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E-tailers and Space Invaders

Some thought Internet startups would wipe out whole sectors of traditional bricks-and-mortar firms. But old-economy companies are carving out their own presence, and some may become the biggest winners on the Web.
Randy Myers, eCFO
April 15, 2000

Barely a year old, Drugstore.com (www.drugstore.com) has been hailed as the biggest and most successful online pharmacy on the Internet. Since the Bellevue, Washington, startup opened for business in February 1999, its revenues have climbed steadily. For the fourth quarter of 1999, Drugstore.com recorded prescription sales of approximately $10.4 million. Total sales for that quarter topped $18 million, a 52 percent jump from the previous quarter. All told, Drugstore.com has served nearly 700,000 paying customers in its first year of operation.

Now compare those numbers with the recent performance of 100-year-old Walgreen Co. (www.walgreens.com), an $18.6 billion-in-revenues drugstore chain with nearly 3,000 bricks-and-mortar stores in the US and Puerto Rico. In October 1999, Walgreen launched its own Internet-based pharmacy. According to Jeffrey Rein, who oversaw the rollout, the drugstore's online operation is logging daily prescription sales that — if they hold — will work out to a quarterly run rate of about $7.4 million. Meanwhile, new customer registration at Walgreens.com is growing by about 25 percent each month, with the site handling 2,000 prescriptions each day. At that rate, Walgreens.com will fill more than 700,000 prescriptions in its first year of operation.

Whether Walgreens actually surpasses Drugstore.com remains to be seen. But the fact that the venerable retailer is even catching up to its virtual rival speaks volumes about the outlook for traditional companies in the brave new world of E-commerce. Until recently, consultants and industry gurus predicted that Internet startups would wipe out whole sectors of traditional bricks-and-mortar competitors. From automobiles to zippers, the experts said, anything that could be sold in a store could be sold cheaper, faster, and better on the Web. The E-commerce revolution, they argued, belonged to the dot-coms.

But a funny thing's happened on the way to the revolution. Rather than cede cyberspace to their E-tailing competitors, old-economy companies have begun to fight back, carving out their own presence on the Internet. In fact, many observers are now suggesting that clicks-and-mortar operators will be some of the biggest winners on the Web.

"There are certainly dot-com companies that have unseated traditional companies," concedes Mary Modahl, vice president of research for Internet consultant Forrester Research Inc., in Cambridge, Massachusetts. "But where my thinking — and the thinking of a lot of other people — has shifted is in the notion that traditional companies would never or could never respond (to the online threat)."

Admittedly, some outfits haven't fared so well in the virtual universe. When Levi Strauss tried to sell its jeans online, its longtime retailers raised such a ruckus about losing business the company eventually shelved its plans. And managers at investment banking giant Merrill Lynch steered clear of online stock selling for years, apparently worried in part about a backlash from the company's army of brokers.

But other bricks-and-mortar businesses have found a home in cyberspace. Says Modahl: "We can already see traditional companies that have done a tremendous job of seizing opportunities on the Internet."

That seizing has revealed a surprising truth about competing in the virtual world. When an established business moves into cyberspace, it brings its brand name, its existing customer base, and its physical network of shops and distribution centers. Often, this puts the company light years ahead of its pure dot-com competitors.

Catalog operators have an even bigger advantage. They're already accustomed to making sales and fulfilling orders without stores. "It's been proven time and time again that when a major retail brand comes online, it immediately sees enormous traffic," says James Vogtle, director of E-commerce research in the Toronto office of Boston Consulting Group, a management consulting firm. "By contrast, pure-play E-tailers are spending enormous sums of money trying to build a brand."

Wising Up
That kind of heavy lifting has sapped the resources of more than a few E-tailing startups. Online music destination CDnow, for one, reported a 154 percent increase in revenues and a 181 percent jump in traffic in the fourth quarter of 1999 — both records. But the online retailer still lost $34 million, and CDnow management intends to slash the company's marketing expenses. "If you're not already a Yahoo or an Amazon.com, you're looking at a lot more than $100 million to establish your brand name on the Internet," explains Modahl. "That's an enormous hurdle — even for companies that are swimming in venture capital."

Bolstered by marquee brand names, traditional companies have been able to stake out entire quadrants of cyberspace. Charles Schwab (www.schwab.com), the world's largest discount brokerage firm, is now the world's largest online broker — outpacing pure E-commerce rivals, such as E-Trade (www.e-trade.com) and privately held Datek Online (www.datek.com). Other financial services firms, including mutual fund giant Fidelity Investments (www.fidelity.com); investment bank Donaldson, Lufkin & Jenrette (www.dlj.com); and commercial banks Wells Fargo (www.wellsfargo.com) and Bank of America (www.bankofamerica.com), have made huge inroads on the Web.


Among the retailers, Lands' End (www.landsend.com), J. Crew (www.jcrew.com), L.L. Bean (www.llbean.com), and Victoria's Secret (www.victoriassecret.com) have managed to duplicate their success in the catalog business on the Internet. Dell Computer (www.dell.com) has taken its direct sales approach into the virtual world — and flourished. KBkids.com (www.kbkids.com), a joint venture between toy retailer Consolidated Stores Corp. and children's product E-tailer Brainplay.com, has generated sizable sales since launching last July.

And of course, there's $3.3 billion Barnes & Noble (www.bn.com), the biggest land-based bookseller in the US Although it may rank second to rival Amazon.com (www.amazon.com) in online book sales, the retailer's online joint venture with media giant Bertelsmann AG, Barnesandnoble.com, sold more than $82 million in merchandise in the fourth quarter of 1999. Combine the dot-com's sales with those rung up at Barnes & Noble physical stores, and the clicks-and-mortar duopoly moves far more books than Amazon.com.

This does not mean that traditional businesses are waltzing their way through cyberspace. Far from it. Old-economy companies face their own set of problems when setting up online businesses. At the top of the list: In most states, bricks-and-mortar operations are required to charge sales tax on customer purchases. Dot- coms, on the other hand, get off scot-free — assuming they don't have a physical presence in a tax jurisdiction in which customers reside. Typically, the tax break translates into a 5 percent to 8 percent discount on merchandise huge drawing card for online retailers. In fact, studies show that consumers would be far less likely to shop online if E-tailers were forced to levy sales tax on transactions.

Beyond taxes, Wall Street has shown a seemingly limitless capacity for backing pure-play E-commerce ventures — often with little regard for how long it might take these E-tailers to actually turn a profit. Conversely, investors have refused to reward established companies that have diverted dollars to an Internet initiative, sometimes punishing companies for daring to disrupt earnings. "When you are a bricks-and-mortar company looking to break into E-commerce," observes Nancy Babine-Kucinski, president and chief operating officer for Lids Corp., "it's harder to spend money that doesn't reward you right away than it is if you are a startup that gets rewarded for losing money."

Lids (www.lids.com), a privately held hat retailer, operates about 370 stores in 46 states. The company launched its Web site in 1999. Although the site is doing well, Lids still has a lot more milliners than millionaires at its headquarters in Westwood, Massachusetts. "If you are a physical company," says Babine-Kucinski, "investors look at your financial statements in a very structured manner."

Absent the reward for investing in their online stores, established businesses tend to spend less on them. "We're finding that dot-com companies are spending nearly twice as much on their sites as traditional companies," says Forrester's Modahl. "And that has largely to do with the two markets that have developed on Wall Street — one for traditional companies, and the other for dot-coms." The numbers don't lie. Through the first two months of 2000, the S&P 500 fell 7 percent. Meanwhile, the tech-heavy Nasdaq Composite index rose 15.4 percent.

Patricia Seybold, head of the Patricia Seybold Group, an ebusiness and technology consultancy, believes investors prize online customers more than offline shoppers. Consider retailer Wal-Mart Stores (www.walmart.com). The Bentonville, Arkansas, department store giant reported sales of $165 billion in 1999. That's 100 times the revenues generated by Amazon.com, a pure-play E-tailer Yet Wal-Mart's market capitalization is only 10 times that of its online rival. "Amazon.com knows a hell of a lot more about its customers than Wal-Mart does," argues Seybold. "And that makes its customers much more valuable."

But managers at traditional businesses are starting to wise up. When Wal-Mart launched a vastly enhanced E-commerce Web site in January, the company announced that the site would be run by a newly formed company, Wal-Mart.com Inc., based in Palo Alto, California. Wal-Mart Stores owns a majority stake in the new enterprise. By separating the operations, Wal-Mart can take advantage of the moratorium on E-commerce sales tax. What's more, a separate dot-com business will be a far easier story to sell to Wall Street than a clicks-and-mortar operation.

Pricey Neighborhood
Christopher Dodds knows firsthand just how fickle investors can be when a traditional company embraces the Internet. Dodds is CFO at Charles Schwab (www.schwab.com), which rolled out Internet trading capabilities for investors back in 1996. At the time, the company got little adverse reaction from the stock market for its bold move. Mostly, that was because Schwab made the service available only to consumers who opened a separate "eSchwab" account. Customers who wished to continue using Schwab's telephone or branch office services had to do so through their regular accounts — which carried higher commission rates. But in January 1998, Schwab began offering online trading — lower commissions and all — to every customer.


Investors, worried that Schwab's revenue growth would slow, started selling. A yearlong rally in Schwab stock came to an abrupt halt. For the next eight months, Schwab's share price went virtually nowhere, even though the brokerage sector as a whole continued to post solid gains. But as it became apparent that Schwab's Internet business wasn't dragging down revenues, investors sent the brokerage's share price tracking upward. Today, Schwab processes about three-quarters of its customers' trades over the Net.

For Dodds, the whole E-commerce initiative was instructive. "Even if a company has a well-thought-out strategy, it sometimes takes a little time for the market to digest it," he notes.

While managers at traditional businesses like Charles Schwab have learned they can compete in cyberspace, they've also discovered it's a high-rent district. Web launches, particularly for large companies with broad product mixes, can be costly. "It's proved to be much more expensive than anybody initially thought," says Vogtle. "For a viable, world-class site, it can easily run into the tens of millions of dollars."

And the price tag keeps going up. When Schwab built the first iteration of its Web site in early 1996, company management kept the project in-house. The cost was thought to be a meager $1 million, although Schwab wouldn't confirm the figure. Last year, Walgreen spent a whopping $20 million to launch its online store.

Moreover, getting a site up and running is only the beginning. "Often, you have to count on spending every year what you spent in the first year," says Seybold. Dodd's experience certainly bears that out. Initial demand for Schwab's online services was so great the company had to add hardware — from 3 servers in April 1996 to 160 by May 1998. By mid-1999, barely three years after launching the virtual service, Schwab was running 800-plus Web servers. In 1999, Dodds says Schwab spent 15 percent of its $4 billion annual revenues on information technology.

Faced with skyrocketing demand — and thus skyrocketing expenses — some companies might be tempted to cut corners. But as several online retailers painfully discovered during the 1999 Christmas season, it does not pay to skimp on the infrastructure of a virtual store. Several virtual merchants were unable to deliver products until after the holiday season, something that didn't endear the E-tailers to customers. "Companies have learned that just being on the Web is not a strategy," says Cheryl Shearer, IBM's London-based global services director for ebusiness. "Being there is just visibility. Being there successfully means the back end has to work as well as the front end."

That bodes well for traditional companies that are moving into cyberspace, argues Rich Leggett, e-solutions analyst for Friedman, Billings, Ramsey & Co., an investment firm based in Arlington, Virginia. "Traditional companies have a long heritage of delivering goods to customers," Leggett says. "All they really have to do now is change their channel of distribution."

Clicks with Bricks
But CFOs at some dot-coms don't necessarily see it Leggett's way. Robert Swan, CFO at online grocer Webvan, believes certain businesses are just better suited to a pure dot-com approach: "Our model enables us to operate with less real estate as a percent of sales, and fewer people," he explains. "That means we will enjoy three times the profitability of traditional bricks-and-mortar grocers."

Webvan, which already services customers in the San Francisco area, is planning to expand its operations across the United States. Despite the high visibility of large grocery chains, Swan thinks established food retailers face an uphill battle going from bricks to clicks. "For traditional food retailers to catch up to us in a clicks-and-mortar environment," he argues, "they need to make a significant capital investment in technology while operating on a business model that already has rather slim profit margins."

Nevertheless, a number of pure dot-coms appear to be embracing the clicks-and-mortar strategy. Drugstore.com (www.drugstore.com), for example, has partnered with Rite Aid (www.riteaid.com), a drugstore chain with some 3,800 stores in the United States. The partnership will make it possible for Drugstore.com customers to order prescriptions online and then pick them up at Rite Aid outlets. And computer maker Gateway (www.gateway.com), a pioneer in the telephone and Internet direct sales channel, has recently been building a network of stores to complement its online operations.

Even E-Trade (www.e-trade.com), one of the most successful online brokerage companies, has opened a walk-in office in New York, and it plans to open another. What's more, in early March, the company announced it was going to buy Card Capture Services, an operator of about 8,500 automatic teller machines. The acquisition would give the high-profile E-Trade a substantial bricks-and-mortar presence.

Of course, as with all commercial revolutions, the battle for cyberspace will ultimately come down to customers. And that's why some industry watchers are now placing their bets on the hybrid. "I fundamentally believe that the clicks-and-mortar companies will win this war. It will be the model that will dominate," insists Boston Consulting's Vogtle. "Quite simply, it's just a better customer experience."


Randy Myers is a contributor at CFO.

Turning Japanese

If the current strategy for most dot-coms sounds vaguely familiar — concentrate on market share more than return on capital, partner with dozens of companies, and obtain plentiful funding — you're on to something. The truth is, the business plans for many Internet startups read like a chapter straight out of the recent history of Japan Inc.

Granted, it would be an oversimplification to say that a single-minded quest for market share was solely responsible for the Japanese economic miracle following World War II. Companies like Sony, Matsushita, and Toshiba also raised quality control to new heights and were masterful at bringing products to market quickly. But capturing market share — almost to the exclusion of profitability — was a crucial component in the success of many Japanese companies. In fact, in the 1980s managers at a number of US corporations complained bitterly that Japanese automakers and electronics companies were unfairly dumping products in countries to gain market share.

These days, pursuing market share is practically the national pastime of e-America. The question is: Will the relentless drive for market share by Internet businesses help fuel an economic miracle like the one Japan enjoyed from the 1950s through the 1980s? Or will it lead to the sort of upheaval that eventually struck Japan in the 1990s?

According to Yoshinori Ando, vice president and managing director for management consulting firm A.T. Kearney in Japan, there are important differences between post World War II Japan and E-commerce at the onset of the third millennium. "Companies in Japan were supported by the Japanese banking system, which provided them with consistent and stable financing to go and chase market share," Ando notes. "As long as those companies were at least marginally profitable, the banks continued to provide that financing."

Conversely, funding for US Internet companies is being supplied by the capital markets, which tend to be volatile. "Right now, the capital markets are willing to let Internet companies continue to make these high investments," Ando says. "But whether they will continue to do so indefinitely is a question yet to be answered. And I'm not very optimistic about that."

Certainly, investors have begun to question the exalted status bestowed on any retailer whose name ends with .com. As of press time, the eTailDEX index of E-commerce stocks tracked by investment bank Robertson Stephens was down 37 percent from its 52-week high, even after gaining 51 percent since last August. Share prices of Internet technology stocks, meanwhile, have continued to rise.

Ecommerce experts say some investors are starting to worry about the parade of parentheses on the financial statements of many dot-coms. "We're still in a very frothy market, but I think that by the end of this year and certainly by the first quarter of next year, it's going to come time to count the chips for E-commerce companies," says Mary Modahl, vice president of research at Internet consultant Forrester Research Inc. Modahl says the reckoning for E-tailers may come in January. "After the Christmas season, people are really going to start to take stock. Are these companies profitable or aren't they? Some companies will not be able to raise more financing."

But James Vogtle, director of E-commerce research for Boston Consulting Group, cautions against becoming too shortsighted when demanding better bottom-line performance from dot-com startups. "It will only become more expensive to acquire customers online," Vogtle says. "So why not try to build your business now instead of forcing yourself into profitability immediately?"

Some industry watchers aren't so sanguine. "Any American firm knows there's going to be a day of reckoning," insists Richard Linowes, assistant professor of management at the American University's Kogod School of Business, in Washington, DC, and longtime student of Japanese business. "What we might call the Japanese mistake may yet play out for Internet companies."

Some observers point out that managers at many Japanese companies are just now focusing on E-commerce. Ironically, Linowes says the late start may prove beneficial. If established E-tailers in the US hit a rough patch over the coming months, he believes startup dot-coms in Japan may be able to coin it off mistakes made in the United States. —R.M.

Mapping the Universe

Typically, an E-commerce initiative will be championed by a company's CEO. But considering that a corporate Web-site rollout can cost upward of $30 million (depending on the business), you can lay odds the company CFO will be involved in the project somewhere along the line.

Management relies on the finance chief mostly to accurately gauge how well the company Web site is doing. But for many CFOs, assessing the performance of an online shop requires a different set of metrics. Besides getting a fix on the number of unique customers at a site, CFOs must measure how much time each customer spends there, if the purchaser is a repeat shopper, and if buyers are visiting the sites of rival E-tailers

Robert Swan, CFO at online grocer Webvan, knows all about it.

"I not only participate in the formulation of strategy and development of the operating plan," he says, "but also develop the metrics internally that will allow us to allocate and align all our resources so that we can achieve our objectives." Swan notes that the finance department at Webvan tracks the number of active accounts at the company, the percentage of repeat customers, and their average order size.


Identifying profitable customers is not the end of the job, however. E-tail operators must attempt to retain those customers. Toward that, Swan says Webvan monitors the performance of the distribution and delivery of goods by the company's couriers. That performance includes merchandise put-away rates, order pick rates, courier deliveries per hour, as well as the time it takes couriers to go from one point to another. "Our business model is not just based on grabbing customers," he says, "but on effectively picking and delivering to them in an efficient manner."

Beyond pulse-taking, CFOs at clicks-and-mortar companies must assess whether an online operation is delivering full value to shareholders. Finance chiefs must constantly evaluate whether it's prudent to hive off online operations — often a tough call. "While it makes sense from an investment standpoint, you need to make sure that the customer experience is seamless between the two distribution channels," notes Patricia Seybold, head of the Patricia Seybold Group consulting firm. "For example, if the Wal-Mart on the Web bore no relationship to the Wal-Mart in the physical world, it wouldn't make sense."

Mary Modahl, vice president of research at Forrester Research, says one way to approach the spin-off question is to look at how closely the traditional and online ventures are related. "If you're in a situation in which some traditional part of your business will never be done on the Web — maybe you run a chain of amusement parks — it often makes sense to split off the E-commerce business," she advises. "But when you're essentially serving a single market, it's better to be integrated. If you're a catalog marketer, it's certainly not a good idea to have a separate E-commerce business." &mdash R.M.

Virtual Realities

Although starting up an E-tailing operation often makes good business sense, it can make for a bear of a rollout. Just figuring out the size of the operation can be nettlesome. "One of the hardest things is to determine the scale of the site for your launch," says Nancy Babine-Kucinski, president and COO for Lids Corp. (www.lids.com), a hatmaker that spent $2 million to launch its Web site last year. "There are still many unknowns in this medium, so you need to be specific up front about what you want to accomplish, or you'll waste lots of money."

For instance, people may underestimate the cost of meshing a Web site with a company's existing technology, says Patricia Seybold, of Patricia Seybold Group, an E-commerce consultancy. She says the integration of systems can comprise up to 80 percent of the technology bill. "That was the hardest part for us," says Jeffrey Rein, who oversaw the launch of Walgreen's consumer Web site last year.

At Lids, the new Web site connects to the company's demand-chain and financial systems. "When someone places an order on our site, it goes into our merchandising system, which checks to see that we have the product in inventory, notes it's being taken out of inventory, rolls the transaction through our financial systems, and sends an electronic order to our warehouse," where an employee picks up the merchandise, electronically creates an address label, and ships it. "It's a paperless process totally integrated into everything else we do," Babine-Kucinski says.

Such integration isn't cheap. Re-engineering processes to work in the virtual world can be a significant expense, notes Cheryl Shearer, global ebusiness executive for IBM (www.ibm.com). "You're learning to run yourself in a different way," she says. "You have to change processes; write them up; train people; and then tell everyone who uses your E-commerce system, including suppliers and customers, how to use it."

Stepping on toes within the organization can be just as problematic. Babine-Kucinski says Lids had to make some changes in its operations to accommodate its E-commerce initiative — like revamping the bonus formula for its 3,000 salespeople. If Lids hadn't changed the plan to incorporate sales over the Web, she says the hatmaker ran the risk of having its staff work at cross-purposes to the company's E-strategy. —R.M.




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