03/08/99
Forbes
Page 124
Electronic commerce is a merchant's dream: no costly stores, no payroll for salespeople, slim inventory costs. In four years almost 90,000 on-line merchants have opened shop. Build a Web site and they will come.
Traditional retailers embrace the dream, too--about 40% are on the World Wide Web and most others plan to join them, according to an Ernst & Young survey. On-line sales totaled $8 billion last year and could grow tenfold in four years.
Promising, but now comes the hard part: turning a profit. Behind high-tech screens are some distinctly low-tech costs. On-line sellers that had dreamed of avoiding bricks and mortar are now building distribution centers and warehouses. The Web's ability to compare prices at the click of a button sparks jarring discounts and costly coupon wars. And for all those eyeballs on-line, marketing consumes a frightful chunk of revenues.
The hurdles can be even higher for traditional retailers going digital. Their on-line sales may simply cannibalize sales they would have racked up off-line--that is, in the real world. Their backshop infrastructures were built to dispatch truckloads of goods to hundreds of stores--not ship small orders to millions of individual customers. (Catalog companies are better equipped but have their own worries; see story, p. 126.)
Manufacturers hoping to sell directly to consumers risk the wrath of the dealers and wholesalers that provide most of their revenues. In short, the Web is both the problem and the opportunity.
No wonder some merchants venture into cyberspace with no small amount of dread. Borders, the second-largest chain of bookstores, opened its Web site last May but wasn't exactly ecstatic about it. The 1,145-store chain's chief executive, Philip Pfeffer, sounds like one reluctant cybernaut: "Books, music and video have all been substantially discounted. Consumers get good value, but in the long run margins are inadequate to support the business regardless of how much volume is done."
Pfeffer worries that Web profits may never come. Borders expects the Web effort to run a loss of $10 million this year and $20 million the next. The chain's stock tumbled 38% when those prospects and other snags were disclosed in early January. It hasn't recovered. Seems investors, unfazed by red ink for on-line upstarts with "dot-com" in their names, are unforgiving when the same applies to old-line firms going on the Web.
Yet Pfeffer, like many marketers--like your company, most likely--has little choice but to go on-line. His rivals at Barnes & Noble had preceded him onto the Web, and both chains had good reason to fear the soaring sales of Amazon .com.
Amazon opened up shop in 1995 and offered discounts of 30% on bestsellers. Barnes & Noble turned up the heat on-line in May 1997 by offering 40% off. Wal-Mart, one of the largest booksellers, has a Web outpost slashing 45% off list prices--and upstart Buy.com promises 50% discounts.
So Pfeffer opened a vein and bled, offering on-line discounts even as he jacked up spending for the privilege of doing it. To gear up for shipping tiny orders to thousands of customers, Borders had to build a separate $15 million distribution center in LaVergne, Tenn. All told, the distribution costs of an on-line storefront can be surprisingly high--about 15% of sales for Web sellers like Borders.
At the front end, Borders had to get cybershoppers into its on-line store. On the Web, that can mean paying hefty fees to other sites for referring their visitors to yours. It is a kind of rent: Popular "portals" like Yahoo lure the critical mass of eyeballs, so e-commerce companies pay for prominent placement on Yahoo and for customer "click- throughs." Such rent and other marketing costs can run to 65% of sales, says the Boston Consulting Group.
Borders spent $5 million marketing its new Web site in 1998 and could lay out $20 million this year. Pfeffer won't confirm the numbers but laments: "I can remember hearing this is a great model. With bricks and mortar comes rent. But the fact is, real estate costs on-line are significant. It makes it really difficult to get profits."
For existing retailers, the scary prospect is that the less- profitable setting of the Web--rather than create extra sales from new customers--will simply siphon off the higher-margin sales from their stores. That could happen at Borders. Buying two or more books can be instantly cheaper on its Web site than in its stores largely because customers can avoid state sales taxes. (Retailers must collect the tax only in the states where they have a physical presence. Borders' separate on-line unit has only two such outposts: the warehouse in Tennessee, and headquarters in Ann Arbor, Mich.)
So Pfeffer looks for other upsides. Even if his Web site never turns a profit, he hopes it can increase sales in stores. Shoppers frustrated by sold-out stock and hard-to-get titles can now place special orders via Web-linked PCs in Borders outlets. This approach could bring in several million dollars in revenue in each quarter, less than 1% of total sales.
Of course, the Web is supposed to be a sales outlet unto itself, and virtually no on-liner has more experience at it than Amazon . And rarely have so many companies been thrown into so much panic by a company that loses so much money. In the past three years Amazon lost a cumulative $162 million on sales of $774 million. Indeed, the deficit has grown nearly as rapidly as revenue. As a percentage of sales, Amazon 's net loss has actually gotten worse, widening from 16.4% in the last quarter of 1997 to 18.4% in the last quarter of 1998. Amazon expects more losses for the foreseeable future.
Even for a pure on-liner like Amazon , distribution costs are a huge drain. When Jeffrey Bezos founded Amazon in 1994, he planned to rely heavily on Ingram Books, the largest book wholesaler in the U.S. The concept: Ingram would keep his inventory--and the costs that go with keeping inventory.
Bezos bragged of offering 1.1 million titles while stocking just 500 bestsellers, in a single 45,000-square-foot warehouse. He set up shop in Seattle in part because of its proximity to some Ingram operations. But he stopped short of letting Ingram handle shipping to individual customers, insisting on deploying his own force to ensure quality of service.
Three years later Amazon relied on Ingram for 60% of its books. That portion has since declined, and today two-thirds of Amazon 's 2,100 employees work on customer "fulfillment," placing orders, packing shipments and answering customer e-mails and processing credit card charges. That consumes close to 10% of revenue, and it could go higher.
Now Ingram is being bought for $600 million by Amazon 's rival, Barnes & Noble. Ingram hopes to keep supplying Amazon , but Amazon is increasingly sidestepping Ingram to buy directly from publishers.
To house all its new inventory, Amazon is opening its third warehouse--a colossal seven-acre facility in Fernley, Nev.--with plans for a fourth and possibly a fifth one. Staffing costs will grow accordingly.
Worth it? Even Sam Walton of Wal-Mart shaved his cost of goods sold only 2% below his competitors by buying direct. Amazon says its gross margins on books have risen four percentage points in 18 months. But music CDs now provide 13% of sales, a big reason the on-liner's overall gross margin fell by 1.6 points, to 21.1%.
Perhaps Amazon will find profits in becoming an on-line landlord. In December Bezos launched a "shop the Web" program, charging "e-tailers" rent to be featured on Amazon . Cyberspace is getting to be as expensive as a storefront on Rodeo Drive. Barnes & Noble's on-line unit is paying America Online an eye-popping $40 million to lock in space as AOL's exclusive bookseller for four years. A bargain?
"I've always felt these portal deals were way too expensive and lock you in for way too long," says Darryl Peck, head of Cyberian Outpost, a Web seller of computers. "No one knows if they're going to work or not."
Music sellers N2K and CDNow agreed to merge in part because their already-ailing finances were hurt by contracts to spend, between them, $108 million for similar marketing agreements. That is almost half their hoped-for full-year revenue--a costly promotion, to be sure. "We don't want to go out and talk about how it's not working," says N2K Chief Executive Jon Diamond. He has renegotiated some deals, which could reduce the cost by $10 million.
Such savings can get eaten up quickly by other needs. Ad budgets are a big jolt. Last summer software seller Beyond.com began a six-month TV blitz for $10 million--exceeding its entire third-quarter sales. Buy.com, an on-line discount store, paid $1.6 million for a single 30-second spot on the Super Bowl.
Special promotions are de rigueur. At the Buy.com site, you can get an Agfa digital camera for $723.95--and a $250 Clik disk drive free of charge. Computer Literacy, an on-line seller of computer books, offers some software developers $19.95 off any purchase north of that amount.
Technology spending can be a drain, too. 1-800-Flowers poured $13 million into its new Web site and will spend $15 million in the next two years to upgrade it. "We've been profitable thus far. Now we're plunging into the dark," says Chief Executive James McCann. "Still, we do believe it's the future. We're betting all our chips on it."
The Web was supposed to all but wipe out the cost of customer support, letting mouse-clicks replace phone orders. Don't count on it. During the Christmas rush, Shopping.com's support lines were swamped with callers who needed a human touch. Some of them were left on hold for an hour. The Web discounter, which sells watches, Cuisinarts and other goods, doubled its support staff to 50 people, easily adding another $1.5 million a year in costs. Yet revenue for the nine months ended Oct. 31 totaled just $4 million.
Compaq Computer Corp. is willing to forgive Shopping.com its cost problems, for now. It has agreed to buy the upstart for $200 million.
Will these Web selling costs go away? Probably not. Web sellers have noticed that on-line buyers are indecisive, filling up their digital shopping baskets as they proceed through a site, but then erasing two- thirds of their purchases before reaching the checkout. They lose their nerve or can't find their way out.
"The bottom line is that e-commerce companies have to spend more on phone centers than bargained for," says Ajit Pendse, founder of Beaverton, Ore.-based Efusion. His firm offers a fix. He pushes "pop-up" buttons on Web pages that could route frustrated customers who are ready to bail out to a service rep, turning the PC into a speakerphone.
There must be some way to make money. Ebay, the auctioneer, is one of the few Websters to turn a profit, in part because it refuses to fuss with "fulfillment"; customers who use the site must do the work to get the booty shipped from buyer to seller. Beyond.com hopes to cut delivery costs by zapping more copies of software over phone lines into customers' PCs.
Scott Blum, the founder of Buy.com, plans to sell some products below cost--in the expectation of building a large enough audience that he can make money on advertising. He hopes so many customers stampede his way that other Web sites will pay him big bucks for customer referrals.
Good luck to him. Someone will get it right, but along the way hype and hope will collide with harsh realities. "This is just a catalog retail business with lower barriers to entry. Margins, if they ever materialize, will always be crummy," grouses Michael Murphy, a veteran tech investor in Half Moon Bay, Calif. He may be right.
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SIDEBAR: Grade-A challenges
"BRICK-AND-MORTAR" retailers thought the Web would slash costs for rent elson and payroll. Some are still waiting for the miracle.
Egghead.com ($140 million estimated 1999 sales) began life as Egghead, Inc., a leading software chain in the 1980s. Mass merchandisers squeezed its margins, and the retail division last saw an operating profit in 1992. Hoping to cut costs, Egghead shuttered its remaining 83 stores a year ago and sought refuge on-line as Egghead.com.
But the Spokane, Wash. on-liner is struggling. Losses were at $21.6 million on $106 million in sales for the first nine months of fiscal 1999--42% more than last year.
It should have been easy. Rather than ship software by mail, Egghead would zap it to customers over the Web. But bandwidth isn't up to snuff. Until buyers can download fast and cleanly, the low-cost sales will be negligible.
Now Egghead is trying its hand at selling clothes, luggage, jewelry-- even country hams. But sales, general and administrative expenses are actually up--to 34% of revenue from 18% in 1992. And gross margins are down from 20% in 1992 to 10% this year. One upside: The "dot-com" in its name helps the stock; it's still around $17. -BRETT NELSON
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SIDEBAR: Pulp Addiction
THE MAIL-ORDER BUSINESS seems like a natural for e-commerce: You have customers who buy remotely; narrowly targeted products; databases on our innermost shopping habits; the fulfillment back-end. Slap on a Web address and free up our mailboxes. Please?
Don't count on it. Fourteen billion print catalogs went out last year, and the massive mailings show no signs of abating. That's two or three for each U.S. household every week. Web commerce hit $13 billion in 1998, but half of catalogers haven't even started selling on-line. The efforts of the other half are downright timid.
Crate & Barrel relegates the Internet to a seconds warehouse, using third parties like Catalog City to liquidate inventory. Williams-Sonoma uses the Web as little more than a glorified store locator. Go to most any catalog site--Harry and David, J. Crew, Smith & Hawken--and one of the first buttons you see is "Order Catalog."
"Why be so quick to give them that option, when they're right there? It's fear," says Robert Lickton, president of Lickton Supply Corp. in Oak Park, Ill. He has switched his bike gear catalog, started by his grandfather in 1935, to a Web-only offering and formed the Paperless Catalog Association to prod the industry's belated efforts on-line.
Catalogers have never been a nimble bunch. They are wary of plowing cash into a channel that provided only 2% of their estimated $87 billion in 1998 U.S. sales. It can cost $250,000 to get started, and a full- scale sales site costs $6 million to start and $4 million a year to run, says International Data Corp.
Yet half of all catalog firms have annual sales of $8 million or less, putting e-commerce efforts out of reach for some. "Even if they get it, they think they can't afford to get it," says Rakesh Kaul, chief executive of Hanover Direct in Weehawken, N.J., which owns Gump's By Mail, The Company Store and a dozen other catalogs.
Yet scrimping on Web costs risks disappointing your customers with lame offerings; they may never return. "People who like to flip through our catalog have a well-defined set of expectations," says Lester Hsieh, head of marketing for Hammacher Schlemmer in Chicago, which launched its Web site in 1998. "If we confuse or bore or annoy them, we're corroding the print brand."
Yes, but look at the payoff: The cost of printing and mailing a catalog is 35 cents to 70 cents; the cost of an extra hit on the Web is close to zero. And fewer warm bodies are needed to complete the transaction, shaving up to $8 off the cost of handling a sale.
At Hanover Direct, Kaul has gone on-line in baby steps, starting with International Male, a trendy men's clothing retailer, in November 1996 and spending up to $300,000 each time. The 12th title, Gump's (home furnishings and knickknacks), went virtual last July.
Kaul learned as he went along. Silhouettes, for plus-size women, needed minimal promotion. Gump's got off to a relatively slower start and requires more promotional spending. Kaul's Web sales grew tenfold last year but provided only 1% to 8% of sales, depending on the catalog. Still, he plans to spend $50 million in the next three years developing his Web stores and other e-commerce endeavors. He thinks most orders will eventually occur on-line: "The catalog's role will be more as a promotional vehicle, a sampler."
Frederick's of Hollywood's Web site, erected in 1996, now provides 8% of sales, and Frederick's figures that portion could surpass 20% in a few years. Victoria's Secret, by contrast, didn't go on-line until December 1998.
"They're making a big mistake," Frederick's president, Terry Patterson, says of her Victoria rivals. Some 45% of Frederick's on-line shoppers are newcomers rather than existing catalog clients. "That 45% was up for grabs," she says. "We're grabbing it first." |
