On-Line Transactions: Who Gets Paid

Above the Crowd
Deutsche Morgan Grenfell Technology Group
Newsletter Issue: 97-03

What is demand creation? We were originally introduced to the subject by Nick Moore, a professional thinker at Franklin Funds. In response to a previous ATC, Nick was arguing that an editorial web site like Amazon.com is especially valuable because rather than simply facilitating distribution, it actually incites demand. It may surprise you that we describe Amazon as an editorial site, but the real value is not simply in the list, but rather the reviews and customer testimonials that help you make a purchase decision. In this light, Amazon is not so much a retailer, but rather a value-added reseller. You could also think of it as an outsourced sales force for publishers and distributors.

In order to appreciate the subtle difference, you must first recognize that in today's hurried world, there is a real cost to product selection. We believe this cost takes two forms. First is simply the time and money spent gathering the data necessary to make the purchase decision. This includes the opportunity cost of the shopper's time, as well as the cost of physical travel. The second cost, which is harder to quantify, is the risk that the decision is made too early resulting in a disappointing purchase. All of the products that you used once and then threw in the closet fit in this category.

Another factor to consider is that by severely lowering the costs and time needed for product selection, you could actually increase demand. We believe that friction in the purchase decision process preempts many transactions. Consider the broad range of items that you know you need to buy, but simply never have the time available to do the proper amount of due diligence. Items we would include in this list include: investments, life insurance, automobiles, vacations, medical procedures, homes, and even hard goods such as furniture. The Web can help you easily find the right product to suit your specific needs, and therefore can actually help spur demand that may not have otherwise existed.

We believe that this implies that the Web sites which provide editorial content that can be used to help ferret out the proper purchase decision will be in the best position to capture transaction revenue. The only trick will be to provide the path of least resistance to purchase. In other words, make it extremely easy for the person pursuing the editorial content to execute the transaction once the optimal product has been identified. This analysis leads us to believe that sites like CNET (CNWK#@, $28), ZDNet, Auto-by-Tel, and QFN (Quicken Financial Network) (INTU, $ 27), are in the leading position to capture transaction revenue. We also believe that value-added demand creation is the key objective of Microsoft's (MSFT#, $100) "essentials" sub-section within MSN. Pay a visit to CarPoint, Cinemania, Expedia, Microsoft Investor, and Music Central and you will begin to understand what we mean. On each of these sites, editorial content leads to potential transactions which are eventually fulfilled by third parties which sometimes remain nameless. "MSN Essentials" is a modern day electronic VAR.

One might question why a third party product manufacturer would be so willing to give up incremental profits by allowing a third party to impose a transaction fee. We think the answer to this question relies on two separate questions, the first of which is, "is the demand that is created incremental or cannibalistic?" If the demand is incremental, any manufacturer would be more than willing to sign up this third party reseller just as they would with any other third party distributor. The only issue is guaranteeing that the cost to the manufacturer of fulfilling this demand allows for a reasonable return on investment. If the demand that is generated is cannibalistic, a second question must be posed -- "is the cannibalization controllable?" If the cannibalization can be controlled by perhaps having the manufacturer launch its own site or through an exclusive agreement elsewhere, than perhaps locking out the editorial based store will make sense. However, the most dangerous decision the manufacturer can make is to ignore the Internet entirely in an effort to protect its traditional revenue stream. There is no room for ostriches in cyberspace.

As much as this analysis points to new incremental revenue for Web-based content businesses, it should also sound a warning to traditional retail franchises. Many retail outlets specialize more in demand fulfillment than demand creation, where the core competency of the store is geographic location. Think about many of the stores in your neighborhood. Do you decide what to buy and then find the store closest to you? These are the stores in the most precarious position. Even when you consider items that you would never order through the mail, the Internet will help you find the store closest to you offering the best value. All of this implies that in the information age, strict distribution will become a tougher and tougher business.

A case in point may be Wal-Mart. Wal-Mart has established a wonderful on-line presence, but we are curious about how Wal-Mart will add value on the Internet. Wal-Mart is about convenience and value and locality -- all of which are aspects of demand fulfillment. If you need commodity products quickly and at a good price you visit Wal-Mart. However, we would propose that most shoppers head to Wal-Mart primarily to acquire an already determined purchase. Maybe the way to determine which stores are specialist at fulfillment is to ask whether or not shoppers enter the tore with a pre-configured list of items. This is not to say that people will stop shopping at Wal-Mart; as there is no need to buy cosmetics or paper goods over the Internet. However, we do believe that all non-commodity products will increasingly be purchased on-line. For some products, the process of "touch-n-feel" appraisal and examination will incrementally be replaced by the use of third-party critiques and customer testimonials.

There are two other forms of Internet transaction revenue that we believe are not necessarily equated with demand creation per se. The Internet allows people with similar interests to efficiently locate each other. We believe this allows buyers to aggregate their purchasing power and demand volume discounts (it could also lead to a spike in class-action lawsuits). The primary near-term "buyer-groups" are America Online (AOL, $ 36) and CUC International (CU, $24). By leveraging the size of their membership base, these companies can dictate preferential pricing from manufacturers, and then offer deals to their customer base that they could not find if they shopped on their own. Many on-line service executives (AOL, @Home, WebTV) are crowing about transaction revenues, and we believe that membership buying will be the easiest form of revenue for these service providers.

The last identifiable form of Internet transaction revenue is epitomized by Onsale ( www.onsale.com ). Onsale, which recently filed for an initial public offering
( http://www.sec.gov/cgi-bin/srch-edgar?Onsale ), is a virtual auction house. Customers can place bids on inventory, and after a predetermined time period, these products are then delivered to the highest bidder. Most of Onsale's products represent either discontinued or excess inventory, and therefore are not necessarily cannibalistic to the manufacturer. Onsale leverages the Internet's remarkable ability to help lost products find their destined owners in an efficient way. Adam Smith would have loved this company.

Of the three transaction models -- demand creation, group purchasing, and auction clearing -- we believe that demand creation has the potential to be the most profitable. For starters, group purchasing and auction clearing are typically associated with commodity-type products. In these environments, the Internet is really an agent of efficiency, squeezing marginal profitability out of the marketplace. Conversely, demand creation deals with adding value to the purchase decision by either reducing the time needed to find the product or increasing the "fit" to the customer's need requirements.

We cannot help but wonder why Consumer Reports has not established a presence on the Web. Perhaps the more important question is, "would they abandon their non-profit status?"

Above the Crowd is a bi-weekly publication focusing on the evolution and economics of the Internet. It is distributed through First Call, fax and email. To be placed on the distribution list contact your Deutsche Morgan Grenfell salesperson or send email to atc-request@abovethecrowd.com with the word "subscribe" in the body. As always, feedback is both welcomed and encouraged. ABOVE THE CROWD is a service mark of J. William Gurley.

Copyright Deutsche Morgan Grenfell Inc. 1997. All rights reserved. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. Any opinions expressed are subject to change without notice. Deutsche Morgan Grenfell Inc. and its affiliated companies and/or individuals may, from time to time, own, have positions in, or options on the securities discussed herein and may also perform financial advisory services, and/or have lending or other credit relationships with those companies. This material has been approved for distribution in the United Kingdom, to professional investors who fall within the exemptions contained within the UK Financial Services Act 1986 - Investment Advertisement Exemptions

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Above the Crowd
Deutsche Morgan Grenfell Technology Group
Newsletter Issue: 97-03
J.William Gurley
bill_gurley@dmgtech.com
+1- 415-614-1159

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Updated February 23, 1997