The Hidden Death Spiral in eCommerce

In this podcast episode, Nathan discusses the prevalent issue of the 'death spiral' that many e-commerce brands are facing in 2024. He explains how rising customer acquisition costs, coupled with a reliance on returning customers, can mask underlying financial problems. The conversation delves into the importance of cohort analysis, understanding customer acquisition costs, and the impact of attrition on revenue. Nathan emphasises the need for brands to track key metrics to identify potential declines in profitability and offers strategies for recovery and sustainability.

Takeaways

- Customer acquisition costs are rising, impacting profitability.
- Returning customer revenue can mask declining first-time sales.
- Cohort analysis helps visualise customer acquisition trends.
- Brands often misinterpret returning customer rates as growth.
- Attrition affects long-term revenue from returning customers.
- Tracking profit on first purchase is essential for sustainability.
- Downsizing operating expenses may be necessary during downturns.
- Understanding blended CAC is crucial for financial health.
- E-commerce brands must adapt to changing customer behaviours.
- Proactive tracking can prevent falling into a death spiral.

Chapters

00:00 The Death Spiral of E-commerce Brands
02:56 Understanding Customer Acquisition Costs
06:09 Cohort Analysis and Its Importance
08:57 The Role of Returning Customers
11:55 Identifying the Hidden Issues
14:56 The Impact of Attrition on Revenue
18:11 Tracking and Preventing the Death Spiral
20:59 Strategies for Recovery
23:55 Conclusion and Call to Action

Transcript

0:01

Welcome back to the podcast. In this episode, I'll be running through the death spiral of ecommerce brands in 2024. It's been a few weeks since we put the last podcast out. And the reason for that is that we want to make these pieces of content as value dense as possible as well as relevant to the times. And I think that this episode is really going to encapsulate that and run through what's seen as a relatively complex topic, but we're going to simplify it down and explain why a lot of ecommerce brands are struggling at the moment of let's say the last 10 to 20 brands that we've taken on about half of them have had this exact issue, which is why I'm making this piece of content so that I can also just refer to it for anyone in future that on boards. But in addition to that, brands that I have audited and helped out over the course of the last few months, almost 100 % of them have had this issue as long as they were doing more than let's call it $50,000 a month in revenue. And so this is a prevalent issue at the moment across majority of brands and they don't see it. it's hidden. And the reason it's hidden, we'll explain in a second once we go into the mechanics of the finances of customer acquisition and then how it starts to present itself within the P &L. And so what am I actually talking about? What is the death spiral of e-commerce brands in 2024? To simplify it down before we start to go into the nuances and the math and explain how you can identify this within your own brand as well. The simplistic explanation is customer acquisition is becoming more expensive and or declining. And so the amount of customers that you acquired last month is not the same as the amount of customers you acquired 12 months ago. However, it's not becoming prevalent within your overall revenue or within your profit and loss statement because it's been propped up by returning customers. And so you have a lot of repeat purchasing, is occurring, which is allowing the P and L to look strong, which is allowing the business to look strong from a revenue perspective. Even from a M.E.R. things look good. But in reality, the brand is on its way to a slow death because customer acquisition has declined by 30%, 40%, 50%, which means that returning customer revenue as well will decline by 30%, 40%, 50 % in three to six months. And so normally where I'm catching these businesses is either right here on the stage where they think things are going well, but Once you start to look deeper in the numbers, you know that they're on their way to a death spiral or I'm catching a lot of businesses that are on their death spiral and they're going, I don't know what's going on. We were doing so well two months ago and now revenue's falling. We're unprofitable. We don't know what's happening. And all you have to do is look at their customer acquisition in the last few months, calculate a blended CAC based on how much ad spend and new customers they acquired. And you can see that they're building up cohorts that are not paying back CAC and that will never repay back. And so they're just pushing losses into the P &L, but it's masked under all of this returning customer revenue. So let me now go into a little bit more nuance as to what this actually looks like when we pull it out onto an Excel sheet and we start looking at the analysis and then also why it is hidden. You can break up paid media, you can break up customer acquisition into cohorts. And you see this within a cohort analysis, which I think people are becoming a lot more familiar with since Shopify made it an available feature within analytics, as well as a lot of third party tooling now always implements a cohort analysis. A cohort analysis is a really important way to be able to visualize and understand customer acquisition within an e-commerce brand. And the reason for that is because it breaks up customer acquisition into individual units. Instead of just looking at the year and going, how was the year? Let's look at blended figures. We want to ideally break everything down as much as possible into incremental units. That applies to ad spend as well, right? Having a blended target acquisition or a blended target return on ad spend is a terrible idea because what that ends up doing is you end up overspending because the top level of spend is just unprofitably layering on an unprofitable ROI. but it blends out and makes sense when you look at an average. So a lot of brands will do the math, for example, and they'll go, we're profitable at a four acquisition or a four MER. But then when you look and you break it up into increments, you'll actually discover that, yes, okay, the first thousand dollars of spend is at a 10, but the next thousand dollars of spend is at an eight, and then a six, and then a four, and then a three, and then a two, and then a one, and then a 0.5. but the 0.5 return up the top here, which is not profitable for any business ever. It doesn't matter because it averages out to the full. So they don't notice how unprofitable the top end of spend is until you break it into increments. The same thing occurs with acquiring customers over time. If you're acquiring customers over, let's say a year and you have a certain amount of spend to do so. You might hit your blended CAC targets. Let's say that you want to acquire customers for $30, $40, and then you just look over the course of the year and you hit that target all well and good. But it might've been the case, and it is the case for almost majority of brands at the moment, that their blended CAC, their cost to acquire a customer was significantly better last year. In fact, I can almost guarantee it was even better in 2022. The cost to acquire a customer is going up across paid channels. And that doesn't present itself until you look at the last few months. And so if you break this out and you look at months and then you have blended cap, and then more importantly, you always need a pairing metric here as the obvious question that people are gonna ask will be, well, what is a good blended cap? And the answer is $1,000 is a good blended cap.$10 is a good blended cap. It's subjective based on the pairing metric, which is profitability on first purchase or profitability within the first 30 days of that. customer being acquired, how much gross profit are we driving? If we drive a million dollars in gross profit, well, we can be happy paying half a million dollars to acquire a customer. But if we're only driving $10 in gross profit, well, we need to have a very low blended cap, and it needs to be just a few dollars. So we can look at blended cap, we can look at a profit on first purchase, and we can start to identify, are we even profitable on first purchase? Just by minusing those two numbers. And what you end up finding for majority of brands at the moment is that they've started to bleed into not being profitable on first purchase and not repaying back their CAC, but they don't notice. And the reason why they don't notice is because they might be holding their marketing agency to a bunch of KPIs that don't look at these incremental units. And the agency doesn't have the technical expertise to be able to even identify this. And so for example, they might say that, look, we are targeting a five return on ad spend. And we might be hitting a five return on ad spend in the platforms. But Google is just heavily over-attributing brand search. And Facebook is heavily over-attributing view through conversions from existing customers who are repeat purchasing. And so the platforms look good when in reality they aren't driving profitable customer acquisition. Now you might go, well, no, we're an e-commerce brand that doesn't look at ROAS. We're beyond that. We look at MER. OK, but MER still takes into consideration returning customer revenue. It doesn't delineate down to just new customer revenue. And so you'll have almost the exact same issue. there's no, it's no better looking at MER on a brand with high returning customer rate than just looking at ROAS. You're going to get the same issues, which is that the returning customer revenue will make things look good. When the paid media spends job isn't to drive returning customer revenue, it's to drive new customer revenue. And so maybe you're brand and you go, I already knew that. I delineate down to acquisition. Okay, now you are in a much better position as particularly if you know what your acquisition mode break even is. What you then need to be able to identify is that if you're operating at under break even, what hack payback period are you happy with? And I had a conversation with a brand the other day and we were trying to come to this understanding of a core KPI to hold ourselves to. because they have this exact issue, which is for two years, they were running profitable on first purchase. And then about six months ago, they got some funding, some things happened and they cranked up ad spend. And they cranked up ad spend with the idea to crank up customer acquisition, crank up revenue and grow as a business. And that is what occurred. They cranked up ad spend by about $20,000 a month and revenue went up by about $20,000 a month. And they saw that as a win. Not because like they understood that that's not profitable. One ROI on that spend is not good. But they know that a lot of people repeat buy. And in fact, they looked at the back end metric in Shopify of returning customer rate, and they saw it's about 70%. And so they went, well, 70 % of these people are going to buy again, which is going to push us into profitability. And then some people will buy again after that. And so we'll make money. And so this is a profitable exchange. something that we should invest in. The issue is number one, that returning customer rate number on Shopify does not mean what you think it means. It doesn't mean the rate in which people repeat buy. That is the proportion of revenue right now in which people repeat buy. So that math was incorrect. But on top of that, the actual CAC went up by two X and it went up to a point in which they never in the entire lifetime of a customer backdating 36 months of LTV, they never generate enough profit. to cover that hundred dollar CAC. And so yes, theoretically you can go, let's crank up spend and acquire customers at the low break even, and then we can pay back. But you need to pay back at some point. And you need to know the math on what the payback is. I would not recommend anyone runs at a CAC payback period longer than 60 to 90 days. Because the longer you push that CAC payback period out, the larger degree of risk you start associating with the acquisition strategy. Because you're banking on the fact that your returning customer revenue or retention lift rate is going to hold as you scale cohort size, which is a huge assumption to make, particularly because as you acquire more and more customers, you're arguably going to colder and colder audiences who were not your initial target demographic, who were early adopters on the product. And so you would think that returning customer rates would actually decline as you achieve scale, which is typically what occurs. And so you start to build inherent amount of risk into cashflow and the acquisition strategy as a whole, as you start to delay that CAC payback period. And so with this brand, we looked at the 60 day average gross profit mark of a new customer being acquired. And we selected that as our blended CAC target, readjusted campaigns accordingly, pulled budgets down where we needed to. And now we're re-orientated towards a 60 day LTV to CAC. ratio that actually makes sense and that is above one. Now, why doesn't this present itself in the P &L? Why don't agencies identify this and why don't brand owners identify this issue? The reason why is because returning customer revenue drives more profit than first time customer revenue. And the reason for that is first time customer revenue has a hack associated with it. When you get a new customer to buy, you have to pay to get that customer in some fashion, unless you have a free distribution channel, like you're an influencer or something, that's really the only way you get around having a cat. And so when you have a CAC associated, your profit is quite low. And that's why new e-commerce brands are generally not very profitable at all, because they have to pay for every customer. And there's only so much profit on that purchase. And so it's really just this arbitrage scenario where you have a profit on first purchase and then you need to drive this CAC down. And as long as you can keep it below this, you make a little bit of money. But where brands start to really open up their margin and turn it to 20, 30 %... EBITDA e-commerce brands is that they start getting repeat purchasing and the repeat purchasing has no real cack associated with it. Yes, there's a, a tiny cost with, email and direct channels that are going to cause some lift there and help out, but you're going to get returning customers regardless and they're going to be 100 % gross profit flows straight into contribution dollars, which puts you in a substantially better ratio for being profitable. And so you can actually do this exercise, which is you can look at your last month P &L, and then you can split it into first time and returning customers. And you can look at how much money you made on the first time customer P &L with all your direct marketing and advertising associated. And you can look at your returning customer P &L, which should have almost no direct advertising and marketing associated. And you'll often find that you're actually making more profit every month on returning customers than you are on first time. Now people often go and they misconstrue that. very heavily and they go, well, we need to put all our effort on returning customers. And it's no, because the returning customers only happen because the first time customers are acquired. Now, why I'm going into this is because when you start to have a decline in first time customers, you will often have an increase as a proportion of returning customers. And so you end up getting more profit being generated within the P and L from returning customer revenue, which ends up covering the losses that are occurring in the acquisition strategy. And so the profitability of the business remains the same. And that is the fundamental crux. And I do apologize that it took 14 minutes to get there, but that is the reason why people don't figure this out. That's the reason why this goes undetected is because you look at the month on month P and L. and you make $10,000 in Jan, you make $10,000 in Feb, you go into a year later, you're making $10,000 in Jan, you're making $10,000 in Feb. So a regular accountant or bookkeeper or a financial operator that even somewhat knows how these things operate, they look at the P &L and they go, the business now is the same as the business last year. And honestly, I don't know if I'm allowed to say this, but I've seen some businesses be sold recently that have been... acquired outside of BlueSense, clients is in some consulting internationally. And I have seen it to be the case where a client is going through this death spiral, where they're returning customer revenues going up, their first time customer revenues going down, their acquisition strategy is failing. And they've done an exit. And they've done an exit based on profits. Based on the fact that profits this year were the same as profits last year. But the business is not in the same position. The business now should be worth about half of what it was worth last year because now acquisition is unprofitable. They're not actually able to get any new customers and make money on those customers ever. The CAC never gets repaid. Whereas last year they were. They were acquiring customers profitably and then not only profitably on first purchase, but these people come back and buy again. And so what the acquirer of this business doesn't realize, but they will realize pretty soon, is that The returning customer revenue that's propping up the profit and making the business look like everything's all normal, it comes down to clients. The one fact of returning customer revenue is that it will follow first time customer revenue. but with about a six to 12 month time delay. And so if your first time customers start to decline today, that's fine. Like your P &L will look fine. You'll be able to cope with it for three to six months, maybe even 12 months. But in about three, six, 12 months time, how cohorts work is that people do not repeat purchase forever. There was an attrition period on a customer, meaning that when a customer is acquired now, let's say all the customers you acquired this month, There was only a certain amount of time in which these customers will repeat purchase from your business before they go through the attrition period and they just never buy from you again. Yeah, okay. There might be a couple of customers that are super loyal and they're continuing to buy from you in two to three years, but most people don't. Most people buy from a brand. They buy a few times over one to two years. And then eventually they attrition out and they either hop to a competitor or they hop to some other alternative or solution to that particular problem. And so because of that attrition period, these customers that you're acquiring now will eventually catch up in their retention uplift and you'll see returning customer revenue decline. And when the returning customer revenue declines, you go into this squeeze period. The second that starts declining, your $10,000 in profit gets eaten immediately and you go into this squeeze where you really start freaking out because you're going, suddenly we've gone from $10,000 a month to $0 in profit. I don't know why. our ROAS is the same, our allocation towards marketing is the same. But for some reason, revenue is going down. And the reason why revenue is going down is because 12 months ago, your first time customer revenue started to decline, you didn't notice it. And then it's only until six to 12 months later that all those customers that you acquired 12 months ago are now repeat purchasing, but there's much less of them. And so you're getting much less returning customer revenue. And this is what's causing this falling knife in overarching revenue and particularly profit. Because you went and acquired all these customers in the last 12 months, but you did it unprofitably. And not just unprofitably where, okay, these people will pay them back eventually, they'll never pay themselves back. You were just driving losses, but you were able to sustain those losses because of what you did two to three years ago. But now it's all over. And so the question becomes, How do you track this? How do you prevent it? And what can you do about it? How you track it is number one, you need to know what your profit on first purchase is monthly. So every single month you need to know your average order value. You need to be able to deduct all your costs off that average order value. Very accurately, you need to have really accurate assumptions on shipping and fulfillment particularly, because that changes these numbers a lot. And then you need to track that gross profit per order. on a monthly basis. From there, you need to track blended CAC as well. You need to know what your cost to acquire a customer is every month. Now you can technically track acquisition more, and I actually like acquisition more, but the reason why you need to track blended CAC is because blended CAC allows you to calculate a CAC payback period. You can't calculate an acquisition payback period. Well, actually you technically can, but it's a little bit harder in terms of the math as to how you would approach that in a Google Sheet. So I just find blended CAC as a much easier way to approach a CAC payback period. It's also a much easier way to communicate to a client or to anyone how that actually operates. If you try to explain an acquisition or payback period, it starts to divulge into complexities. So that's the first two. You need to know your profit on first purchase month on month. You need to know your blended CAC month on month. From there, you also need to know what your uplift is on first time customer profits over a three, six and 12 month period, because that's going to allow you to understand how much returning customer revenue you actually get out of a new customer being acquired. You do not want to be using the returning customer revenue figure. that's on the backend of Shopify. Why? Because that figure just shows you today's returning customer revenue divided by total revenue. And in fact, what you'll end up, and this is just another misinterpretation of analytics that really destroys these businesses, is that as your first time customer revenue declines, let's say you start going through that death spiral and your acquisition strategy starts to become unprofitable, but you don't notice because returning customers are still occurring. Well, what ends up happening here is that's your new customers. and that's your returning customers. so percentage wise, your returning customers start to become a higher percentage of daily revenue. And so what e-commerce founders commonly make this mistake, agencies make this mistake as well, because they don't understand Shopify analytics, is that they think that returning customers is getting better. They think that, we're actually becoming operationally better. We're becoming better at email. We're becoming better at SMS. Maybe even the spend that we're deciding to allocate on Facebook to existing customers is working well because our returning customer rate is going up. I remember last year it was 30%. Now it's 60. Huge red flag. If you see your returning customer rate go from 30 to 60 % on the back end of Shopify, immediately check everything that I've just said because you're probably going through a death spiral. Because your customers don't suddenly start purchasing 2X more from you and returning back to store unless you've made some really sophisticated, strategical changes operationally to the business. Improve customer support substantially. Improve your product portfolio that better facilitates returning purchases. Change the packaging and the approach to offers at an operational level, at a merchandising level, sorry. They're the things that will really, you've to do all of those things, probably plus a couple more to get a doubling in returning customer rates. Realistically, returning customer rates stay pretty stable over time for almost 90 % of businesses that I've looked at. You have to make some substantial changes to the merchandising of the business to be able to do that kind of inflection. And so all that means is that you have less new customers now and that your returning customers is making up majority of your revenue and then it's falling off. And so that just bleeds into further poor decision-making by the business owner. So that's how you can track it. You need to be looking at You need to be looking at first time profits and you need to be making sure each month you're acquiring customers profitably. If you're not, you need to reassess the acquisition strategy. You might need to pull budgets down. You might need to reassess your positioning within the market and look at how you can get into profitability. Let's say that you are three to six months into this death spiral and you've just hit break even. You've just hit this point where you're making $5,000 in profit per month off returning customers. but your acquisition strategy is losing $5,000 a month. What you need to do incredibly quickly is either downsize operating expenses or get funding. Get funding is enormously risky and you're gonna do it probably at a terrible return. And so you need to downsize operating expenses. And this is a really harsh reality that I've had to say to, honestly, in the last quarter, I've probably said this to four to five business owners. And a few of them took on the advice and they're doing well now. And a few of them didn't and we'll see how that turns out. But the reason why you need to downsize operating expenses is because currently acquisition isn't profitable. And if acquisition continues to lose $5,000 a month and your returning customer P &L is just continuing to decline, you're going to go negative. You could argue, we'll just fix the first time customer P &L. But the reality is if they've been running ads for the last two years at a negative CAC, it's not an easy fix. You don't suddenly flick a few buttons, change a setting in a PMAX, and suddenly the business is going from a terrible acquisition strategy for two years to suddenly printing money. If it was that easy, someone would have figured it out and clicked the buttons. Now, other improvements that could be made? Absolutely. You could normally come in and change a paid media acquisition strategy from negative 5K a month to maybe negative 2K a month. But getting it into breakeven and then profits is very difficult and will take at least 90 days. And so what do you do in those 90 days prior to where you're driving losses? You need to downsize OPEX. You need to pull OPEX down and you probably need to pull ad spend down as well. You need to take off any inefficiencies you can out of the top incremental amount of spend there and make sure that you're just generating as much profit contribution dollars as possible. And that's ultimately the final death spiral of an e-com brand, which is that they acquire customers. They're not very profitable. Then they start getting returning customers and that starts driving profits into the P &L. And so they go, wow, we're starting to make money. Let's take all this money and reinvest it into just acquiring more customers. And so they start doing that, but they let their blended CAC blow out. And so they start actually acquiring customers unprofitably or with huge CAC payback periods. They don't really notice though, cause the returning customers are driving profits. And then because they're on this trajectory, that's 45 degrees, they see the future. see next year we're to be six mil, the year after we're going to be 12 mil. They start loading up on operating expenses to facilitate that. Warehousing costs go up, staffing goes up. Let's hire 15 people. Let's get a marketing manager. Let's get this. Let's get the other. Let's actually ditch agencies. Let's go in-house. Let's hire a bunch of people. Which there's consequences of doing that in terms of how quickly you erode company culture by bringing yourself in that quickly in a fast growing business. another podcast in itself. They start doing that operating expenses get loaded up and then they feel the crush because that cack that wasn't getting paid back finally hits them six to 12 months down the line once returning customers start to decline. Their operating expenses are blown out of proportion. They can no longer cover operating expenses. Profit contribution is not high enough. Negative EBITDA. They have to cut OPEX. They have to cut ad spend. they have to completely downsize and revert back into a three to $4 million business or they go under. They're really the two options. So it's really important to understand that dynamic within an e-commerce brand and within the P and L and this split between first time and returning customers. and the reason why I'm making this piece of content is because I've seen it so many times. I've thought of this theory about a year ago. I understood this concept about a year, a year and a half ago. In fact, I talked about it, to a few clients, but I never really saw it. I didn't have the evidence to actually back it up. But then I built a bunch of internal tools that allows me to see this dynamic live on every single brand I ordered. And then I started seeing it everywhere. I started going, my God, this is not just a theory that I thought could play out. This is playing out on almost every brand I look at. It's just customer acquisition declining, going into unprofitability on a hack of those cohorts. And then they're not noticing because the returning customer PNL is just propping up the entire PNL. And they don't realize that in three to six months, it's a sinking ship. And meanwhile, because things are going well right now, they're hiring more people and they're loading up, not knowing that in six months time, PNL is going to zero. Really crazy death spiral to be in. But something that I see all the time. And this video, even if you're a cold audience watching this, you work at an agency or an e-commerce brand, I don't know, you just follow the podcast. Funny enough, I'm not actually really making this for you. I'm making this for the 20 brands that I'm gonna audit over the next month, that I'm just gonna drop this podcast on them and go, hey, by the way, this is you. This is the explanation of what's happening right now in your business. Please watch this video and then let me know if you have any questions at all. So with that being said, that brings me to the end of this podcast. I do hope this was helpful for everyone. Obviously you need the tooling in place to be able to identify. this actually playing out within a business. It's great theory to have. It's great to understand how this works, but you need to go out and actually build the tooling to be able to understand how this is actually playing out and if this is even playing out in your business. If you are an e-commerce business watching this and you wanna know if this is playing out and you wanna use the tooling that I've built, reach out to us, bluesensedigital.com.au. We can run a completely free audit for you. We use all of your... historical in platform and Shopify data and we can identify all of this immediately. And so I can tell you what cohorts didn't pay back CAC. I can show you your profit on first purchase over time. I can show you your average retention lift at the three to six month mark. We've got it all. The tooling's there. So just reach out.