Profit margins and growth plateaus

Gilt Groupe is a private shopping site that offers steep discounts on specific fashion items for a limited amount of time. For example, you may find a 70% discount on a Lacoste shirt that’s valid for the next 2 days. Such sites give brands a great way to liquidate large amounts of unsold inventory through alternative channels that don’t compromise the positioning of their own full-price channel.

Gilt Groupe was founded in 2007 and successfully grew to an over $1.1 billion valuation in 2011. However, it is currently rumored to be on the verge of a sale to Hudson’s Bay, the owner of Saks Fifth Avenue, for $250M. Gilt Groupe is said to have had $600M of revenue in 2014, and $125M of revenue in Q3 2015. The latter is $500M annualized. So a sale for $250M implies a 0.4X – 0.5X revenue multiple. This is a pretty low multiple even for an e-commerce company, so what’s the reason?

I don’t know Gilt Groupe’s detailed financials, so these are only hypotheses. But I think that the low multiple is a result of a combination of low product margins and the company hitting a growth plateau.

Let’s take the low product margins first. Gilt Groupe’s deeply discounted sales model makes it structurally difficult for the company to achieve healthy product margins. Let’s be aggressive and say that a brand achieves 90% product margins in full-priced sales through its own channels. If the same product is sold for 70% off on Gilt, this leaves a 20% margin for Gilt even if the brand offers its products to Gilt at cost.

We’re investors in many e-commerce businesses and a good rule of thumb is that you need at least 30% product margins as a startup to be able to build a strong vertical e-commerce business. These let you reach 40%+ product margins at scale, which imply 30%+ gross margins (after variable warehousing, packaging, shipping, and payment costs are deducted) and the ability to produce a variable profit sufficient to cover your fixed cost base. Gilt is unlikely to have such metrics.

In the absence of healthy product margins due to the structure of its discount-driven business model, Gilt was still able to reach a $1.1 billion valuation in 2011 due to its past growth and promise of future growth. Investors believed that the company’s product margins would improve as it scaled, and they likely did, but not enough to produce 30%+ gross margins when growth plateaued.

You can only sell a growth story for so long. Growth eventually plateaus in all businesses. And when this occurs, you’re left with the fundamentals of the business. It’s therefore important to have a view on the scale at which you believe a business’ growth will plateau, and how much, if any, profit the company’s business model will allow it to produce at that scale.