This is likely here but just in case:
July 23, 1998
Amazon.com, Others Face
The Big Internet Challenge
By GEORGE ANDERS
Staff Reporter of THE WALL STREET JOURNAL
Steve Riggio of Barnes & Noble Inc. and Rick Vanzura of Borders Group
Inc. are no strangers to price wars. But the two executives at the book-selling
chains, which rely heavily on a strategy of everyday discounts, wince when
they look at the fast-growing market of selling books over the Internet.
"Nobody is making any money," Mr. Riggio says. Bestsellers are discounted
30% to 40%. Powerful Internet search engines are enabling consumers to find
the cheapest price for any title in print, using just a few mouse clicks to
canvass dozens of vendors. "Right now," Mr. Vanzura says, "there are zero
incentives to maintain profit margins. All the incentives are to increase
revenue, even if that means doing business at a loss." Both say the Internet is
vital to their companies' future, but neither will predict when their on-line
ventures might turn a profit.
Meanwhile, the stock of the pioneer Internet
bookseller, Amazon.com Inc., has soared into
the stratosphere on the premise that its strong
revenue growth will eventually produce strong
profits. Wednesday, the company reported a
316% spurt in second-quarter sales to $116
million amid continued losses, this time
amounting to $21.2 million, or 44 cents a share.
Analysts don't expect it to post an annual profit
until 2001.
Soaring Capitalization
Nevertheless, Amazon.com's market
capitalization has climbed to a startling $6.4 billion, nearly the combined
value of Barnes & Noble and Borders, which together have sales 10 times
Amazon.com's.
Amazon.com's shares are being propelled by an Internet-stock frenzy that
may be the biggest speculative bubble since the biotechnology craze of the
early 1990s. The latest marvel is Broadcast.com Inc., a company in the easily
duplicable business of putting TV and radio broadcasts on the Internet; the
company went public last Friday at $18 a share, leaped to $62.75 that day and
finished Wednesday at $68. Such speculation often ends badly, and the
Internet boom may be especially vulnerable because of a crucial but widely
overlooked fact: The Net, by its very nature, is hostile to profit margins.
Most investors seem to believe that the Internet will someday produce
unusually rich returns because it is a cheaper way to reach customers, without
onerous expenses such as paper record-keeping, brick-and-mortar shops and
piled-up inventory. Yet the very things that attract users to the Internet --
speed, convenience and unlimited breadth -- make it treacherous for
profit-hungry merchants. With just a few keystrokes, consumers can play
business rivals against each other. That ability is turning the Net into a
relentlessly efficient market in which vendors will be hard-pressed to win,
and defend, any lasting competitive advantage.
Chaotic Battle Looming
If various merchants can't separate themselves from the pack, they are likely
to transform most on-line markets into low-margin commodity businesses.
Price cuts will become the main weapon in a chaotic battle for market share.
Hoping to avoid this profit squeeze, on-line companies are spending heavily to
try to create brand loyalty in cyberspace. They are pumping up ad budgets,
developing on-line communities of what they hope will be loyal customers,
and trying to make it hard for newcomers to go anywhere except their site.
Optimists hope that Internet branding will give companies the cachet -- and
pricing power -- of a Nike Inc. or a Gillette Co. But these initiatives have a
desperate tinge; if strong brands can't be created in a year or two, the
Internet's competitive forces will intensify.
Already, search-agent software is enabling consumers to hunt automatically
for the best deal. Meanwhile, companies are springing up to auction goods and
services on-line, further pitting merchants against one another. With hardly
any barriers to entry on the Net, any momentarily hot market spawns a glut
of Web sites, forcing some Internet publishers to discount ad rates as much as
40% in recent months.
A Vast Assumption
Investors are focusing on the explosive revenue growth of Internet commerce,
while assuming that profitability will surely follow. Overall, the Federal
Filings Inc. index of Internet stocks is up 168% this year. Among the
highfliers are a half-dozen companies with net losses, revenue of less than
$150 million a year -- and market values of at least $1 billion each.
Internet fever could rage on for months, as long as the overall stock market
stays strong, the industry's surge in revenue continues, its leading companies
don't run out of cash, and investors cheerfully regard operating losses as
"building the business." But if any of those conditions change, trouble could
beckon. The toughest test may come next year, when many analysts expect
Internet companies to be pushing toward profitability. If they are wrong, and
earnings remain a mirage, on-line stocks could be vulnerable to a punishing
sell-off.
Amazon.com's chief executive, Jeffrey Bezos, says its position is much
stronger than critics realize. He says the company already has absorbed many
of the big fixed costs of entering electronic commerce and, going forward, is
well-positioned to enjoy the Internet's low variable costs. "We think we can
have the lowest prices and the best service," he says, but adds that he doesn't
envy securities analysts trying to value the stock. "Our job is to create a
strong, lasting company," he says. "Their job is to figure out what it's worth
-- and when. That's probably a harder job."
At Yahoo! Inc., the leading operator of Internet directories, Jeffrey Mallett,
chief operating officer, says, "This is a pretty unforgiving business." Though
dazzled by how far the four-year-old company has come (Yahoo! is valued at
$10.6 billion, more than New York Times Co. or Washington Post Co.), he
says he doesn't gloat. Instead, he tells employees: "The Internet is like an
ocean. If you turn your back on it, it can crush you in a heartbeat."
Counseling Employees
In San Mateo, Calif., recently, David Peterschmidt, chief executive of Inktomi
Corp., took the unusual step of counseling, via e-mail, his 120 employees on
the stock market's wild ride. In five weeks, the stock of the Internet-search
software company has nearly quadrupled from its June initial-public-offering
price of $18 a share. Inktomi now has a market value topping $1 billion, even
though the company has yet to post more than $7 million in quarterly
revenue, let alone turn a profit.
"We are living in a big financial fish bowl," Mr. Peterschmidt warned. "The
least amount of news seems to trigger a big reaction around us." Have fun, he
added, but don't lose sight of the need to execute flawlessly the company's
business plan. "We have a lot of external obligations to meet to our customers,
our partners and ourselves internally," he wrote. "We cannot allow the
activity around our stock price to pull our focus away."
The tension between brand strength and relentless price-cutting is especially
intense in the business of trading stocks on line. At least 70 brokers have been
lured to the Internet, expecting paper-free transactions to be more profitable
for them. For most, however, any back-office efficiencies haven't helped the
bottom line much; they have been forced to keep slashing commission rates to
stay competitive.
A year ago, commission rates of $19.95 for trading 1,000 shares were
eye-catching. Now, though, rates of $14, $12 and even $7 abound. Only a
handful of firms have been able to keep on-line fees higher. Two of them,
Fidelity Investments and Charles Schwab & Co., already had trusted brand
names built up over decades of serving traditional customers. A third, newer
competitor, E*Trade Group Inc., is profitable but is being forced to spend
heavily to increase its visibility, while charging well below Schwab's prices to
get business.
Comparison Shopping
Consumers have increasing power to drive down prices in other markets, too.
Search engines run by Excite Inc. include a comparison-shopping service
called Jango, which scans a myriad of on-line vendors and finds the best
prices for books, compact disks or other goods. The Hotbot search engine run
by Wired Ventures Inc. offers a similar service, operated by Junglee Inc., of
Sunnyvale, Calif.
Anyone wanting to buy videos on-line, for example, can see quickly what a
dozen vendors are charging for the 1997 hit "Men in Black." A $21.99 quote
from CD Now Inc. doesn't look so good compared to the $20.99 at Reel.com
Inc. or the $20.45 at Video Online Express. And all those prices lose out to
the $16.99 asking price at Videoflicks Canada Ltd. -- matching the price at
Viacom Inc.'s Blockbuster stores. As on-line competition intensifies, whatever
savings retailers can achieve from paperless record-keeping are likely to slip
into customers' fingers instead of pumping up profit margins.
Yet thousands of merchants are trying to sell everything from Rachmaninoff
to radish seeds on the Internet. Some of the companies are offshoots of
traditional retailers, but many are closely held start-ups. They are spurred on
by optimistic forecasts from Internet analysts and even the Commerce
Department, predicting that on-line merchandising will soar from almost
nothing in 1995 to tens of billions of dollars a year soon after the millennium.
These vendors' business models are almost identical: easily searchable catalogs
on the Internet, payment by credit card, and home delivery by shippers such
as United Parcel Service of America Inc. Nearly all of them hope to emulate
Amazon.com's rapid growth in book-selling and its 12-fold leap in
stock-market value since going public last year.
Casualties Likely
"Some percentage of these companies just aren't going to make it," Yahoo!'s
Mr. Mallett says, even though he usually is one of the Internet's biggest
cheerleaders; after all, an abundance of on-line merchandisers means more
companies that want to buy advertising space on Yahoo!'s widely visited
directory pages. But as Mr. Mallett surveys all the companies trying to get
started in on-line commerce, he says: "A lot of them aren't really businesses.
They have a few people, an idea and a lot of optimism. That's it."
Hoping to stand out from the crowd, many Internet merchants have budgeted
as much as 70% of their venture-capital seed money for marketing. Their
goal is to create the Internet equivalent of a Fifth Avenue address in
Manhattan. That would help shield them from their many competitors;
consumers would flock to the most renowned Internet sites, convinced they
had found the best, without dallying to see what else might be available.
The leading search-engine companies are telling merchants that such
exclusivity can be had, for a price. These publishers are knitting merchants'
pitches into the content of "portals," the heavily trafficked sites where most
Internet users start their wanderings. Such access isn't cheap; some deals have
involved payments as high as $30 million over three years. But on-line
merchants are gambling that these outlays will steer more customers their
way, while making it harder to find their rivals.
In book retailing, Amazon.com and Barnes & Noble have been snapping up
premium positions on more than 20 of the most-trafficked parts of the
Internet. "Between them and us, virtually all the portals are locked up" for
books, says Mr. Riggio, who is Barnes & Noble's vice chairman. Other
on-line companies selling insurance, cars and groceries have been making
similar deals on a smaller scale.
For the search-engine and directory companies operating these portals, this
land grab in cyberspace has been great. Both Yahoo! and its top rival, Excite,
recently reported a tripling of second-quarter revenue, fueled in part by
premium-merchant alliances.
Unpredictable Changes
It's unclear, though, whether top billing on Internet portals alone will keep
competition at bay. Even as Yahoo! and Excite negotiate these deals, they are
promoting their Jango and Junglee services, which undercut the importance of
premium positioning. Moreover, the Internet community's penchant for
constantly creating more sites is likely to shift usage patterns unpredictably.
Merchants signing multiyear marketing deals with Internet publishers may
need to get out their checkbooks repeatedly to chase after Internet users'
mercurial browsing habits.
Meanwhile, merchants continue to buy "banner" ads on popular Web sites.
These can be clicked by viewers, who then are transported to the merchant's
own Web page. But in candid moments, merchants say many of those banners
don't always work as well as they had hoped.
Anne Benvenuto, senior vice president for marketing at Auto-By-Tel Inc.,
says only 1% to 1.5% of Web viewers are clicking on her company's car-sale
banners now. A year ago, she says, the figure was 2%, and two years ago,
3%. And executives at Garden Exchange Inc., an Internet garden-supply
company, say they are moving more of their ad budget away from the Net
and onto cable TV, which they think can be more effective.
With too many Web pages chasing too few advertisers, a glut of Web
advertising sites is developing, and some buyers are getting big discounts. Jack
Rogers, president of the on-line unit of First Mortgage Investors Inc. in
Plantation, Fla., says that a year ago, he paid $50 per 1,000 viewers for
banner ads on financially oriented sites, but now the price has dropped to $30.
Venture capitalists readily acknowledge that an electronic-commerce shakeout
is looming, making it likely that they have bankrolled far too many such
start-ups. Yet with the stock market giving hefty valuations to almost any
on-line business, they say they feel obligated to keep placing bets at the
Internet casino until they stop winning.
Extraordinary Bargains?
Meanwhile, many buyers of Internet stocks believe that even at today's prices,
they are acquiring what may someday be seen as extraordinary bargains.
"These could be like television in the early 1950s," says Bryan Grace, an
analyst at the Houston money-management firm of Vaughan, Nelson,
Scarborough & McCullough. Reviewing some stocks that his firm owns, he
adds: "Yahoo! could be similar to CBS. Amazon could be the Wal-Mart of the
Internet. That's what you need to believe to feel comfortable in these stocks."
Yet officials at Barnes & Noble and Borders have trouble figuring out how to
make their on-line stores produce even the meager margins of the real-world
book business, which average 2% to 4% of sales. They aren't backing down
from pushing their electronic sales, but Amazon.com's $6 billion market
value puzzles them.
Analysts are in the same boat. At San Francisco securities firm Volpe Whelan
Brown & Co., analyst Andrea Williams keeps re-running her numbers to see
whether Amazon.com can "grow" into its current stock-market valuation. In
her most optimistic scenario, the company will quadruple its revenue by 2001
and enjoy an improvement in operating margins. It also will be able to shrink
greatly its marketing commitments as percentage of sales, from the current
23% to at most two-thirds that level, without slowing sales growth. That
would let the company report annual earnings for the first time in 2001, she
says.
Ms. Williams says she has tried assigning Amazon.com a price/earnings
multiple of 100 three years from now. (The typical stock currently trades at a
multiple barely one-quarter as high.) If Amazon.com meets all those targets,
she says, it could trade at $85 a share. Wednesday, Amazon.com closed just
above $134.
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