Retailers, E-tailers and the Next Great Business Model

• 11/03/1999

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

BancBoston Robertson Stephens (www.rsco.com) estimates Internet retail sales will grow to $23.3 billion in 2001, up from an estimate of $19.1 billion in 2000. This year's retail sales are expected to hit $13.9 billion, up from $8.6 billion in 1998. In addition, the number of Web shoppers will grow to 58.9 million buyers in 2000 from 36 million at the end of 1998. 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 system architecture at J. Crew (www.jcrew.com).The company's Web site represents a multimillion dollar revenue stream for J.Crew. "Everyone has now realized their business hinges on having a successful e-commerce strategy."

As a result, the focus among e-tailers is shifting from technology to business strategy. The search for new business models has intensified. Technology-related services, such as Web hosting, are becoming commodities. "The technology is mature, and now everyone is getting down to business problems," Hansen says.

At the same time, the promise of e-tailing has created a frenzy among investors, who seem to be throwing cash at anything with an ‘e’ in front of it.

Consumers can buy some strange things online, but the most surreal e-tail transactions are happening on Wall Street. For example, as of early June, the online Barnes & Noble bookstore (www.barnesandnoble.com) was worth about $3 billion, $1 billion more than the real chain of physical stores.

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

High flying e-tailers have the option of taking over old-line retail chains. As of early June, eBay’s (www.ebay.com) $22 billion market capitalization was higher than Sears Roebuck -- worth $18 billion -- and JC Penney Co. -- worth $13 billion. eBay could realistically afford to buy either one. In fact, the company recently acquired an established auction house, Butterfield & Butterfield (www.butterfields.com). Priceline Inc. (www.priceline.com), with its $16 billion market capitalization, is worth more than some of the airlines that it sells tickets for.

"The Internet business market is vastly overhyped," says Tim Harmon, vice president of retail and distribution strategies at the Meta Group (www.metagroup.com). "Infrastructure matters, and people are not going to abandon brick and mortar for the Internet."

Harmon offers some macroeconomic considerations to back up his assertion. "One assumption is that overall consumer spending will increase, and it can’t, it won’t," he says. "The other assumption is that they [online retailers] will take enough revenue away from The Gap and Wal-Mart to create standalone viable business models, and that is not true either."

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

Auctions, affiliate marketing, personalization, noncash rewards programs and other business innovations designed to take advantage of the Web are evolving rapidly.

Following the success of eBay, dynamic pricing and auctions are becoming common features on e-tail and other large Web sites. In addition to Onsale, eBay and Priceline, other sites that offer auctions include CNET, Yahoo, Lycos and Amazon.com.

Some sites aim to simplify complex buying decisions. For example, Point.com (www.point.com) makes it easy to compare and order different cellular service plans -- something that can be a nightmare when done by telephone. Travel sites and car buying sites also aim to make it easy to buy services and products that are traditionally difficult to compare.

Other sites focus on marrying products to content and community -- like newspapers without distinctions between news and advertising. BabyCenter Inc. (www.babycenter.com), for example, sells a large line of baby products, but its site includes discussion 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-tail market in 1999 with $3.94 billion in sales, followed by travel at $3.75 billion, online brokerage 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 dominate particular sectors. For example, ePills, PlanetRX, Drugstore.com and Greentree want to rule the world of online drugstores; Homegrocer, Peapod, Netgrocer and Webvan want to own the online grocery business.

Other winners in the e-tail game may rely on sales of popular brands that appeal to demographic groups that are represented among Web users, or they may focus on products that are easy for consumers to compare by price, such as music CDs.

In fact, the ease of comparison shopping on the Web suggests the long-term winners will be those companies that differentiate themselves based on customer service, broad product selection, ease-of-use, non-monetary rewards and high-quality content.

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

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. Fast growing Wal-Mart took 10 years to reach $1 billion in annual sales; Amazon.com did it in three years.

"Traditional businesses can’t react quickly enough," according to one manager at a well-established retail firm now moving online. "How can Toys R Us compete with Etoys, which is willing to operate at huge losses to grow at the rate they are growing?"

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

Channel disruption and development costs are other issues. Established companies can run into trouble if their Web site undercuts an existing dealer network. And it’s worth noting that the cost of e-tailing is not trivial -- there are substantial costs in running virtual malls: site development costs, Internet services, advertising and backend and fulfillment costs can be enormous. But existing retailers have little choice except to move ahead.

Despite their differences, e-tailing upstarts must contend with some of the same issues that traditional retailers must face.

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

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

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

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

"I can’t imagine many circumstances that would justify hosting internally, unless you already have a 24x7 operations center," J.Crew's Hansen says. "The standard of infrastructure at a colocation facility is going to be considerably higher than at most businesses."

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

As a catalog retailer, J. Crew already maintains a 400,000-square-foot warehouse. But for companies not already in a similar situation, outsourcing may be attractive. "If you are not already doing pick and pack, you want to think very hard before starting -- it is a huge investment," Hansen says.

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

For existing retailers that want to make the jump into e-tailing, it may make sense to hire outside help from a new wave of consulting companies focussed on e-commerce. Companies, such as Scient (www.scient.com), Viant (www.viant.com), IXL (www.ixl.com), USWeb/CKS (www.usWeb.com) and Proxicom (www.proxicom.com) can help with Web design, programming, business process engineering and marketing.

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 granted nearly a dozen patents covering a wide range of basic operations, including shopping carts, payment by credit card over the Internet, scrolling stock tickers and online auctions.

While some may argue the U.S. PTO no longer applies meaningful criteria to patent applications, patents represent one of the more tangible forms of intellectual property. High-profile recipients of business model patents include Priceline Inc., CyberGold Inc., Netcentives Inc. and Open Market. Priceline has a patent that covers Dutch auctions online. Open Market has patented online shopping carts and some online payments. Both NetCentives and CyberGold own copyrights that cover non-cash rewards for watching ads.

Given the breadth of these and some other e-commerce patents, a wave of litigation is all but certain. Priceline’s patent already faces two legal challenges, and the company also faces charges of patent infringement. In March, Network Engineering Software filed an infringement suit against eBay.

The trickle of business model patents is likely to become a flood. The patents granted to date were filed a few years ago. Last summer, the Federal Circuit Court of Appeals ruled methods of conducting business are patentable. The ruling greatly extends what can be patented.

It’s worth noting, however, that despite some successes, such as RSA Data Security Inc.’s patents of public key encryption, broad high-tech patents have not always ensured business success. A few years ago, Comptons New Media received a patent for interactive CD-ROMs and attempted to claim licensing fees from the entire industry. Compton’s plan did not work: the company eventually declared bankruptcy.