Just-in-time deliveries and Internet connectivity has developed in such a way over the past ten years that many direct marketing businesses base their business model and success on virtual inventories.  What do I mean by “virtual inventory”? Essentially, virtual inventory is drop shipping merchandise orders directly from vendors’ stock rather than the more traditional stocking merchandise in anticipation of demand.  While there are exceptions, a company with virtual inventory should have the ability to achieve faster growth, better focus, and higher valuations than more traditional “stock and ship” companies.

Let us briefly discuss the risks and benefits of both models.

THE STOCK AND SHIP METHODOLOGY HAS SEVERAL STRENGTHS: 

First, the stock and ship method has the potential of being a lower cost alternative.  In the traditional inventory method, a company should carry a higher initial mark-up than the virtual inventory method.  After all, committing to a single one-thousand piece order should be less expensive than buying one thousand, one-piece orders.  While operational and measures may disguise the true costs, bulk purchases are initially less expensive.  Furthermore, since one is outsourcing fulfillment operations, fulfillment expenses may be more expensive than a company owned facility.  Finally, vendor fulfillment centers may not be efficient for shipments to individuals if the centers usually ship bulk merchandise orders. 

Second, service and control are the next key issues.  The traditional marketer is loathing not to see the inventory levels of each item during each order.  Not being able to tell your customers if or when a third party can ship is a stumbling block in many instances.  With virtual inventory every new vendor will need to be integrated into your system.  Many will resist, perhaps limiting your product selection.  But let us assume today’s integrated systems can give you visibility into your vendors’ warehouses.  This leaves another  roadblock - relying on third parties for your in-stock positions.  Relinquishing control is a line many merchants do not dare to cross.

THE VIRTUAL INVENTORY ADVANTAGES:

Virtual inventory, on the other hand, does not carry as much of the risk of being overstocked at the end of the season.  Since, often times, you only buy what is shipped; markdowns and liquidations can be reduced or eliminated as inventory is now the responsibility of the vendors.  While most proprietary goods will be foregone, you will benefit in other ways.

The key benefit to virtual inventory is lower working capital requirements.

First, inventory tends to be one of the largest assets of direct merchants.  If you can work without inventory, then that capital can be deployed in other areas, such as marketing and circuatlion. With more money devoted to marketing, growth can be accelerated.  Even with faster growth, no additional inventory capital is needed, allowing you to grow yet again. If  inventory levels are “guaranteed” by the vendor, then more resources can be used for marketing.  The first reason why valuations for virtual inventory companies are higher than traditional companies is the potential to grow faster.  Faster growth generally means higher valuations.

We can quantify a second reason for higher valuations. In a formal valuation setting, net working capital requirements are a drag on cash generated and net present value calculations.  Our estimates show that eliminating the need for additional inventory during a growth phrase of a direct marketer will add at least one turn, and possibly two, to the enterprise value of the business.  The marketplace may even place higher valuations on this business model.

ILLUSTRATION:
A $20 million marketer with a cost of goods of 50% and which turns 3 times a year carries, on average, $3.3 million of inventory. If that merchant’s sales grow at 10% per year, the additional inventory needed to sustain that growth has a net present value of between $1.2 million and $1.5 million (depending on the discount rate used). A virtual inventory model company with similar characteristics does not need to invest that money in inventory to fuel its growth.  If the $20 million dollar company earns $1-2 million a year, then the inventory management model added nearly a full turn to the value of the business.  (It would increase a 6 multiple to a seven multiple.)  This change in valuation does not include the probability that the virtual inventory model is likely, in fact, growing faster than the traditional company!

CONCLUSION
There is a final reason why virtual inventory models work well.  In part, the modern direct marketer industry grew as a way to bring unique merchandise into every home.  This role required three key strengths:
1. Select and Sell Desirable and Unique Merchandise;
2. Find Customers Who Want to Buy the Merchandise
3. Manage a Supply Chain to Get the Merchandise to the Customer.

As the world shrinks and supply chains become more routine the third key success factor, managing the supply chain, creates less value.  Now, with virtual inventory a reality, merchants can focus on the first two value making skills.  As a colleague of mine at Bentley College once told me, when the company I ran was struggling with working capital requirements, “You want to be in the business of finding and generating customers, not stocking merchandise.”

Stuart Rose is a Managing Director at Tully & Holland, Inc. and a regular contributor to Multichannel Merchant.  Tully & Holland are specialists in corporate finance serving retailers, direct marketers, and consumer product manufacturers, and is a member of FINRA, DMA and NEMOA.