Too Few Pennies From Heaven
The Economist
July 1, 2000

 

Some people see the slump in dot.com share prices as marking the death of e-commerce. In fact markets are just valuing e-commerce firms more sensibly.

IF AMAZON.COM cannot cut it, can anybody? What a question. Shopping on the Internet is booming—this year consumer spending online may reach $100 billion globally. And Amazon is the best-known e-tailer of them all. Bricks-and-mortar behemoths are scrambling online to protect their markets from the Seattle firm’s relentless march; it is revered for its skill at winning and keeping loyal customers. Yet the talk has shifted from praising Amazon to burying it. On June 23rd Lehman Brothers issued a report suggesting that Amazon could run out of money within a year, crushed by debt and chronic unprofitability.

Because Amazon is the biggest and is often thought to be the best of the e-tailers (its founder, Jeff Bezos, was Time’s Man of the Year last year), the effect was immediate and frightening. Investors bailed out of the company, cutting 20% off Amazon’s already depressed share price. They also slashed a few more points off other bedraggled business-to-consumer (B2C) e-commerce firms, bringing some online retailers’ shares to less than 10% of their level of six months ago. Worse, the Lehman report, along with some lukewarm comments by the usual dot.com cheerleaders at other investment banks, capped a gradual reappraisal of Internet business models across the board. With the markets’ decline, the rules seem to have changed; profits, not potential, are king. The Internet’s period of grace is over.

For sceptics of Internet stock valuations, this is a time for rejoicing. Amazon has always held a special irritation for those left on the sidelines of the dot.com boom. It was the poster-child for new-economy profitless growth, having run up cumulative losses of $1.2 billion. Every time the grinning Mr Bezos announced that he had raised another few hundred million dollars for expansion, traditionalists shook their heads. Even when Nasdaq’s correction earlier this year pummelled other dot.coms, Amazon fell by less than most—and Mr Bezos changed his business plan not one whit. Now Amazon has been humbled, and markets have regained their senses: the emperor at last stands bare.

For other dot.coms, it was sobering. Amazon was, and is, the model e-tailer. Consumers love its vast selection and ease of use: with 20m customers, it is the leading online book, video and music retailer in every market it has entered, from America to Germany. After a series of acquisitions and alliances, it has evolved from a bookshop into a Wal-Mart-like superstore, selling everything from hand tools and garden furniture to cosmetics. Its innovations in personalisation and customer service are famous. Many Internet companies have emulated at least some of Amazon’s business practices, from its aggressive use of stock options to its deficit spending on an epic scale. If Amazon is broken, so will be many others.

So what are the lessons from Amazon’s humiliation? They are not as simple as they might seem. The easiest answer is that profits matter, but you get no argument from Mr Bezos there. He has always aimed for profits eventually; he simply chose to make hay while the sun shone, investing huge sums when market enthusiasm permitted it, with the aim of building a self-sustaining e-commerce empire by the time the inevitable market correction came. Yes, this was every other dot.com’s strategy, too (including many firms that had no business being in business at all); but Amazon was both one of the earliest and one of the most successful.

In the jungle  

A better answer is that the new mantra should be not just profits some day, but a clear path to profitability soon. Companies now need to show investors that, with every quarter, they are getting closer to making money; indeed, those going public today typically must persuade them that they will be in the black within 18 months of listing. In contrast, Amazon’s losses have grown with every quarter (see chart ). Yet, contrary to Lehman’s analysis, Amazon insits that it is on track to generate positive cash flow this year, well before it runs through its $1 billion in cash and liquid securities. And it is worth remembering that AOL, now such a stockmarket darling that it bought Time Warner, lost more money than Amazon over a period twice as long. If the business model looks right, markets will still make allowances.

 

The most worrying lesson might be that online retail is itself the wrong business model. This is the scariest conclusion of the Lehman analysis, and it echoes current gloomy market sentiment about B2C as a whole. Comparing such figures as inventory turns and gross margins, the Lehman report levels the ultimate insult: Amazon “is displaying the operational and cash flow characteristics of a normal retailer.”

These are fighting words. Even in their depressed state, Amazon shares trade at a huge premium to such offline competitors as Barnes & Noble, thanks to the assumed savings in virtual shelves and the growth opportunity inherent in the Internet. The Lehman analysis reflects the non-virtual realities of the business: as Amazon has grown, it has found that it needed to build and staff its own warehouses to ensure that it could ship goods quickly. Now its headaches resemble those of bricks-and-mortar retailers: too much inventory, razor-thin margins and expensive returns.

Yet the conclusion that there is no difference between e-tail and retail is overblown. For all its rapid growth, e-commerce is still in its infancy. To compare Amazon in a growth spurt with mature offline retailers is misleading. Not only will the e-commerce market swell to many times its current size over the next few years, increasing economies of scale for web retailers, but the spread of Internet technologies through the rest of the economy will also make it easier to do well. Amazon had to build its own warehouses and carry inventory risk because there was no other way to guarantee availability or to combine goods from different manufacturers or distributors in a single package. But in time logistics companies such as UPS, trucking firms and distributors will surely take over this role. Indeed, Amazon could eventually spin off its distribution centres to offer this service for other firms.

What is true, however, is that the more wired the world gets the easier it will be for traditional retailers to move online to compete with Amazon. Indeed, Merrill Lynch’s top Internet analyst, Henry Blodget (who made his name betting on Amazon), reckons that more than half the online retail market may eventually go to traditional retailers. But this would argue for them being valued more like a dot.com if they succeed in their transformation, rather than for Amazon being treated like a traditional retailer. It is not a rejection of the e-tailing business model; it is rather a recognition that successful models will be a mix of virtual and physical, something Amazon has already accepted.

Model plans  

The confusion and debate over Amazon’s business model is echoed to one degree or another across most Internet commerce. If B2C is most shunned on Wall Street today, that is at least partly because it is the most mature business sector: there is enough of it out there to reveal which business plans are not working (which is to say most of them). Other areas of commerce are simply too new and untried to reflect more than broad and relatively uninformed sentiment.

Thus, of the 1,000 or so business-to-business (B2B) marketplace, service or technology firms, fewer than 200 have revenues; and only 30 are publicly listed. Their market value has fallen across the board, some because their shares had reached impossible heights, others because the difficulties in getting many traditional firms to move to e-business and to work together are becoming more apparent. Other new initials such as business-to-employee (B2E) or business-to-government (B2G) are even worse, with virtually no benchmarks to go by. Trying to keep track of which Internet business sector is in and which out is a dizzying exercise.

What that means is that how a firm positions itself can also have a huge effect on its finances. Pity the B2C firm that is running short of cash and needs to tap the capital markets again: Boo.com, Toysmart and Violet are only a few of the prominent e-tailers that have been forced to liquidate over the past few months when their tap ran dry. Plenty of other B2C firms are in similar trouble and have laid off staff: Skymall, KBkidS.com, Beyond.com and Drkoop.com, for example. Make a convincing shift to B2B, however, and venture capital, at least, remains an option. Or somehow recast yourself as a wireless play, as Infospace, an “information infrastructure” firm, has done, and your money troubles are over—at least until that sector falls out of favour, too.

Because so many Internet business models are crafted mainly to attract funding, first through venture capital and then from the stockmarket, firms have been forced to redraft business plans on the fly in an endless game of chase-the-hot-sector. When B2C faded, some consumer firms scrambled to reposition themselves as B2B plays. The usual tack was to sell or license the technology that they had developed for their own site to other firms, or simply to offer it as a service for a fee. In the face of uncertainty over market directions, Wall Street wanted to see multiple revenue streams, and dollars from other businesses counted for more than bucks from punters.

In Britain, for instance, a site called Liv4now has been best-known as a raunchy Internet portal that combines fashion news with sex tips. But rather more fashionable these days is its more sedate B2B side, NEO1, a provider of online technology. In America, AskJeeves is a friendly consumer-search service that makes money from advertising, but its management is now pushing the software as a corporate-search tool; licensed versions can be found in AskMartha on the Martha Stewart home decorating store, and similar services on Microsoft’s and Earthlink’s sites. Likewise, Onvia and Works.com both once aimed to sell office supplies to small businesses; now Onvia is a B2B marketplace, while Works.com provides procurement services that lets bigger brands such as Dell and Grainger offer their own business-supplies superstore.

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