Retailers, E-tailers and Next Generation Business Models

• 09/30/1999

With tens of millions of Americans now shopping online, Internet retailing, ore-tailing, has gone mainstream.

BancBoston Robertson Stephens estimates Internet retail sales will grow to $23.3billion in 2001, up from an estimate of $19.1 billion in 2000. This year's retail salesare expected to hit $13.9 billion, up from $8.6 billion in 1998. In addition, the numberof Web shoppers will grow to 58.9 million buyers in 2000 from 36 million at the end of1998. The amount purchased by each online consumer will increase to $325 per year by 2000,up from $238 this year.

"E-tailing has obviously arrived," says Marc Hansen, vice president of systemarchitecture at J. Crew. The company's Web siterepresents a multimillion dollar revenue stream for J.Crew. "Everyone has nowrealized their business hinges on having a successful e-commerce strategy." As aresult, the focus among e-tailers is shifting from technology to business strategy. Thesearch for new business models has intensified. Technology-related services, such as Webhosting, are becoming commodities. "The technology is mature, and now everyone isgetting down to business problems," Hansen says. At the same time, the promise ofe-tailing has created frenzy among investors, who seem to be throwing cash at anythingwith an 'e' in front of it.

Anomalous Phenomena
Consumers can buy some strange things online, but perhaps the most surreal e-tailtransactions are happening on Wall Street. For example, in early June, the online Barnes & Noble bookstore was worth about $3billion, $1 billion more than the brick and mortar chain.

And this kind of market capitalization is being achieved without turning a profit. Amazon.com, for example, lost $175 million in the lastyear--leading some to joke that the company should change its name to Amazon.org toreflect its non-profit status--but it retains a market capitalization of nearly $20billion.

High flying e-tailers have the option of taking over old-line retail chains. As ofearly June, eBay's $22 billion market capitalization washigher than Sears Roebuck, worth $18 billion and JC Penney Co., worth $13 billion. eBaycould realistically afford to buy either one. In fact, it recently acquired an establishedauction house, Butterfield & Butterfield. Priceline Inc., with its $16 billion marketcapitalization, is worth more than some of the airlines that it sells tickets for.

"The Internet business market is vastly overhyped," says Tim Harmon, vicepresident of retail and distribution strategies at the MetaGroup. "Infrastructure matters, and people are not going to abandon brick andmortar for the Internet."

Harmon offers some macroeconomic considerations to back up his assertion. "Oneassumption is that overall consumer spending will increase, and it can't. It won't,"he says. "The other assumption is that [online retailers] will take enough revenueaway from The Gap and Wal-Mart to create standalone viable business models, and that's nottrue either."

To put it another way, the U.S. retail sector accounts for about $2.7 trillion insales. Wal-Mart alone, with $132 billion in sales in 1998, dwarfs the online sales ofevery Internet retailer combined.

New Business Models
Auctions, affiliate marketing, personalization, noncash rewards programs and otherinnovations designed to take advantage of the Web are evolving rapidly. Following thesuccess of eBay, dynamic pricing and auctions have become common features on e-tail andother large Web sites. In addition to Onsale, eBay and Priceline, other sites that offerauctions include CNET, Yahoo, Lycos and Amazon.com.

Some sites aim to simplify complex buying decisions. For example, Point.com makes it easy to compare and order differentcellular service plans--something that can be a nightmare when done by telephone. Traveland car buying sites also aim to make it easy to buy services and products that aretraditionally difficult to compare.

Other sites focus on marrying products to content and community--like newspapers thatdon't distinguish between news and advertising. BabyCenterInc., for example, sells a large line of baby products, but its site also includesdiscussion forums, original content and articles sponsored by vendors such as Johnson& Johnson.

Not all e-tailing sectors are adept at taking advantage of new business models.BancBoston Robertson Stephens estimates that computer hardware will be the biggest e-tailmarket in 1999 with $3.94 billion in sales, followed by travel at $3.75 billion, onlinebrokerage at $2.29 billion, books at $1.25 billion and computer software at $764 million.

Mirroring the trend in the standard retail world, many e-tail startups hope to dominateparticular sectors. For example, ePills, PlanetRX, Drugstore.com and Greentree want torule the world of online drugstores; Homegrocer, Peapod, Netgrocer and Webvan want to ownthe online grocery business.

Other e-tail winners may rely on sales of popular brands that appeal to demographicgroups representative of Web users, or they may focus on products such as music CDs thatare easy for consumers to compare by price. In fact, the ease of comparison shopping onthe Web suggests the long-term winners will be those companies that differentiatethemselves based on customer service, broad product selection, ease-of-use, non-monetaryrewards and high-quality content.

"It's not just about putting a catalog on the Internet. If that's all you thinkabout, you will fail," says Pehong Chen, CEO of Broadvision Inc., which sellspersonalization software for one-to-one marketing. "You have to really think abouthow to exploit this new channel and how it impacts business processes, and then findpeople to help you."

Retailers Respond
Traditional retailers face some tough issues when competing against e-tail businesses.

One is speed of execution, which is clearly on the side of online e-tailers. Fastgrowing Wal-Mart took 10 years to reach $1 billion in annual sales; Amazon.com did it inthree years.

"Traditional businesses can't react quickly enough," according to one managerat a well-established retail firm now moving online. "How can Toys "R" Uscompete with Etoys, which is willing to operate at huge losses to grow at the rate they'regrowing?"

It's partly a matter of culture and expectations. Even with backing from a CEO, there'sthe pressure of turning a profit in the traditional retail environment. Moreover, a newWeb store may pull existing customers from retail outlets to the Web rather than generatenew sales. And if you're Borders Books, should you to match the discounts--or losses--ofAmazon.com? For now, new e-tailers seem to be free to lose money: Traditional retailersare not.

Channel disruption and development costs are other issues. Established companies canrun into trouble if their Web site undercuts an existing dealer network. And it's worthnoting that the cost of e-tailing is not trivial--there are substantial costs in runningvirtual malls: site development costs, Internet services, advertising and backend andfulfillment costs can be enormous. But existing retailers have little choice except tomove ahead.

Does E-tailing = Retailing?
Despite their differences, e-tailing upstarts must contend with some of the same issuesthat traditional retailers face.

One is customer acquisition costs and customer retention. It often takes upward ofhundreds of dollars to snag one customer, so it makes sense to develop ways to keepcustomers coming back. Similarly, call center operations, fulfillment, warehousing andshipping present problems for both e-tailers and retailers.

When all is said and done, there is tremendous overlap between the critical successfactors for e-tailing and retailing. Good prices, easy ordering, liberal return policies,big ad budgets, effective branding, strong financial backing, customer retention andclever merchandising are essential for both.

Options for Outsourcing
Most virtual businesses are anything but virtual. Behind every e-tail operation there isthe reality of Internet services, fulfillment, call centers, shipping, billing,warehousing and distribution. Fortunately, would-be e-tailers have a growing range ofoutsourcing options.

Start with Web hosting. Rather than run redundant T1 or T3 connections to supportservers on company premises, many large e-tailers now opt to locate their servers atfacilities with multiple high-speed Internet connections. Hosting services, such as AboveNet Communications and Exodus Communications Inc. let customers place their ownservers in facilities that are similar to a self-storage facility with a T3 connection.Hosting companies can also help with system maintenance and applications-level support.

"I can't imagine many circumstances that would justify hosting internally, unlessyou already have a 24x7 operations center," J.Crew's Hansen says. "The standardof infrastructure at a colocation facility is going to be considerably higher than at mostbusinesses."

For e-tailers whose property consists mainly of HTML, it makes sense to outsourcefulfillment operations, such as warehousing and shipping. While some e-tailers can forwardorders to manufacturers willing to drop ship products, others are turning to companiesthat have large warehousing operations. Shipping companies such as Federal Express andUnited Parcel Service are also moving into warehouse operations.

As a catalog retailer, J. Crew already maintains a 400,000-square-foot warehouse. Butfor companies not yet in a similar situation, outsourcing may be attractive. "Ifyou're not already doing pick and pack, you want to think very hard before starting-it's ahuge investment," Hansen says.

But some companies are taking the plunge. Toys "R" Us, for example, isspending $30 million on a new 500,000-square-foot warehouse in Memphis, Tenn. AndAmazon.com is constructing new facilities in Nevada and Kentucky.

For existing retailers that want to make the jump into e-tailing, it may make sense tohire outside help from a new wave of consulting companies focusing on e-commerce.Companies, such as Scient, Viant, IXL, USWeb/CKS and Proxicomcan help with Web design, programming, business process engineering and marketing.

Patently Ridiculous
Many e-tailers are now filing patents on their business models, and oddly enough, the U.S.Patent and Trademark (PTO) office seems happy to oblige. To date, the PTO has grantednearly a dozen patents covering a wide range of basic operations, including shoppingcarts, Internet-based credit card payment, scrolling stock tickers and online auctions.

While some may argue the PTO no longer applies meaningful criteria to patentapplications, patents represent one of the more tangible forms of intellectual property.There are several examples of high-profile recipients of business model patents. Pricelinehas a patent that covers Dutch auctions online. Open Market has patented online shoppingcarts and some online payments. Both NetCentives and CyberGold own copyrights that covernon-cash rewards for watching ads.

Given the breadth of these and other e-commerce patents, a wave of litigation is allbut certain. Priceline's patent already faces two legal challenges, and the company alsofaces charges of patent infringement. In March, Network Engineering Software filed aninfringement suit against eBay.

The trickle of business model patents is likely to become a flood. The patents grantedto date were filed a few years ago. Last summer, the Federal Circuit Court of Appealsruled methods of conducting business are patentable, a ruling that greatly extends whatcan be patented.

It's worth noting, however, that despite some successes, such as RSA Data SecurityInc.'s patents of public key encryption, broad high-tech patents have not always ensuredbusiness success. A few years ago, Compton's New Media received a patent for interactiveCD-ROMs and attempted to claim licensing fees from the entire industry. Compton's plan didnot work: The company eventually declared bankruptcy.