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The Dot-Com Model—Profits Are Essential

Other dot-coms are improving their financial performance, indicating they are learning as the Net evolves. However, many are still struggling. They are not just facing off against each other anymore, they are competing against established businesses and traditional business models. The struggle to turn thin gross margins—the raw profit before paying salaries, advertising, warehousing, handling, and other overhead costs—into bottom-line profits is daunting for many. But the true power of the Net will not be realized until it is profitable. Productivity growth must be translated into bottom-line earnings. The potency of the technology is unassailable, but profits—or the promise of them—is vital. There is no future in losing money and making it up in volume unless increased volume really does reduce costs.

The industry is in a period of dramatic soul-searching agitation. Yahoo!, for example, began charging companies that list products on its online auction site. Amazon.com and Bluefly—an online seller of designer clothing—have raised prices and shipping fees. Barnes & Noble is selling downloadable books on its website and offering big royalties to lure authors.

Bertelsmann AG, the German media powerhouse, broke with the rest of the music industry to cut a deal with Napster, instead of suing it like so many of the other giants in the music industry. The trick was for Napster—with Bertelsmann—to come up with a way to distribute music online without violating copyright laws. Napster announced in early 2001 that it would be charging a monthly subscription fee to reimburse royalties to recording companies—a significant shift from its free song-swapping beginnings. Napster lost an appeal to overturn a lower court ruling that it must stop offering music under copyright, so it stayed alive by screening the file names that passed through its computers, blocking the exchange of pirated tunes. However, its users have delayed this effort simply by using aliases for band names. Meanwhile, Napster and many other companies, including the record labels, have been scrambling to create a digital rights management system that would be convenient and allow payment. If the music industry pushes Napster too hard, its 50 million clients will go underground, using copycat programs, technology, and sites. Some alternatives are decentralized, unlike Napster, so they couldn't be shut down with a single power switch, making court orders harder to enforce. This fact may buy Napster time to "legitimize" itself in the eyes of Recording Industry Association of America.

Companies like Bertelsmann recognize that the old business model is no longer viable. It is working hard to develop an innovative new one. But this isn't so easy. As many unprofitable dot-coms have found, people underestimate how long it takes to come up with a new business model that works—for the consumer and for the shareholder.

Some Budding Attempts

Consider, for example, one of the Net's better-known brands, Priceline.com, which made news in late 2000 when one of its highly publicized lures from the Old Economy, Heidi Miller, former CFO of Citigroup, fled along with other key executives after only a brief stint. Priceline's "name-your-own-price" or "demand collection" system is one of the pioneering ideas in e-commerce. Yet the company has lost millions of dollars and its stock sank from a high of nearly $96.00 on March 13, 2000, to a low of $1.31 at year-end. Its core business has been selling airline tickets, but it moved beyond that with little success, as the name-your-own-price system seemed to put off consumers.

Most importantly, Priceline has trouble turning a profit even in the airline-ticket business, because its expenses are so high. Priceline buys tickets for unsold seats that the airlines heavily discount, then marks them up to earn a gross margin of 9 to 12 percent, compared to only 5 percent for offline travel agents. The rub is, the company has poured its gross margins from the airline tickets, as well as hundreds of millions of dollars raised in its stock offerings, into largely failed forays into other product lines. Also depleting cash were their expensive computer systems, high-priced software programmers, and glitzy ad campaigns featuring William Shatner.

Priceline could be profitable tomorrow if it cut costs and focused on the core airline-ticket business, but even there it is running into trouble. The airlines themselves want a piece of this action. Like so many other pure-play dot-coms, its success—at least in terms of revenues—has lured the traditional players into its markets. A number of the major airlines backed a competing start-up, Hotwire.com, that sells cheap airline seats. While Hotwire doesn't tell customers up front which flight they are taking or how many connections they will need to make to get to their destination, it does reveal the price of the ticket, rather than requiring the consumer to bid. Many consumers are put off by Priceline's complicated system that requires a user to guess what the ticket will go for, place a bid, and then check back later to see if the bid was accepted. Hotwire may well force Priceline to reduce its gross margins. Priceline is still struggling with its pricing model, assuming that the airlines will continue to give it first crack at cheap seats because it does not reveal the true price of the ticket, theoretically protecting them from having to match the price for other customers.

Priceline, like so many other dot-coms, is in a make-or-break period. Execs are reconsidering their pricing model and their nontravel businesses. Many analysts are skeptical, suggesting their best option may be to merge, be taken over, or go private. In the meantime, the cash is running out.

Other Examples—Bluefly and Webvan

Bluefly's blueprint was similar to so many other dot-coms: Undercut the prices of the traditional bricks-and-mortar businesses and make up the difference through the efficiencies and reduced-cost structure of a Web-only business. In Bluefly's case, the product is designer clothing; it calls itself "the outlet store in your home." For Bluefly, like so many other dot-coms, the efficiencies did not surface. Indeed, in many ways its costs are higher than for traditional retailers.

In this business, profit begins with markup, the amount retailers charge above what the goods cost them wholesale. Bluefly's strategy was to keep the markup low to attract shoppers and to assure they return. This certainly was good for the Bluefly customer, but hell for the Bluefly shareholder. Bluefly's gross margin was only 28 percent, well below the more typical 48 percent at Lands' End (which sells its own private-label merchandise at much bigger markups) and the 40 percent at Macy's parent, Federated Department Stores Inc. After expenses, Bluefly has been losing millions.

The thinking was that without the traditional costs of stores, clerks, and catalogs, the online outlets could thrive on very thin profit margins that would drive their unwired competitors out of business. But this business model did not work, not for eToys, Pets.com, Garden.com, Furniture.com—or for Bluefly. Taking orders directly from customers, whether by phone like the catalog companies or by the Net, requires expensive computer systems underpinned by customer-service representatives. It also means operating a warehouse or paying someone else to do it, keeping a ready supply of the most popular items, handling the items one by one, and shipping them at often great expense. The logistical problems can be enormous. And then there is the high rate of returned merchandise, much higher than that for store-based shop-ping where the items can be touched, seen, and tried on. This is why most catalog companies sell largely their own brands for which the markup can be much greater. Even traditional retailers such as the Gap or department stores like Sears, Saks, and Bloomingdale's intersperse their own brands throughout the product lines and pitch them heavily.

Bluefly and the similar dot-coms' only choices are to raise markups and to reduce costs. This means they have to get goods for less and/or charge more to the customer. Suppliers do discount larger volumes of goods, so scale is important. Fulfillment costs also fall as volumes rise. As well, return rates can be reduced with better information and descriptions on the site. But, even with all of this, analysts feel that Bluefly and the others must raise price to achieve the 38 percent gross profit margin some say is necessary for an online company to prosper. This is tough because shoppers do a lot of price comparisons online—more than in the stores—because it is so easy. This is one of the beauties of the Net, at least for customers. This enormous price pressure was the death knell for many dot-coms. But consumers also like the convenience, selection, and service of the Net, and they will be willing to pay for it. For example, when Bluefly raised its shipping charges in the summer of 2000, there was no customer backlash.

But, clearly, the challenges are real for the online retailers. Volumes are crucial, but growing sales require costly advertising and rock-bottom pricing. Repeat orders and big orders are the key. Online grocer Webvan has found it impossible, thus far, to turn a profit on the average order. The margins are just too thin and the costs of delivery and handling are too high for most items. That is why the traditional dairies and grocery stores gave up their home-delivery services years ago. Other than in high-income, densely populated areas like Manhattan, these services disappeared in the 1950s. (Remember the milkman?) Also, consumers have to plan ahead to order online. For items like groceries, many will want to continue to just pop into the store when the need arises.

There is demand, however, for the convenience and service of online (grocery) shopping. With the surge in busy two-income families with young children, it is a real lifesaver for many professional women. A frequent-buyer program might help to lock in customers. But the beneficiaries of this 1950s-style convenience are going to have to pay for it, and the Webvans of the Net are going to have to make sure their service, product quality, and selection are consistently up to snuff. These sites are in the process of widening their product offerings to include a growing array of high-margin products, such as cosmetics and nonprescription drugs. They could also act as the "last-mile delivery" operation for other Internet and traditional merchants—such as dry cleaning, photo finishing, and book and flower delivery.

For Webvan, time is running out. It was founded by Louis Borders, the reclusive mathematician who started the eponymous bookstore chain. He focused exclusively on building a complex inventory management and distribution system, which turned out not to be worth the money. With operations in ten cities, the company burned through $100 million in cash a quarter. It was also overzealous in its expansion plans, setting out to enter twenty-six cities long before it had proved that its model worked. Webvan abandoned these plans, but the jury is still out. The stock price fell 99 percent from its high. If Webvan fails, it will be by far the biggest financial disaster the Internet has yet seen.

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