Hard Times for E-Commerce?

Some springtime dispatches from the front lines of the electronic-commerce wars:

• CDNow.com sees a planned merger with a mail-order music club fall through and watches its stock price plunge. Auditors warn of “substantial doubt” that the e-tailer can survive. CDNow announces plans to cut quarterly expenses by $12 million and seek a partner to throw it a lifeline.
• ValueAmerica, an e-tailer selling goods of all sorts, cuts both its product offerings and its workforce as business stagnates. Its auditors harbor “substantial doubt” that the company can stay afloat.
• Shares of EToys plunge from $86 last year to about $5.50 this spring. The company blames a host of new online competitors as well as high costs associated with problems it had filling Christmas orders.
• Bertelsmann AG, Europe’s biggest media conglomerate, postpones the initial public offering of its online bookstore. The reason: the overall decline in Internet stock prices.
• Drkoop.com, a medical information site, announces steps to conserve $100 million in cash and warns that its first-quarter loss will be much higher than initial estimates. Seeking life-support, Drkoop hires an investment bank to assess options, including a possible merger or sale.
• Plans by Peapod, an online grocer, to raise $120 million in new financing fall through, leaving it with about $3 million in cash. Ahold, a giant Dutch supermarket concern, steps in to rescue Peapod with $20 million in revolving credit.
• Forrester Research, a firm that analyzes the Internet industry, predicts that most pure e-tailers will be out of business by 2001. Forrester cites three reasons for its forecast: weak financial health, increasing competition and investor flight.

Is Internet commerce, which has generated so much excitement and investor interest in the last few years, witnessing a wholesale shift from dot-coms to flop-coms? After reading these dispatches, should e-business executives sound retreat?

To be sure, many e-commerce companies have hit hard times. And the reasons are legion, such as spending too much to woo customers, choosing a single-product niche, or being late to market. Ironically, some are suffering because of one of the Internet’s strengths: some World Wide Web sites allow consumers to quickly find the lowest price for a product, thus buyers can easily sever their tenuous allegiances to one seller and purchase stuff from others.

But Wharton alumni who run e-commerce companies, Wharton faculty members, e-business investors and a securities analyst say that a shakeout was inevitable and that the long-term future remains bright for e-commerce companies with the right product mix, strong leadership and good old-fashioned business sense.

The outlook is especially promising, they say, in the B2B sector, even though succeeding there will be no slam dunk because the notion of B2B as the next big thing has lost a bit of luster, too. Still, there will also be many winners in the business-to-consumer (B2C) arena. A report issued by Shop.org, an e-tailing trade group, and the Boston Consulting Group, notes that B2C e-commerce totaled $33.1 billion in 1999 and is expected to reach $61 billion in 2000.

What’s more, say the Wharton alumni and others, the days of a clean separation between pure Internet companies and traditional brick-and-mortar businesses are numbered. Already the lines between these two segments are blurring as companies form “clicks-and- mortar” hybrids. Before long, many pure e-commerce companies will build stores and establish other physical-world presences to supplement their Web sites, while brick-and-mortar companies will develop online presences.

In the meantime, however, the winnowing process will continue, as poorly run, poorly conceived, cash-starved, and late-entrant e-commerce companies hit the canvas or are acquired by healthier firms. Certainly, the months and years ahead will not be pretty for some e-businesses and their backers. Investors who threw money at anything with a dot-com suffix got walloped in April when technology stocks as a whole tanked and took down many dot-coms with them. For many companies, sky-high valuations plummeted to more earthly levels, and the shortcomings of several troubled companies were disclosed for all to see.

The Forrester report, which covered B2C only, paints a dismal picture, at least for the near term. The company says “the tide is turning against [dot-coms], and consolidation will soon steamroll across the weak ones.”

Forrester predicts that firms selling commodity products, such as books and software, will suffer declining growth rates and will consolidate by the fall of 2000. In addition, many merchants selling undifferentiated merchandise at razor-thin margins, such as toys and pet supplies, will go under before the Christmas shopping season. But Forrester believes companies selling branded, “high-style” products like furniture and clothing will remain stable until 2002.

The Shakeout in Perspective

Thomas Gerrity, former Wharton dean and now director of Wharton’s Forum on Electronic Commerce, is not convinced that a shakeout began when the prices of dot-com stocks tanked in April. He says the process actually began before that.

“This is a perfectly normal process of innovation and entrepreneurship,” Gerrity says. “A lot of new ventures are started all the time in any industry and only some succeed.”

And since there are tens of thousands of Web sites peddling goods and services of some type, not everyone is guaranteed success. What has drawn attention to the springtime shakeout, says Gerrity, himself an entrepreneur, is that “the Internet is arguably the most revolutionary technology in terms of its broad impact on business and society. It causes change and innovation across virtually every industry and business function. So this is a new thing, but this is also a very old thing. [Economist] Joseph Schumpeter wrote about the process of creative destruction, one of the wonderful aspects of capitalism.”

Like Gerrity, Stephen J. Andriole, senior vice president and chief technology officer at Safeguard Scientifics, the Wayne, Pa. incubator of technology companies, is not convinced that “shakeout” best describes what has been happening in e-commerce.

“If you step back and take the long view, words like ‘shakeout’ and ‘correction’ make it seem like there’s a big bang,” he says. “Another interpretation, however, is that the invisible hand of sane financial fundamentals has been working all along anyway. In baseball tryouts, everybody gets to show the coach what they’ve got. There are some good players on the field and some really bad players, and the coach cuts the bad players. What we’ve had is the first cut.”

Andriole says that “people are taking a harder look at business models and trying to determine if they’re sustainable over a period of time. If I have a business model and I project a certain amount of revenue, maybe two years ago I was more tolerant of seeing two to three years of losses. Today, people are looking to determine when financial fundamentals enter the picture and they then make valuations accordingly.”

Investors are beginning to challenge the revenue projections of dot-coms to see if top-line growth can be achieved “organically” or only through mergers and acquisitions, Andriole says. Executives at Safeguard, a major supporter of the Wharton Business Plan Competition, expect significant M&A activity this year as many companies are unable to meet revenue projections.

Closer Scrutiny

Belatedly, investors of all stripes are scrutinizing e-merchants more closely.

“In the early days of e-business, getting visibility and traffic to your site were key,” says David Schmittlein, professor of marketing, deputy dean and academic director of Wharton’s major in e-commerce. “These were seen as somewhat viable ways to measure valuation because there were so few alternatives. But as things evolved, getting traffic wasn’t enough – getting repeat traffic, or ‘stickiness’ was necessary. Then a push for revenue surfaced.”

All along, investors wondered when they would see companies actually turning profits. Some online businesses are now profitable, or close to being profitable, says Schmittlein. As a result, “the patience with those that have not [been profitable] starts to wear thin,” he says. “We are clearly at a point where the basis of valuations for Web businesses are beginning to increasingly look like those for other, more traditional businesses.”

Eric K. Clemons, professor of operations and information management, says many e-commerce entrepreneurs are struggling because they underestimated the difficulty of doing business on the Web.

“I don’t think most entrepreneurs ever explicitly calculated what it would take to succeed,” says Clemons. “They had ideas that were exciting to them. Sometimes the ideas were great and sometimes they were silly.”

Furthermore, Clemons says, “If you try to buy market share in the beginning by selling below cost, you will have tremendous difficulty continuing to do that later, since you will have to charge higher prices than competitors, and do so in an efficient, transparent online marketplace. If I had to guess, I’d say that these companies that are in trouble are in trouble because investors have figured out that their business plans were based on selling at a loss to buy share.”

One person not unhappy with the prospect of dot-coms falling by the wayside is Hussam (Sam) Hamadeh, WG’97, president and CEO of Vault.com, a web site that, among other things, serves as an underground, “inside scoop” guide to companies for job seekers. Named a top site by Yahoo! Internet Life, the Silicon Valley Reporter and U.S. News & World Report, Vault’s anonymous message boards dish first-hand dirt on working conditions at companies across the country.

“There’s a shakeout going on and that’s probably helpful for the industry,” Hamadeh says. “Some companies were making it harder for companies with good business models to break through. They were driving ad costs up and taking attention away from [financing sources].”

Hamadeh notes that many companies were rewarded by the financial markets “for doing certain things that didn’t make economic sense. They were rewarded for revenue growth regardless of losses. They were rewarded for building brands and doing splashy ads, even though those ads didn’t have positive returns.”

Too Much Spending

Catherine M. Skelly, vice president and e-tailing analyst at Gruntal & Co., says that “a lot of companies got run up [in value] much too aggressively. They never really ran a tight ship and they had a large [market capitalization] at one point, probably undeservedly. Any time there’s a tremendous amount of excitement about a particular sector, we’ll see companies rise and get ahead of themselves.”

Skelly agrees with Hamadeh that overspending on marketing has played a major role in many Internet companies’ mounting losses. “Many companies spend $80 to $100 to acquire each customer,” she says. “That’s worthwhile, or not worthwhile, depending on how much that customer will spend.”

For example, Skelly explains, CDNow sells compact discs — commodity products that have low profit margins, are easily replicated by other e-tailers and have little added value. Hence, CDNow customers have little incentive to remain loyal. Plus, she says, CDNow’s customers may buy only a few CDs per year.

“If CDNow acquires a customer at $60 and that customer does two transactions a year at an average of $25 per transaction and the gross profit is, say, 20 percent on those transactions, then CDNow has spent $60 to reap $10 in gross profits,” Skelly figures. “If the customer does two transactions a year, it will take CDNow years to recoup its investment in that customer.”

Skelly looks for companies that enjoy high gross margins and offer customers opportunities to buy more than one kind of product as often as possible. “That’s one reason Amazon.com keeps introducing new product categories,” she says. “The more it can push customers into new areas, the more transactions and profits it can make.”

For his part, Hamadeh notes that, while Vault.com is not yet profitable, “we do make a profit on every customer. That’s the important thing.”

He adds that he spent his final year at Wharton writing a business plan for Vault.com. It was a time before what he calls the “Internet craze” had yet to take off. “From day one we had a plan to run this business for a long time. We had a 10-year operating plan, built a management team and always kept a lid on expenses. Had we started this in 1998 or 1999, we might have had a different mindset.”

Knowing Your Customer

Marketing professor Peter Fader says the drubbing that e-business stocks took in the spring may not mean anything when it comes to evaluating the prospects of dot-coms. “I think looking at the financial markets is a terrible mistake,” Fader says. “We’ve known for a long time that these valuations were just not correct. What matters is whether the cash register is ringing or not.”

Often, Fader says, the cash registers may be ringing, but even that doesn’t always tell the whole story. He points out that many dot-coms are deluding themselves if they believe they will succeed because they have large numbers of people visiting their sites. A key problem, Fader says, is that many people may visit a site, but only a small percentage may come back to buy again.

Fader analyzed data from CDNow going back to 1997 and found that “you get a tremendous number of people checking it out, but there’s this slow, over time, distinct drop-off. People buy less and less frequently. That drop off is being masked by a constant influx of new people. If you take a snapshot at any one time, it appears as if there’s a lot of activity because the new bodies outweigh the few old bodies still around.”

The financial woes of some Internet companies also raise questions about whether the flood of venture capital to dot-coms will slow to a trickle. Hamadeh of Vault.com says fledgling firms shouldn’t worry because entrepreneurs with good ideas should be able to tap other sources of capital.

“One thing to understand is that the typical venture capital firm wants to invest in companies and liquidate its positions in six to 12 months,” says Hamadeh, whose own company, launched in 1997, has investors that include a legal books publisher, a business information company and a former Disney executive. Five years ago, your average company did not get VC funding. They were usually funded by individual private investors, bank loans, small-business loans and corporate investors. Until a few years ago, it was rare for start-ups to go to venture capitalists, In another year, we’ll go back to those days.”

Gerrity, however, says VC financing will remain important. “People can cobble together bank loans but there’s no substitute for equity,” he says.

The Road to Success

However e-businesses obtain financing, observers say dot-coms will have to take any number of initiatives if they are to succeed in the years to come. For one, e-businesses must recognize that the days of the pure Internet company are numbered.

“Companies will become more hybrid,” says Hamadeh. “If it’s an e-tailer, it will have to have retail stores. If it’s a content company, like ours, it may have to publish books and magazines.” From its beginning, he says, Vault.com has published books and magazines on topics ranging from salary negotiations to how job seekers should write cover letters.

What’s more, pure e-tailers will find that retailing giants like Wal-Mart will prove tremendous competitors as they leverage their brand names, deep pockets and buying power, says Gruntal’s Skelly. Wal-Mart spends much less to acquire a customer than pure e-tailers, so it is able to devote resources to other areas of the business, like customer fulfillment.

Skelly adds that Amazon.com has been working to establish a physical presence by aggressively building distribution centers and investing in a company called Kozmo.com, which got its start by delivering videos, CDs and magazines in Manhattan by bike messengers.

“It’s very symbolic of Amazon to establish a physical presence,” Skelly notes. “Kozmo also has an investment from Starbucks, and I wouldn’t be surprised to see Amazon partner with Starbucks or some other retailer to provide more service and convenience to its customer base.”

One company that has long had one foot in the bricks-and-mortar world and the other in the virtual world of e-commerce is BarnesandNoble.com, the world’s fourth largest e-tailer, according to Media Metrix, a research firm. Robert Albert, WG’98, BarnesandNoble.com’s director of strategy and business development, says a key aspect of his company’s strategy is to be a “multi-channel player.”

“Based on the strength of the Barnes & Noble brand name, we’re banking on that strategy and it’s been working out,” he says, noting that BarnesandNoble.com had five million customers and $200 million in revenue in 1999. “We’re a separate company from the parent company of Barnes & Noble, the stores. That has allowed us to expand our expertise in e-commerce.”

ICG: Banking on B2B

When technology stocks got knee capped earlier this year, so did the shares of Internet Capital Group, a leading investor in business- to-business (B2B) Internet companies. ICG’s stock plunged from about $183 in December to about $33 as of early May.

But Douglas A. Alexander, W’83, managing director of the Wayne, Pa., company, stayed cool. “If you’re the only stock to get hit you worry,” he says. “Otherwise, you shrug your shoulders. We’re in this for the long term.”

Indeed, he says, the decline in valuations of B2B stocks is generating opportunities for ICG. “We’re in the acquisition stage.” There seem to be as many definitions of B2B as there are B2B players. But ICG divides the market into two broad categories – market makers, which facilitate commerce between buyers and sellers, and infrastructure providers, which make the equipment and software behind e-commerce.

ICG has made 34 investments in market makers and 35 in infrastructure companies, Alexander says. Two of the market makers partnering with ICG are e-Merge Interactive, a marketplace for the cattle industry, and PaperExchange, which provides Internet sales and distribution of paper and pulp. An example of an ICG infrastructure partner is Breakaway Solutions, which provides application service hosting, e-commerce consulting and systems-integration services to growing companies.

“Companies have tried to make supply chains more efficient all the way back to Henry Ford and the Model T,” Alexander says. “The Internet has just given them a much richer infrastructure to do that to a degree impossible before.”

Alexander cites two key differences between B2C and B2B companies. “You’re not going to see B2B companies writing $100 million checks to build brand. If you look at where the money is spent on the B2B side, it’s about integrating into supply chains, which I think is a plus because technology is being put into place to bring real value.”

The other difference, he says, is that “the B2C dot-com players are competing head to head with bricks-and-mortar companies. On the B2B side, the dot-coms are automating the relationships between bricks-and-mortar companies. It’s a completely different dynamic. On the B2B side, the smart companies want this to happen. It’s going to lower the cost of building a business, get them closer to customers and drive revenue.”

M-commerce: The Next Big Thing?

For months, Albert has been working on a relatively new phase of e-commerce. It’s called mobile commerce, or m-commerce – the attempt to reach customers through cellular telephones and hand-held computers, which are known generically as personal digital assistants (PDAs) or personal information managers (PIMs). Palm Inc.’s Palm Pilot and Microsoft’s Pocket PC are two well-known brands.

Albert’s project is called BarnesandNoble.com’s On the Go.

Users who log onto bn.com/onthego can buy books, music or software, send greeting cards, and check the locations of Barnes & Noble’s retail stores. “It makes us ubiquitous,” says Albert.

In the short-run, Albert does not expect On the Go sales to rival that of the regular website. “But, by 2003, there will be more wireless devices connected to the Net than personal computers in this country,” he says. “We’re going to be there and be ready. Meanwhile, it’s a way to attract new customers.”

Most consumers, of course, aren’t yet able to take advantage of m-commerce. But Skelly is also enthusiastic about its long-term prospects. “Eventually, you won’t just have cell phones with tiny little screens,” she says. “You’ll have cell phones with larger, crisp color screens to buy things, and send e-mail and watch movies.”

Safeguard Scientifics’ Andriole, noting that his company has made two investments in wireless communications, agrees that “wireless will be huge.” More broadly, Andriole says, Safeguard prefers the B2B market’s prospects over the B2C segment.

“The market size of B2B is 10 times the size of B2C,” he says. “Also, B2B tends to be more predictable and repeatable. B2C is susceptible to the general economy, interest rates and emotional factors. Organizations like Safeguard can’t be all over the place. We’ve done the analysis and we like B2B better than B2C.”

It was major news in April when Safeguard announced that it had narrowed its online investment focus to the Internet’s infrastructure market. In becoming the first major technology company to do so, some investors and business media interpreted the move as a sign that Safeguard was pessimistic about the prospects of B2B.

Andriole, however, says the company’s move was widely misinterpreted. For one, he says, infrastructure – which Safeguard defines as the software, communications networks and e-services that enable B2B transactions – is essential to B2B businesses. For another, the company still supports the B2B sector through its network of partner companies, particularly Internet Capital Group (ICG), also of Wayne, Pa.

“We incubated ICG,” Andriole says. “We own 15 percent of ICG. Why would Safeguard say anything to jeopardize that investment? We were saying, ‘Why should we focus on B2B when ICG is the best in the business?’” (See sidebar for more on ICG).

Despite Safeguard’s enthusiasm for infrastructure and B2B, Andriole also says there will be “huge winners” in B2C. “Anybody with a big footprint today, like Yahoo and America Online, have a shot, especially if those models morph [into new kinds of businesses]. They’re in a great position. Those companies make money for crying out loud.”

Not a New Paradigm

It is often said that e-commerce companies have to discard traditional “offline” thinking if they are to succeed, but Wharton’s Clemons doesn’t buy that assertion.

“I’m amused when I hear entrepreneurs say there’s a whole new model of business and it’s not about selling and it’s not about customers but about ‘click-throughs’ and how click-throughs translate to access to the Internet site. I’m appalled when I see this repeated in the business press. At some point, somebody has to sell something to somebody and has to sell it to them at a significant profit.”

When asked to list the characteristics of successful dot-coms, Clemons says “the cool [Internet] guys answer that the bricks-based guys just don’t get it, they don’t move fast enough, they don’t understand. That’s a bogus answer. Instead the long-term questions are, ‘Does this company provide superior quality, superior customer service, superior customer delight? Two, ‘Does it open a new market that couldn’t previously be served cost effectively?’ Three, ‘Does it reduce costs?’ In the long run, if it doesn’t increase what you can charge, increase the number of people you can serve or decrease costs, it’s just plain silly.”

Clemons also says it’s important not to underestimate the advantage that clicks-and-mortar companies have.

“A question I often ask in class is whether a clicks-and- mortar or a pure physical company would be better or worse, and they all say clicks-and-mortar because clicks-and-mortar has more resources. I say, ‘Fine.’ Then I ask about clicks-and-mortar versus clicks. They look at me in horror. They want to believe that pure click players have an advantage, but they really have to struggle to make up reasons why Amazon’s valuation should be higher than BarnesandNoble’s.”

The Role of Branding

Branding is another pivotal issue going forward. Some argue is that dot-coms should not spend generously in an attempt to build a brand, says Farhad Mohit, WG’96, president and CEO of Bizrate, based in Marina Del Rey, Calif. Bizrate helps consumers by posting ratings of how e-tailers compare in terms of prices, customer service and other factors. Mohit says entrepreneurs should take advantage of what he calls the Web’s “network effect” – old-fashioned word-of-mouth juiced up by modern technology.

“eBay did not grow to where it is because it spent a lot of money building a brand,” Mohit says. “It grew because the more sellers came on board, the more buyers realized that eBay was the only way to go. That’s the network effect: more brings you more.”

Wharton’s Fader takes a different view. “Half the people you talk to say branding doesn’t matter, but I think branding matters more than ever,” he says. “People are spending money on branding but they’re not doing the right things. Pets.com’s use of sock puppets in ads during the Super Bowl don’t give people a reason to go there.”

Instead, Fader believes that companies should build brand loyalty by offering quality and giving consumers good reasons to revisit sites and buy products. E-commerce firms are misguided if they think they can readily capture the hearts and minds of customers.

Often, Fader says, e-businesses assume that customers are “looking for relationships with vendors to build a community of like-minded users. But convenience and selection matter as much as price or community.”

Dot-coms must also recognize that they can gauge consumer loyalty, but they cannot manage it. “You can anticipate the tide, but you can’t say, ‘We’re going to make these people loyal,’” Fader says. “You can try, but you’ll lose a ton of money by lowering prices and offering discounts. Companies are doing that, which is unprofitable.”

Most fundamental of all, e-businesses must learn more about the buying patterns of their customers. Like traditional companies, Fader says, dot-coms need traditional, well-understood metric benchmarks to measure accurately how much traffic they are generating, how many window-shoppers become buyers and how often people visit the site. Then, e-businesses can work on figuring out how to get people to buy more. But many e-tailers resist using metrics because they have erroneously convinced themselves that e-tailing is “new and dramatically different” from retailing, Fader says.

In its report, Forrester says that e-tailers must “strike back at brand confusion and product duplication by distinguishing themselves through customer service. Presence across the multiple channels and platforms, exclusive manufacturer deals to carry specific products and a range of delivery options will help build lifetime relationships.” Following the wave of e-tail consolidation, Forrester sees bricks-and-mortar retailers gaining new strength by leveraging assets like customer history, product selection, fulfillment and strong relationships with manufacturers.

At some point, however, the differentiation between e-tailers and retailers will disappear, says Gruntal’s Skelly.

“Eventually, it will be as natural for someone to buy something on the Net as it is to buy something out of a catalog.” she predicts. “The Internet gives consumers more power to make choices as to what they’re going to buy, and it brings them closer to having perfect information. Retailers have to respond to what consumers want. So a company like the Gap, which has stores all over the place, can now reach customers with its Banana Republic catalog and a Web site. And I can use all three channels at my convenience. Eventually, we won’t look at this as e-tailing and non-e-tailing. It will be just retailing.”

Says Gerrity: “There is no cookie-cutter formula for success on the Internet. It’s a matter of meticulous care and a deep understanding of each product segment. You have to make the right moves and position yourself correctly. We’re still at Chapter One, and maybe about to enter Chapter Two, of a long and fascinating book.”