In this episode of Industry Focus: Consumer Goods, analysts Nick Sciple and Abi Malin dive into the direct-to-consumer (DTC) market -- how it's evolved, why it's gained so much traction recently, and where it can go from here. Learn why DTC is so popular in niches like hygiene products, makeup, and mattresses; how big box companies like Target (NYSE:TGT) and Walmart (NYSE:WMT) are responding to the threat these tiny players pose; what the DTC trend means for consumer goods producers like Unilever (NYSE:UN) (NYSE:UL) and Procter & Gamble (NYSE:PG); what companies and trends investors should focus on to profit from the DTC movement; and much more.

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This video was recorded on Dec. 17, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Tuesday, December 17th, and we're discussing direct-to-consumer sales. I'm your host, Nick Sciple. Today I'm joined by Motley Fool analyst Abi Malin. Abi, what's up?

Abi Malin: Not much. How are you?

Sciple: I'm doing great. I think you've said this is your first time back on Industry Focus since you were an intern. How does it feel to be back?

Malin: It feels great. Feels very natural. Very stoked to be on.

Sciple: That's awesome. We're going to talk about direct-to-consumer sales today. With this being our last CG show of 2019, last show of the decade, I think this is an interesting trend to look at. We started out earlier in the 2010s, you think about Dollar Shave, Club Warby Parker, these companies that really emerged. But the story that really got me interested in talking about this today was, last month, beginning of November, we saw Shane Dawson and Jeffree Star, two major YouTube stars launch their Conspiracy makeup palette and they literally broke the internet when it launched. Abi, are you familiar with these two influencers and their products?

Malin: Yeah -- I mean, I followed this story a little bit. I think it's interesting to show the power of social media, the power of followers, the power of marketing, and the evolution of brand development these days.

Sciple: Yeah, how easy it is to connect with your consumer. Kylie Jenner, we heard about that earlier this year. It's just so easy to market when you have this YouTube channel and all these people that just love you, and you can create this content, sponsored content, almost, for yourself to create this brand.

First off, before we kind into this business of direct-to-consumer, let's define our terms. When we're talking about direct-to-consumer marketing or a direct-to-consumer product, what do we really mean there?

Malin: For our context, we're really talking about, direct-to-consumer companies are companies that manufacture and ship products directly to buyers. They remove that traditional store or middleman operation there. Think, for example, you could order directly from Hershey's website, or you could buy it in a grocery store. The direct-to-consumer channel would be the website.

Sciple: Right. You've seen more and more companies developing that as their key strategy. You think about Lululemon, you really have to go to a Lululemon store to get that product. Really changed how retail has been operated.

Do we have any facts or figures about how big this market is, and how it's developed over the past decade or so?

Malin: Yeah. According to the U.S. Census Bureau, e-commerce sales in this most previous quarter of 2019 increased about 16.9% over last year and accounted for about 11.2% of all sales. And then, within that e-commerce is really that direct-to-consumer portion. The estimate that I saw was about 40% of all U.S. manufacturers have a direct-to-consumer channel. So, a growing portion within the growing part of retail.

Sciple: Right, and it's the portion of retail that is really experiencing growth, while we hear terms like the retail apocalypse, those sorts of things thrown around Macy's, these big department store chains --

Malin: JC Penney.

Sciple: That's another one. We may talk about that a little bit later. Nike has been one example of a company that's had huge success in this direct-to-consumer channel. You can look at 2010, $2.5 billion in revenue in that channel. This year, they expect to be over $12 billion. So you're looking at, what's that, close to a 6X over the course of a decade, really squeezing out that middleman. And, as e-commerce has grown, direct-to-consumer marketing has really grown. I saw, in 2019, DTC ad spend was up 50% year over year. So, this trend is really starting to grow significantly.

I guess I want to talk about, why is this happening? There's been demographic trends that have shifted. Obviously, social media. But, what do you think has really driven the growth in this channel?

Malin: I think it's a variety of factors. But historically, if you look at American culture, for economic reasons, for societal reasons, for cultural reasons, we've always been a retail consumerist culture. In 2018, the U.S. had about 23.5 square feet of retail space per capita. Comparatively, Canada was the second largest at 16.8, Australia at 11.2, the U.K. was at 4.6. We've always had a plethora of retail space.

But I think the tides are changing now. We're expecting about 12,000 retail locations to close in 2019. The problem with traditional retail is that you had a lot of producers fighting over prime shelf space. It was either, you are on the prime shelf or you are really not bought. That was always a struggle. And I think, as people have shifted more to buying online, it's easier to target customers online. So, those ads are a lot more effective, they're a lot cheaper to place, so you're able to drive sales a lot more efficiently. So, rather than using these traditional retail stores, where people used to go in and browse and buy via foot traffic, you have people searching directly for exactly what they want. So, when someone searches Nike sneaker, blah, blah, blah, it's a lot easier for Nike to immediately serve that ad themselves rather than relying on, say, an Amazon or a Nordstrom or someone else to place that product in front of them.

I think it's just been a shift as people continue to shop more online and continue to go for convenience over a physical location.

Sciple: Yeah. You mentioned Nike and Amazon. I think that's an apt example now, because earlier this year, we saw Nike announced that they're going to remove their products from Amazon to try to control their own brand in a more significant way. You can almost look at online retail as, this first decade or so has been a few big players aggregating the brands. Amazon, eBay, and those. And today, we're seeing that kind of dis-aggregate, with Nike and others controlling their brand, direct-to-consumer.

How much do you think our generation's -- 20s, early 30s -- consumption habits is maybe driving this change? Concern about more conscious consumerism, those sorts of things, do you think that's been an important trend for DTC?

Malin: I think one of the things that's really pushing this direction is, you've had a plethora of venture capital. Having a big scale works when you're trying to launch a lot of products in a cost-effective way. We've seen the pendulum swing to the other side with lots of venture capital. It's given a lot of companies the ability to really focus on niche markets and be, maybe, a little bit less effective in scale and more effective within a small segment. So, yeah, I think the pendulum is shifting. I don't know that it will stay this way forever. And interestingly enough, you've seen a lot of these direct-to-consumer brands, I would almost call it like a second wave. Previously, you had Allbirds, which was only online. Now they have these smaller pop-up shops, or even a couple of physical locations. I know Warby Parker is very similar. You're seeing a push, again, into the physical retail from direct-to-consumer. I think a lot of that is fueled by venture capital and consumer habits.

Sciple: Yeah, I guess once you get that physical location -- Apple is probably the first example of that, of a company that really controlled its brand, went into physical retail, and the opportunities it's created for them, everybody jokes about the line at the Apple store to get my phone fixed. It's because your product has really become that popular, you have a presence in all these towns. That's really starting to happen for these DTC brands.

To your point about the niches that these brands play in, a lot of brands -- we've seen cosmetics, obviously, beauty, Jessica Alba's Honest Company in the cleaning space, razors, Harry's and Dollar Shave Club. Why do you think these particular niches have seen success early in the direct-to-consumer commerce space? What is special about those, that they've had success?

Malin: I think you're looking at industries that have historically not met consumer expectations. One of the biggest examples of direct-to-consumer businesses are those mattress companies. Just offhand, you can think of Purple, Casper, Helix, Leesa. I know there's a million others. Buying a mattress has historically been, A, a very unattractive business to be in. You have to keep a lot of warehouses to store a lot of large items. People make this purchase once every 10 or 20 years. You don't typically see repeat customers. As a consumer, there's a lot of options. They're not ubiquitous across stores. There's no real brand name. So, you've had a lot of challenges. So, I think, places where you've seen consumer dissatisfaction is where you've seen these niches be able to really come in and solve it in a way that would have previously been unaffordable at the scale that they're doing. So, mattresses is a good example of that one.

You mentioned personal care, so, Harry's, Dollar Shave Club, Flamingo, Billy!, Honest Company, Glossier. A lot of that has to do with transparency and pushing for more clarity around honest ingredients, that wellness trend of people caring a little bit more. And you get a lot more clarity from an individual brand than you would, say, at a Target

So, I think it's general consumer dissatisfaction in these stagnant industries where you've seen a lot of the disruption.

Sciple: Yeah, I think one common trend you see among all of those products is that the utility is very simple. The utility of a bed, it's just a cushion that I lay down on. The utility of a razor, it has to be sharp and cut the hair like I need. Even if you look at makeup. The pigmentation and those sorts of things are important, but there's not a huge difference when you really lay the products down next to each other, and the substances that go into them. So, when you have the razor and blade model, traditionally something that was very favorable to business and unfavorable to the consumer, there's an opportunity to build a brand, and you have a value proposition that's very easy to communicate to the consumer.

One other trend on DTC retail, as we've seen more pushes from companies to go direct-to-consumer, there's been a response by retailers themselves pushing into more private label, going direct-to-consumer with their own consumption. A 2019 PLMA survey found that two-thirds of respondents agreed that the store brands they have bought are just as good or not better than the national versions of those same brands. More than 40% said they buy store brands frequently or always. 25% more are buying more store brands than they did five years ago. I think that goes to the same trend that I mentioned, these core utilities of these brands are pretty easy to communicate. And then, that price utility.

How do you think private label interacts with direct-to-consumer, and consumer habits, and how retail is changing going forward?

Malin: I always consider the private label to be maybe the standard, I would say. Maybe your benchmark is that. So, to be an effective direct-to-consumer company, you need to compete somehow effectively. You either need to have a better product, or it needs to be cheaper. Likely, it's probably not going to be cheaper just because of the economics of those businesses. So, you really have to be a little bit better, and better can just be more appealing advertising. You have this fanbase where people just weirdly very much like you. I think Harry's is a perfect example of that. People who use that love that. But fundamentally, it's just a razor, right?

If I were a consumer goods company at this point, I would be very nervous about these direct-to-consumer companies that are continuing to upset what you had previously taken as given revenue.

Sciple: The companies that come to mind immediately there are Unilever, Procter & Gamble. Described earlier how traditionally, retail was all about your ability to dominate shelf space, who can be at eye level? How can I get in the most number of stores possible? When the store is really, do I have internet access, shelf space becomes less and less relevant.

Malin: And price becomes harder. Online, all prices are right at your fingertips. You're not necessarily having the struggle of having to visit multiple stores to compare prices. So, either you need to have something that people are willing to pay extra for, or you need to be the cheapest.

Sciple: Right, yeah. The ability to compare prices is tougher because you don't see the two brands right next to each other. Mindshare becomes so important. If I think I need to get a mattress and I think Casper, and I see the Casper mattress right there, I don't see that the Purple mattress is $50 cheaper. So, I think creates difficulties in the sense of, it's hard to charge a premium price; but once you develop your brand, some people may trust you so much that you can command that premium in and of itself.

I do think it's tough. I would not want to be running Procter & Gamble or Unilever today. It's just a very difficult environment to be going into. Your retail partners that are really key to your business are pushing into private label, which is taking share from you. And then, on the more conscious consumerism branded side, the DTC folks are chipping away at your business. So it's really tough for growth.

Here's a question I have, too, on DTC. It makes me think a little bit about craft beer. Once these craft beers get too big, they're not cool anymore. Do you think that same aspect may come true in DTC a little bit? That as these brands get big enough, that cachet of, "It's this under-the-radar brand" goes away? Do you think that success can almost hurt these companies?

Malin: I think it's a good question. You have to look at why people are going to them. If it's a push for transparency, like in cosmetics, I would think the ceiling is higher than something where ... I can't think of a great example offhand. But something where, maybe it's just about the new trendy thing, or like the new function. I think there is a habit to be formed, particularly with makeup. As someone who wears makeup every day, I would say it's very painful to try and change that. You have to get used to things and whatever. So there is a barrier, which actually is even worse for these stagnant Unilevers and Johnson & Johnsons. That's painful. When people break habit to try something new fundamentally, your product is horribly flawed. There has to be something terrible.

Sciple: Right. Yeah. [laughs] Who switches detergent, right? I use Gain because my parents used Gain. I don't know why I reach for that one, but it's the one that's familiar to me.

The last thing I want to talk about when it comes to DTC. We talked about folks like Warby Parker, and folks that are forming their own retail. We haven't talked about or touched on, some DTC companies are forming relationships with more traditional retail partners to move to market. The example that comes to mind for me is Kylie Jenner making the deal with Ulta to get into stores. What are the advantages of that for a DTC company? How do you see those playing out over time, those relationships?

Malin: The advantages, obviously, as a direct-to-consumer company, if you are entering one of these stores, you're getting scale immediately. There are probably lots of people who were unaware of Kylie Jenner's makeup brand before it was in Ulta. Now they're browsing by it, they see it, they're intrigued, they try it, etc, etc. For Ulta, they get to attract all of Kylie's fanbase who wants to come get these new products. It's kind of a win-win for both, I would say.

The other thing that I think, as a direct-to-consumer brand, when you enter an existing retail channel, I think the name of the game is always going to be credibility. Once you've entered one of those channels, it's a vetting process. You automatically get a little bit more credibility by being aligned with an Ulta or a Target or enter-your-big-box-name-here. I think direct-to-consumer was made possible, really, by these ubiquitous, secure payment platforms -- PayPal or Stripe. Entering a physical space gives an increased level of credibility.

So, I think it's a win-win to some degree for both.

Sciple: Right. I think, you look at Target -- once I started seeing Harry's right next to Gillette, that really cemented that this brand is real. It's not just one that I see on the commercials anymore. There's pros and cons there. I mentioned earlier, being able to see a product right next to its competitor can give you a price signal that you might not get otherwise. But it's a trend that I think we'll see continue to develop, particularly for these brands that -- it's difficult if you're Kylie Jenner to have one store that's just your makeup brand. But you can easily push into Ulta or that sort of thing.

Alright, the last thing I want to talk about is, for investors that are interested in this direct-to-consumer trend, have seen it developing over time, becoming more and more significant, part of our purchasing habits, what do you think are the ways that you'd be most excited to invest in the direct-to-consumer trend?

Malin: I think maybe the most insulated would be the advertisers. Regardless of whatever platform people are using, those ads have to be placed in front of the right people. Your big advertisers, obviously, are Google, The Trade Desk, Facebook, even Pinterest I would put in that category. People who really help serve ads to the right clients would be my first choice of investing in this trend.

Sciple: Yeah, I agree with that completely. The example that I think about about direct-to-consumer and these platforms that just blows my mind at what's capable of being accomplished with them -- and it's a negative example, but I think it's one that a lot of people will be familiar with -- is the Fyre Festival. You built this brand that nobody had ever heard of by a coordinated series of Instagram posts, which built up this massive amount of hype, which ended up being multiple documentaries about it. But it just shows the power of these brands.

When you look at a company like Shopify, how does that fit into the direct-to-consumer trend? I think they had 12% of Black Friday revenue. How big is the opportunity for a company like that in this space?

Malin: I would say huge. Shopify can power a lot of small businesses. It gives a lot of assistance in terms of back-end business management tools to a lot of small merchants. Shopify, I would even say Amazon, Etsy I would put in that category. Any platform that helps with logistics is going to help direct-to-consumer brands.

Sciple: OK, going away, Abi, do you have any direct-to-consumer brands that you use that you would recommend to our listeners?

Malin: Good question. I've shopped on Revolve before. They are recent IPO. The reason I would consider them direct-to-consumer, not only are they just an e-commerce website, but they design clothing based on Instagram trends. Very much using data to design. It's a really interesting business. And as a consumer, I use it all the time.

Sciple: Cool. I think the one for me that I think is interesting -- I don't know if it's necessarily direct-to-consumer. Would you call Poshmark direct-to-consumer?

Malin: Yeah, as a platform company. Yeah.

Sciple: So, Poshmark is in the resale industry. It's basically a giant online garage store, where you can sell your -- I think they describe them as your closet -- your used clothes, you can sell online. I think the resale industry is going to be massive going forward. We talk about how there's concerns among millennials about sustainable consumption. When you're using resale, that's one way to avoid that. Some estimates say that the industry could be as big as $64 billion a year by 2028. I think that's an interesting one. I don't know if it will come public. I think they pushed back their IPO date. But that will be one that I'll be interested to see the numbers on.

Malin: Yeah. I think we're seeing a lot of activity within the market in that space. We had The RealReal go public recently. Poshmark was slated for the end of 2019, has been pushed to 2020 at some point. Lots of players there. Super interesting space.

Sciple: Abi, thank you for coming on Industry Focus! I hope we can get you on again more often than the last time you've been on.

Malin: Hope to see you before the next five years.

Sciple: Exactly, exactly. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stock discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Abi Malin, I'm Nick Sciple, thanks for listening and Fool on!