for ‘21 and ‘22 but the current inflationary environment has put many in precarious positions.

However, there are tremendous opportunities for these types of businesses if they pass the first test above and can be recapitalized with realistic growth expectations. 

Quick due diligence tip: Depending on SKU count, a quick analysis can quickly peel out the distribution of the most profitable products. Knowing supply chains have mostly stabilized, models can now include inventory velocity or turns in addition to a unit economic margin analysis for each product. This can be particularly powerful for those selling on Amazon where demand can be tuned up and predictable over time. For direct online sales, doubling down on the high performers by pairing products with how customers buy (and when) can help right the ship while shedding low-performing inventory in the process. Again, try and use at least three years of pre-pandemic data to get a sense of what the product compound annual growth rate truly looks like.

The above graph shows a typical profit by SKU chart for pre and post pandemic. For SKU 3, we see it dipped due to supply chain disruptions but is coming back up to pre-pandemic levels and a good bet to place. SKU 2 has slipped and is still declining and should likely be cut unless it can demonstrate real opportunities for turns in volume to make up the loss on margins.

3. Acquisition Costs & Traffix Mix

Apple broke Facebook with its iOS updates on tracking. What this really meant is the easy days of digital marketing were forever over. If a company had built a very predictable and scalable growth curve only on paid social media, it’s likely been in a tailspin ever since. Many DTC brands were driving 80-85% of their traffic with Instagram or Facebook ads given its incredible ability to target and retarget users cost-effectively.

Quick due diligence tip: Evaluate the traffic mix to the website. Here’s a quick snapshot of two brands using real data that has been redacted: Risky Retail and Consistent Commerce.

The above graph shows how Risky Retail is pulling 80% of its traffic from Paid channels like Facebook and Instagram with almost nothing coming from Email/SMS or SEO. This business will be subject to huge profitability and revenue swings due to privacy changes while also being extremely cash hungry given rising inflationary costs on ad platforms with ever declining attribution. Proceed with caution unless there are incredible margins and real moats to protect the business.

Bonus Clue - Traffic Mix Compounding Over Time - What Nobody Looks At

As discussed above, the most stable (and valuable) ecommerce sites have a nice diverse mix of traffic coming to the ecommerce site and ideally among that mix,  a very strong SEO pull with great content bringing in highly engaged traffic. Once that highly engaged traffic is onsite we hope the audience makes a purchase  and also signs up for an owned channel like Email or SMS. 

In investor terms, this is the “Modern Portfolio Theory” applied to ecommerce. Greater risk increasingly resides in paid media traffic and influencers (referral) and for the past few years have provided great returns. We’re seeing this now repeat itself with TikTok and the promise of easy money with the right user-generated content going viral. 

We could play with risk, or beta, in a few ways depending on when we want to exit the business for these types of channels. But for now, think of paid channels as having a high degree of risk due to iOS changes, increasing ad costs and even loss of attribution signals.

How to handle this?

In due diligence, you want to look at traffic channels like assets and how they are changing over time. Just like with compound growth, you want to apply that same logic to how traffic is getting to the site at a high level.

Here’s Consistent Commerce again and looking at their traffic growth by channel from launch through 2022:

The above graph shows an ecommerce brand that has successfully fine tuned its traffic mix to minimize revenue-disruption risk. Note how SEO overtook paid within 18 months of launch and as a result has been declining ever since.

What we see, and this is rare, is this company strategically fine tuned their traffic over the years in the following ways:

  1. They invested in content and SEO to get their site pulling in traffic without paying directly for it. It’s a long-play for sure but this has compounded at around 18% year over year to now being over half their traffic. This is a key KPI you want to suss out in due diligence as you measure customer acquisition costs (CAC).

  2. Email/SMS channels started at 0 and compounded at 35% yearly to now claim almost 20% of traffic. This channel is almost like an annuity when done right with customer segmentation and automation using first- and zero-party datasets.

  3. Paid made up the majority of traffic at launch (gotta get customers somehow). However, this company was able to reduce reliance on paid channels by about 12% per year and park it around 20% of the total mix.

  4. Referral traffic (such as influencers or Reddit) has made up very little traffic and thus greatly tamps down the volatility for sales volumes. What goes up really fast, tends to come crashing down really fast. Low referral traffic eases inventory spikes when viral content can quickly put a rush on a product, quickly selling it out of stock. This is a nightmare from an operations and capital perspective unless the risk-appetite is high to ramp and exit quickly.

Sites like Consistent Commerce create nice flywheels that spin up over time without devouring massive amounts of cash to juice traffic along the way.  If you’re curious, be sure to check out our 5C Flywheel Framework(™) that we teach in our PE workshops and in our classes and case studies for Harvard Business School.

Ultimately, you want to find and acquire companies like Consistent Commerce with traffic trendlines  circa 2018 or 2019: SEO and Email/SMS is growing, Paid is declining, and there is no over reliance on fickle influencers.

Which produces financial graphs like this:

Here we see the above traffic compounding off channels like SEO and Email/SMS which translates into growing revenue while also preventing eating all our margins with paid ads. 

Curious On Our Methods?

The above examples are taken from our work with private equity investors in the ecommerce space and also scaling merchants up for successful exits or capital raises. All names and numbers have been redacted or abstracted.

If you’re interested in exploring some of our methods and how we work on these types of problems with interdisciplinary teams, be sure to check out our Growth Plan offerings which provide a much deeper deep dive into the ideas above along with some machine learning methods to forecast potential returns using daily sales and traffic data over multiple years.

In addition, we have a wonderful conference each fall in Bozeman - feel free to request an invite on our Private Equity in Ecommerce event page.

Use coupon code WELCOME10 for 10% off your first order.

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