How Consumer and Retail Companies Are Embracing Mass Customization

Fast fashion shops where you can pick and choose an outfit that's just your style, touchscreen soda machines that let you mix up any concoction of your choice, a rising tide of interest in craft and artisan goods -- the past few decades have seen a major push toward customized (or personalized) products and services.

In this week's Industry Focus: Consumer Goods, Motley Fool analysts Vincent Shen and Asit Sharma talk about three companies that are leveraging customization as part of their own businesses -- Nike (NKE -0.18%), Starbucks (SBUX -0.35%), and Etsy (ETSY 2.86%).

A full transcript follows the video.

This podcast was recorded on Oct. 4, 2016.

Vincent Shen: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at quickenloans.com/fool.

Welcome, Fools, to the latest episode of Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Tuesday, October 4th, and I am your host, Vincent Shen, ever appreciative of listeners, old and new, for taking this time from your day to join us as we break down some of the latest developments in consumer and retail. Joining me via Skype from the beautiful city of Raleigh, North Carolina, I think, Asit, unless you're traveling, is senior Fool.com analyst Asit Sharma.

Asit Sharma: I'm here in Raleigh. And it's a beautiful day.

Shen: In light of our show today, I wanted to ask you, what was the last purchase you made that you felt gave you an opportunity to customize a product, or even service, to your liking?

Sharma: To answer that question truthfully, I'm going to have to reveal what a truly boring guy I am. This is a purchase I'm about to make. I'm looking for this obscure set of essays by William Makepeace Thackeray. He wrote Vanity Fair. It's out of print. It's even hard to get on Amazon, or if you poke around an old bookstore. It's just hard to find. And I discovered, surfing around the web, that there are these small publishers which will print old texts on demand. You get to choose your binding, your cover, and even your font. For a guy like me, that's really exciting. I was going to say that I was getting this beautiful custom mountain climbing equipment made by a master craftsman who lives off the grid in a shed in Oregon, but that's not true.

Shen: I had no idea that things like that existed, in terms of the custom binding. How do they actually get the material, in terms of the content for the essays?

Sharma: A lot of these have rolled off of copyright. If you think about texts that are now approaching 150, 200 years old, they're common property. So, you and I could pull these off of the web, and if we have the equipment, we can also print it on demand and send it out to folks.

Shen: Got it, that makes sense. Listeners, the reason I'm bringing that up, in terms of this customization angle, is that the main part of our discussion is this increasingly important trend among a lot of companies, especially in the consumer retail sector, that are giving consumers more and more options to customize or personalize the items or services that they purchase. Asit, before the show, I really liked the way that you had summed up a bit of the history, and where we currently stand in terms of the consumer retail world with customization. Can you share some of that background with listeners?

Sharma: Many of us are familiar with the Jet Age iconography, what things looked like in the '50s. We see those beautiful pictures, illustrated pictures of airplanes flying off into the sky, like Pan Am, etc. It was a really exciting time for people who had more disposable income. Mass-produced goods were just coming into being. Plastic was a new material. There was a thirst for cheap material that was made of plastic, wasn't any different from what your neighbor could buy. And that's one end of the pendulum. In the intervening decades, the pendulum swung all the way to the other end. Now we have a desire for a differentiated experience. We still want things to be cheap, we still want things to be accessible, but now we're willing to wait for a product, it can be custom, it can be differentiated. It's probably a symptom of the modern life we're living, that we want handmade things, things that have some bit of craft or customization about them.

Shen: Absolutely. I can totally understand that. You mentioned the rock climbing equipment that you were not buying, but I'm actually shopping for a new sleeping bag for cabin trips and camping trips. Of course, I can go to an REI, for example, and pick up a bag off the rack. But in the outdoor goods industry, there's a lot of what's called "cottage industries," local or at least domestic, a lot of handmade products. So I've been looking into a quilt from a company called Enlightened Equipment. They give you the option to choose not only the interior and exterior color, but the weight, the size, what temperature rating you want it. That's really customized, like you're talking about, to exactly the needs that I want, even the aesthetics and look of the product I want. 

Next up, listeners, we're going to dive into three key studies, or examples, of some bigger companies and different levels of how they're approaching customization in the sector.

Before we do that, here's a big thanks to Rocket Mortgage by Quicken Loans for supporting the show. Whether you've purchased a home in the past or are currently scouring the market, you understand how frustrating and time-consuming getting a mortgage can be. Fortunately, Rocket Mortgage is bringing the mortgage approval process into the 21st century. With Rocket Mortgage, you can easily share your bank statements and pay stubs at the touch of a button, helping you get approved in minutes for a custom mortgage solution that's tailored to your unique financial situation. It's fast, powerful, and completely online, so you can do all of this from your smartphone or tablet. If you're looking to refinance your mortgage or buy a home, check out Rocket Mortgage today at quickenloans.com/fool. Equal Housing lender licensed in all 50 states, nmlsconsumeraccess.org number 3030.

Our first example, Asit, is Nike and what they're most famous for, and what most dominates in terms of their revenue and their profitability, which is their footwear and their NIKEiD customized shoes. Can you tell us a little bit about that?

Sharma: Absolutely. Nike has their iD store, NIKEiD, and this is a place you go online and customize your own footwear. This sells at a 30% to 50% premium over what you might buy in a store. It takes three to four weeks to deliver. There are a couple things that really benefit Nike here. Obviously, there's incremental profits in it for the company, which I just mentioned. If you take the difference between buying a preferred sneaker online at a discount versus going to a store, which has no discount, but paying that premium, you can see that's a very nice margin pop for Nike. 

But there's also customer education in this for Nike. If you go online to the store and just go through the options -- you can do this without having to buy a product. I did myself, the Nike Sock Dart sneaker. You'll learn as you construct your shoe exactly what a "heathered engineered mesh upper" is. I had no idea what that was when I started this. You can see that Nike wants to put you in the shoes of a sneaker designer and make you see their products from their perspective. That forms this bond between the manufacturer and the customer, which becomes hard to break. We'll talk about the implications of that in just a bit. Vince, have you ever had an opportunity to build a sneaker of your own?

Shen: Yeah, for the show, I wanted to see what it was like. I built a version of the LunarEpic Flyknit Low sneaker through NIKEiD. Just to give listeners an idea of what optionality you actually get through this system, the UI on the site is very easy to use. In all, it took me maybe five or 10 minutes. If you want to be very selective in terms of exactly the colors and the combinations, playing around with that, it might take you a little longer. But, all in all, a very simple process. This includes customizing how the upper looks, the laces, the midsole, even the color of the Nike Swoosh, you can add a flag or a logo to the tongue of a sneaker. And you can have -- I love this part -- text placed on the heel of a shoe, different for the left and the right side. It can be a number, your initials, whatever you want. I thought that was a really nice touch. As Asit mentioned, it's about $200 all-in for the sneaker with the various customization options. When it comes down to it, there are a lot of different combinations in terms of what the final product will look like. 

We weren't able to find as much information, but to give you an idea of how, with Nike, in terms of their manufacturing process to produce these NIKEiD offerings -- but also, in previous episodes, we've talked about Under Armour and the various innovation efforts they're trying to push on the manufacturing side -- but, how the company is able to deliver these customized shoes to consumers in a timely manner. We know how impatient consumers can be when it comes to online shopping, expecting as close as they can get to that instant gratification. I think four weeks is on the longer side, but if the product is exactly the way you like it, people are willing to wait that extra time.

Sharma: Absolutely. And that wait actually builds anticipation, as long as it's not too long. There's a really apparent dynamic going on here in that Nike is building loyalty for its brand. We look at that single purchase as this incremental margin pop. And it is that for Nike. But, if you look at it from their perspective, they want to build you as a lifetime customer.

Let's set ourselves apart -- we have two personalities, we're investors, but we're also customers. I'm going to disassociate myself from the customer side of things, because I don't have the moola, personally, to plop down $200 every so often and design my own shoe. But, suppose you had the moola. Once you go through this process, it's awfully hard to go back. We see that with a lot of different instances of customization in our buying careers. Once you get used to customization, you don't want to go back and buy something off the shelf. For Nike to have you as a customer -- let's say 85% of your future purchases throughout your life, rather than having to entice you into the store every time you go back, besides its competitors like New Balance and Adidas, that's extremely valuable to them, to make you a lifetime customer.

Shen: That's an awesome point, the idea that instead of fighting for those spending shopper dollars each trip to the store, win them over through the experience, build that loyalty through something like NIKEiD, and keep them coming back, and then you don't even have to worry in the future nearly as much about the competition, be it Adidas, New Balance, or Under Armour.

For our next example, we're going to go to the world of coffee. That's, of course, one of the biggest names there now, if not the biggest, Starbucks. Between what I feel is a pretty sizable menu, when you walk into a store and you look at it, tons of options. Then, you have the different options for what kind of milk you want. There's flavor shots, and they also offer different temperature levels. I don't think I'm missing anything else there. That has to be hundreds, if not thousands, of different options for your final drink and what it tastes like when you get it at Starbucks. How does this play into the customization trend that we've been discussing?

Sharma: Starbucks as a retail organization is inherently about customization. This is the novelty of the anti-McDonald's. Before the show, Vince and I were talking about, 15 or 20 years ago, the lack of options, and how ubiquitous that McDonald's cup of coffee was. If you think about extremes on the sides of the pendulum, this is the opposite extreme of the customization pendulum. There are literally so many customization options, Starbucks could choose to rest on those laurels, but it doesn't. It's always trying to push customization one step further. There are two paths to customization that we're going to talk about today. One is pretty expensive per store, and the other is almost costless. We'll talk about the costless option for Starbucks at the end of the episode, and let you, the listener, try to figure out what we're talking about. What customization option does Starbucks offer that costs them almost nothing?

To get back to this first path, several of you who are coffee snobs or connoisseurs like myself probably remember when Starbucks acquired a machine called a Clover. This was back in 2008. I had tried this coffee out in Toronto several years ago. It's a machine that used to retail at $11,000. If you think of a coffee machine that's a little bit bigger than the size of a laser printer, this is quite an expensive piece of equipment. But what this machine does is, it allows the barista to work with the customer for brew time, down to the second, and how much exposure the water has to the actual coffee grounds. You can dial in a precise temperature. This is the Holy Grail, for many people, of customization for coffee. It's a vacuum type coffee process, and it's extremely delicious when it's done right. But I will say, it takes some experimentation to get this right. Each cup runs you $3 to $4 for that small size, the tall size, at Starbucks.

Shen: I'm impressed. I remember hearing a bit about the news, in terms of how they were adopting this Clover system, how costly it is. I'm not as big of a coffee drinker, so I will defer to your expertise and your preferences here. But I understand in this world, whether it's with sneaker heads in Nike shoes, or coffee, or so many other things out there, there is some aficionado out there who likes it down to the most minute detail. That's playing out with the trend that we're seeing with some of these companies. 

Sharma: Exactly. Starbucks is using precisely the same strategies that Nike uses. They're educating the customer, they're giving the customer a sense of product design. In doing that, they're trying to increase that lifetime value. Now, fellow coffee snobs, I know that in your cities, you're going to local coffee shops and hanging out drinking great coffee. But how many times have you been in transit and stopped at a Starbucks? For some of us, we might as well go for the Clover option if they have it, because it's closer to what we're used to having. And Starbucks is well aware of this. They know that not everyone is going to be a Starbucks loyal customer for life. But as they moved us all up this chain of premiumization, that is customers who, years ago, were drinking that McDonald's cup, and now come in and ask for all sorts of variation on their coffees, as you were talking about, Vince, that increases their profit. 

And I would like to take just a second to say something about both Nike and Starbucks, which is important to know if you're an investor. Each of these companies, for a large global conglomerate, has an incredible growth rate. I think Starbucks has been growing at a compounded annual revenue growth rate of about 11% over the last several years. Nike's most recent quarter, they grew total revenues 8%. This is very difficult to do when you're in the billions and billions of dollars of revenue.

How does customization play into this? We talked today about that incremental profit that both companies make when you start to customize your order. That's the first go-around. Customization, initially, is incremental. But as time goes on, it becomes part of the company's recurring revenue base. So, when Vince finally gets won over to highbrow coffee drinking, and comes in every day and orders that same premium cup of coffee, they've turned that first time incremental experience into their revenue base. That's how these companies manage to grow revenues even as they scale up, again, into the billions of dollars.

Shen: Thanks, Asit. Moving on, because we're running out of time, I want to cover two more topics. One is our last example. Hopefully, we can quickly go through it. This is a really good example. The company is Etsy. It's smaller than the other two companies we've focused on so far, but I think they're a perfect example in terms of how customized or personalized products are becoming so popular. Etsy, if you're not familiar with it, is an online marketplace for handmade craft artisan goods. The company went public in April of 2015. That first day of trading was, arguably, its best day. The price, from $16 per share, jumped up to $30 in the first day of trading. With some new competition, which we'll talk about quickly, the stock has already had a mini boom-bust period in the ensuing year and a half. It's currently trading back around $15, but it topped out at $30, was at some point as low as $6 to $7 per share earlier in 2016.

The company has 1.7 million active sellers, 26.1 million active buyers, by far the biggest platform of its kind for handmade crafted goods. What do you think about the company, Asit?

Sharma: I think the company is an interesting long-term buy. Everyone had concerns about Etsy post-IPO, because it had such a high marketing spend relative to its sales. Folks were worried about Amazon.com's handmade marketplace coming into competition with Etsy. Also, there was a concern that, is there really a market for this long-term? The craft and artisan movement, is that a fleeting fad?

I think what Etsy has shown us recently with its results is that, No. 1 they are able to control their spend. They're moving their marketing spend more to a digital-based marketing. So, we're starting to see a little bit better pop in gross margins and in the bottom line. Also, Amazon.com, for all its might, doesn't seem to have impacted Etsy's business so far. I'll put that back to you in just a second, Vince. Thirdly, the company is growing its global sales at a great clip. This last quarter, they grew international sales by 57%. This indicates that they can continue to expand globally. If you look at Europe, Asia, and Africa, where some of their business is starting to spread, there is a lot of demand for the same kind of artisan materials and customized materials that we're enjoying here in the United States.

Shen: Yeah, absolutely. On the Amazon Handmade side, for a company that's obviously proving themselves to be very strong in this e-commerce space, this model, they too are expanding abroad. I think, initially, they were in just a handful of European countries. Now, they're spreading across the entire continent. Amazon Handmade is still a much smaller platform, though. They are at the point where they might have about, the last number I found was 500,000 product listings, whereas with Etsy, it's a much bigger number, in the millions. When you take all of that into account, I think, overall, this trend is the kind of situation where the tide lifts all the ships.

Obviously, Amazon is not a competitor I would ever underestimate in this space, and Etsy should be aware of what the company is doing and how it might impact their business. But, overall, this trend is something that will continue to grow, and as Etsy finds its footing, can decrease marketing, for example, as a percentage of its revenue. They have ... 81% of the gross merchandise sales in 2015 came from repeat purchases. Shoppers are obviously building some of that loyalty that you mentioned, Asit. And they like what they see. I personally think that Etsy is really attractive marketplace. My experiences shopping there have been very positive. Amazon is definitely very familiar, but there's something about Etsy, there's just something special about the way it's crafted. The way it started was for these handmade customized goods, whereas Amazon, it was the more traditional retail items.

Sharma: I agree. Etsy has that cache of offering the handmade artisan goods. You almost want to look there first. Just to sum up on Etsy, they have the first-mover advantage, which seems like they're retaining. This year, they raised fiscal guidance for revenues, profit. It may be a bumpy ride, so we're not obviously advising people to jump into this stock. But definitely keep an eye on it. It seems like they're holding their ground so far, and there is a market, as we discussed this entire episode, for custom goods. And Etsy is in the right place at the right time.

Shen: Our last example, we flip to the other side of the coin. We had three companies that have, at varying levels, really turned their attention to customization, or increased choices for the consumers, and the draw it can have with shoppers in terms of building your business, growing your business. On the other side of the coin is, our example, what can happen if you fail to see that consumers want options.

Sharma: Aeropostale is a name that's familiar to many of us who wandered into shopping malls, and parents who have teenage kids. It used to be a wonderful brand, a leading brand, very into these big Aeropostale logos on their sweatshirts, etc. Well, for the last several years, teenagers, preteens, those moving into college, have moved away from logos because of this whole sea changer shift away from mass goods into custom goods. So, if you think about walking into a store, maybe you can't get something customized as you wait, but you certainly don't want a huge logo splashed on the clothing. And that's a trend that's been apparent to a lot of folks who watch the fashion industry.

But Aeropostale was in denial. As other companies were shrinking their logos, or making them disappear altogether, Aeropostale continued to splash that big logo on their displays. The net result is the company declared bankruptcy in May of this year, and now they're undergoing a rescue package. Some of the rescuers are the actual malls that are on the hook for the Aeropostale leases. 

So, this is a cautionary tale. We call this a supertrend, because it goes across industries -- the customization supertrend. If you ignore it, it's actually to your peril. For those of you who are interested, there's an excellent article in Bloomberg yesterday about this. It's Rebel Teens Are Killing America's Clothing Giants.

Shen: I think, in this example, the fact that they didn't see that changing preference in terms of logos, definitely, the company, and maybe even 10 years ago, when I think back to my time in high school and going into college, 10 to 15 years ago, their competitors -- think American Eagle Outfitters, Abercrombie & Fitch -- they all followed that. The clothes looked very similar. Now, if you think about the fast-fashion houses that have become more successful, it's less of a logo, but different pieces so that people -- coming back to the customization idea -- can build the outfit to look like they want. There's more of that individuality with how people want their fashion to look.

Asit, I know you mentioned that second, very inexpensive customization route to that Starbucks has taken. I wanted to let you touch on that at the end, and we can discuss that before we close out for the day.

Sharma: Sure. Listeners, when you walk into Starbucks, your barista writes your name on the cup. That's an almost costless way for Starbucks to offer customers customization. It's really personalization, but it's part of the same bucket. You may get tired of it after a while, but for masses of people, that's something that's looked forward to, when a regular walks in and sees their name on the cup, or gets greeted by name eventually. Starbucks has figured out that there are a number of ways to come at customization. It's not all about those expensive Clover machines, or the high-end roasteries that are opening up all over the world. It's also about the personal touches. You can customize almost for free if you put your mind to it.

Shen: Yeah, I thought that was a very interesting take. At first, when we were talking about this episode, I was a little bit skeptical. But when you presented it, something as simple as writing each person's name on the cup, and when the order comes up, how they shout out the person's order is ready, including that as part of the entire process, the experience of visiting a Starbucks store, I think that is, surprisingly, a relatively important piece of it, and it contributes overall to people and their loyalty that Starbucks has been enjoying with their coffee drinkers.

Sharma: It's simple, but it resonates.

Shen: Absolutely. That's all the time we have for today, but you can continue the conversation with us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send us any questions or comments via email at [email protected]. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!