Technology

The Dot-com Before the Storm

Amid market turbulence and a devastating cash crunch, CFO Steve Schoch struggles to keep eToys on course.
John GoffSeptember 15, 2000

Scene:

The eToys Inc. offices in Santa Monica, California, just a stone’s throw from Hollywood — if the stone’s encased in a missile. The headquarters of the online toy retailer is the new-economy equivalent of an acid trip. One receptionist morphs into another receptionist. They look exactly the same, but different. Both cheerily answer the phone while seated in front of a giant, eight-foot-high Etch-o-Sketch. The backs of chairs seem to stretch to the ceiling, as if they were made out of saltwater taffy. Senior managers, clad in polo shirts and jeans, hand out business cards with their baby pictures on them. Conference rooms carry the names of cartoon characters and beloved pets. Mechanical, tail-wagging dogs roam the hallways. Mazes lead into other mazes. Everywhere you look, toys and more toys and bright cheery smiles.

Exterior:

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Back in the real world, things are a bit more grim. As in most quadrants of cyberspace, it’s tough times in toy town of late. Several online toy merchants, including Red Rocket, Toy Time, and the Disney-backed Toysmart, have recently gone belly-up — if such an act is possible in a virtual universe. Shares of eToys common stock has taken a particularly nasty beating, plummeting nearly 90 percent from its high just 11 months ago. And the company’s losses continue to mount. In fiscal 1999 — the first year eToys had any revenues to speak of — the online merchant lost $28 million on revenues of $30 million. In FY 2000, which ended on March 31, the loss was $190 million on revenues of $151 million. Analysts predict the startup will continue to bleed red ink, with losses topping $180 million in 2001.

Steve Schoch knows these figures by heart. A former assistant treasurer at Walt Disney, Schoch signed on as CFO at eToys Inc. (www.etoys.com) last January, only three months before the children’s online retailer went public. “It took all of five minutes to decide to take the job,” recalls Schoch, a boyhood pal of eToys redoubtable founder Toby Lenk. While industry watchers say Schoch had a hand in the turnaround at Euro-Disney, getting the French to embrace a rodent was child’s play compared with what the CFO now faces at eToys.

Amid a suffocating capital crunch — a shortage touched off by the massive stock market sell-off in the dot-com sector — Schoch must scarce up enough capital to keep eToys going. The widespread lack of cash in cyberspace has shut down dozens of E-tailers of late, including Hardware.com, UK-based Boo.com, and the no-longer Living.com. Says Michael Fleisher, president and CEO at research firm Gartner Group (www.gartner.com): “The days of investments in cool Internet sites with thin business strategies are over.”

That puts Schoch on the spot. To plump up the company’s operating capital, the CFO will have to get a handle on eToys’ advertising spend — currently 38 percent of the E-tailer’s budget. But such reining in must not do mortal damage to the brand-building that’s crucial to the company’s survival. “Cutting marketing spend can have a catastrophic effect on the revenues and longer-term market position of dotcoms,” notes John Soden, a partner at PricewaterhouseCoopers Business Recovery Services (www.pwcglobal.com/uk/eng/about/svcs/brs/index.html), in London.

But keeping eToys in cash isn’t Schoch’s only concern. The CFO must also help the E-tailer do battle with deep-pocketed, land-based behemoths like Wal-Mart and Kmart, which are only now moving into the E-tailing business. “The bricks-and-mortar companies will be strong competition,” predicts Seema Williams, a senior analyst at Forrester Research (www.forrester.com). “They sat out the first couple of innings.”

Interior:

Surprisingly, the 41-year-old Schoch does not appear unnerved by the darkening clouds. Indeed, the eToys CFO displays a remarkable calm for such turbulent times. “In a sea of turmoil, Steve Shock is a steadfast warrior,” proclaims Lenk, eToys CEO. “He’s absolutely unflappable. He’s the Ice Man in Top Gun.”

Much of that confidence stems from Schoch’s belief that, generally speaking, E-tailing is best left to E-tailers. Contrary to conventional wisdom, Schoch insists that barriers to entry into the online world are high — a virtual reality he thinks brick-and-mortar operators will soon discover. “The skills to run an E-tail operation have only been developed over the last three to four years,” Schoch notes. “We are well ahead of the curve. Land-based companies have far less experience at this.”

Brash words coming from the CFO of a business that has yet to turn a profit since its launch in 1997. Certainly, the recent shake out in the dot-com galaxy has been sudden and frightening. But the ongoing consolidation in cyberspace is hardly an unexpected twist, hardly a surprise ending. For two years, any 29-year-old with a degree in computer science could get seed capital. Such largess was bound to come to a halt. “Venture capitalists understood going in that some B2C dotcoms would do well, and some wouldn’t,” says Jeanne Metzger, director of marketing and membership services at the National Venture Capital Association (www.nvca.org). “So they bet on similar companies. They bet on a couple of eToys, knowing that one of them would make it.”

This is not to say the ugliness won’t continue, at least for a while longer. There will be more high-profile bankruptcies, more downsizings. But once sanity returns to the capital markets, some very strong online businesses will be left standing. With fewer rivals, remaining E-tailers will find brand-building much easier. Customer acquisition costs will drop — and margins will go up. Parentheses, so common on balance sheets now, will be replaced by profits. That, in turn, will sooth investors, attract suitors — and drive share prices back up. Says Al Case, president of EMetrix, a division of Gartner Group: “Once category-dominant players emerge, brick-and-mortar companies will come into the market. That will boost valuations.”

Pallet Surprise

Surviving the current rough stretch won’t be easy, however. According to Schoch’s timeline, eToys will reach operating profit breakeven for the full fiscal year 2002. But in the first quarter of this fiscal year, eToys lost $45 million. That performance had some analysts wondering if the E-tailer would make it through to Christmas — the toy seller’s prime season. But in mid June, Schoch surprised the analysts — and his boss — by raising $100 million in a private placement of convertible preferred stock and related warrants. “It’s incredible that Steve was able to raise $100 million in this market,” admits Lenk. Incredible is one word for it. “Without that funding,” says Williams, “eToys would have been in serious trouble.”

The funds did not come cheap, however. The preferred shares carry a 7 percent dividend yield, payable in cash or eToys common stock. Company employees, who have already seen the price of eToys stock drop from $86 a share to $5 in less than a year, can’t be thrilled by the potential dilution. Nevertheless, Brian Nagel, formerly of A.G. Edwards (www.agedwards.com), in St. Louis, believes the $100 million from the private placement should get eToys through the 2001 holiday season. What’s more, the cash position enables company management to concentrate on more-pressing needs. “We are no longer exposed to the capital market craziness,” says Schoch. “Now we can focus on building the business.”

According to analysts, much of the heavy lifting is already done. Despite the prohibitive costs, eToys has built its ordering and fulfillment systems from the ground up. The company’s computer network, including a control room that appears to be at DefCon 3, is now fully in place. The software that runs on the network is proprietary.

In addition, eToys recently opened a 1.16 million-square-foot distribution center in Danville, Virginia (the company’s 764,000-square-foot West coast center is in Ontario, California). The Danville facility gets the company’s inventory closer to customers: 70 percent of eToys shoppers live east of the Rockies. “Capex [capital expenditures] has been the slow death of a lot of E-tailers,” Schoch acknowledges. “But we have to have real-time connection to inventory databases across multiple facilities, so we built it ourselves.”

Whether eToys inventory and fulfillment systems are ready for Christmas 2000 is the $64,000 question. Currently, standard shipment of an eToys item takes four to ten days for delivery — not exactly light speed. “The big question analysts have about eToys right now is do we have our back-end humming?” concedes Schoch.

Last year, as sales at the company increased fivefold, the online merchant was forced to outsource some of its fulfillment to the Fingerhut Corp. (www.fingerhut.com).While eToys did not encounter the difficulties that plagued other E-tailers during the holiday season, some analysts believe eToys was stuck with too much inventory following the 1999 holiday season. Company management ended the fulfillment arrangement with Fingerhut this year. “You just don’t outsource your core competency,” explains Ted Augustine, chief logistics officer at eToys. “This is not a business where you want to deliver a product three days after someone’s birthday.”

Schoch believes the company’s investment in its back-end systems, while costly, provides a sizable competitive advantage. By his lights, brick-and-mortar operators are simply not equipped to handle small orders and individual items — part and parcel of the online toy business. “We are in a unit-based business. But they’re used to moving pallets,” he says. “None of the assets of land-based companies are appropriate for running an Internet operation.”

Summertime Blues

Maybe so. But land-based stores have something virtual merchants don’t have: land-based stores. That, of course, makes it easier for customers to return items — a real bugaboo for E-tailers. What’s more, large retail operators like Wal-Mart sell millions of toys a year. With that kind of inventory churn, they command the full attention of toy manufacturers. “EToys’ buying power is not on a par with Wal-Mart and Toys “R” Us,” argues Forrester’s Williams. “Hasbro cares more about Wal-Mart and Toys “R” Us than about eToys.”

Consumers are the same way. Everybody’s heard of Wal-Mart and Kmart. By comparison, eToys is a virtual unknown. Like other E-tailers, eToys has spent a lot of money building its brand name. In 1999, the company spent $120 million on marketing and sales — out of $222 million in total operating expenses. Of that, $50 million went to advertising. The E-tailer’s television spots, such as the one about ZaZa’s brother, have won critical raves.

Still, some analysts wonder if expensive corporate branding campaigns translate into loyal online customers. “A lot of companies have hidden behind building brand names when it means advertising,” Nagel insists. “But splashy advertising doesn’t work.”

Even eToys senior managers concede that the company needs to be a little smarter about how it spreads the word. Toward that, the E-tailer has struck promotional agreements with PBS and talk-show host Rosie O’Donnell. And earlier this year, eToys completed construction of a data warehouse. “With it, we can get the entire history of a customer,” says Schoch. “It helps with our direct marketing.” But the eToys CFO notes that the company’s data mining efforts will be more effective when the E-tailer’s database is bigger than its current 2.1 million customers. “It can be very powerful,” Schoch says. “But we’re just dipping our toe in right now.”

EToys also tested the waters by launching an $8 million ad campaign this summer — the company’s first nonholiday media promotion ever. Company watchers say such campaigns are crucial to the long-term viability of the E-tailer. In 1999, eToys generated about 70 percent of its sales during the Christmas holidays, higher than the 60 percent industry average. That means the company’s state-of-the-art assets sit nearly idle for 10 months of the year — not exactly an ideal situation. EToys management hopes to drum up enough off-season business to reduce its holiday sales to less than half of total revenues. “How well we dampen seasonality is very important,” says Schoch. “We have to get revenues from our spare capacity.”

Judging by early returns, the plan appears to be working. From June through August, eToys recorded sales of nearly $25 million. That’s a 212 percent increase from the same period the previous year.

Shelfless in Santa Monica

While industry watchers praise eToys management’s efforts to weather the current dot-com crisis, it remains to be seen if the eToys story will have a Hollywood ending. “Wal-Mart has the buying power, and toys can be returned right to the stores,” cautions Williams. “That means eToys will always have to be a lot better.”

Schoch says eToys will be a lot better. Despite market pessimism, the former civil engineer remains a firm believer in the virtual business model. “Land-based companies must fill their shelves,” he explains. “We don’t have any store shelves. Thus, the asset base we need to produce value is significantly smaller.” According to Schoch’s calculations, eToys will reach contribution breakeven this year — that is, the company’s gross profit dollars will be sufficient to pay for all fulfillment, customer service, and credit card costs. “Our numbers are improving all the time,” he says.

Some analysts agree, noting that eToys gross margins in the first quarter of the company’s fiscal year 2000 hit an all-time high. Analyst Nagel predicts that, in time, eToys profit margins will exceed that of land-based rivals. Unlike some other online merchants, Nagel says, “EToys is not chasing margins.”

But they are chasing some big goals. If the Santa Monica-based E-tailer does go on to become the dominant seller of toys in the 21st century — as founder Lenk boldly predicts — financial details like return on assets and contribution break-even will tell the tale. But for now, the company CFO remains firmly fixed on the bigger picture. “The challenge isn’t just financial,” proclaims Schoch. “It’s taking this thing to profitability. I’m betting my personal future on the long-term sustainability of eToys.”

Right now, long-suffering shareholders would settle for a solid Christmas.

Cut To:

In August 2000, following several missteps at its online operation, Toys “R” Us announced it had formed a partnership with Amazon.com to sell toys over the Internet. Reportedly, Amazon.com had been having troubles of its own with its fledgling online toy business, launched in June 1999. At the press conference trumpeting the agreement, Amazon CEO Jeff Bezos tried to explain the thinking behind the partnering. “As we enter new product categories, there’s a learning curve — not a bad thing,” Bezos reportedly said. “But it can be very expensive.”

Back in Santa Monica, Steve Schoch must be nodding his head.

John Goff is the editor of CFO.com.

Blue Light Specials

For further evidence of just how rotten things have gotten in cyberspace, check out F****dCompany (http://216.150.6.70/). Essentially a fantasy league for dot-com prognosticators, the site details — in all its gory — the downsizings, layoffs, and closings that have struck the online universe of late.

Ironically, the current dot-com consolidation, while hell for virtual operators, may turn out to be a boon for old-economy companies. The plunging share prices of online companies means brick-and-mortar businesses — businesses that didn’t necessarily leap into the digital economy, mind you — should be able to purchase virtual channels on the cheap. “The market correction has brought a more realistic valuation for the dotcoms,” notes Teo Soon Hoe, group finance director at the Singapore-based conglomerate Keppel Group (www.keppelcorporation.com). “It’s also easier to pick out the potential winners now that we can identify the sure losers.”

This spring, for example, Royal Ahold (www.ahold.nl), the Dutch-based supermarket and food-services giant, which owns Stop&Shop grocery stores, purchased 51 percent of promising — but struggling — US food E-tailer Peapod (www.peapod.com). Under the agreement, Peapod, which lost $29 million in 1999 on sales of $73 million, will continue as a stand-alone company.

The deal makes sense for both sides. Peapod gets cash, a $20 million line of credit, brand-name recognition, and the buying power of Stop&Shop. For its $73  million investment, Royal Ahold picks up Web-based software, ordering systems, and Peapod’s ecommerce expertise.

Analysts wonder why more old-economy companies haven’t gone shopping for blue light specials. A survey conducted in May by Fletcher Advisory (www.fletcheradvisory.com) and PricewaterhouseCoopers showed that 7 out of 28 UK ecommerce companies run out of cash every six months. Managers at many of those companies would likely welcome a capital infusion. Al Case, president of EMetrix, a division of Gartner Group, says buying, rather than building, an online channel eliminates a lot of headaches for traditional companies. Explains Case: “You can take money that’s going down the rat hole of infrastructure development and turn it into an equity stake.”

When seeking out possible acquisitions, CFOs should focus on E-tailers that have strong technology platforms but little or no earnings, a high burn rate, and brands that are compatible with — but weaker than — the traditional company’s products. Case notes that US companies that take less than a 20 percent stake in a dot-com may use the cost method of accounting for equity investments, which means the investment is reported, at cost, as an asset on the balance sheet. Thus, no losses from the dot-com end up on the acquirer’s balance sheet. “This method works particularly well with privately held dotcoms,” he notes.

Of course, companies looking for dot-com bargains will have to act quickly. Share prices of E-tailers are bound to rebound, particularly as more dominant players emerge from the rubble. “At some point, managers at brick-and-mortar companies will realize they don’t do ecommerce well,” says Case. “But right now, I’d say a lot of big companies are asleep at the switch.” —J.G., with Enid Tsui

Too Many Chefs

If virtual operators are finally learning to rein in their excessive spending, they also seem to be getting better at curbing their wanderlust. The practice of partnering with every company in the known galaxy — all the rage in the early dot-com days — has started to wane of late. Indeed, industry watchers say managers at cyber companies are showing more restraint when putting together deals.

They certainly couldn’t show much less. As Edward Moed, managing partner of Peppercom (www.peppercom.com), a New York-based public relations firm that specializes in Web partnerships, says: “A lot of these partnerships are fluff. There is no thought about what their goals are or how they set benchmarks so that they can evaluate if this [partnership] is a success.”

The simplest form of Net partnership is a link swap. With this type of “viral marketing,” Moed says even the smallest company can spread its logo across cyberspace. The next rung up the food chain is affiliate programs, where one site sends traffic to another, usually in an exchange for a percentage of any business the traffic generates. There are thousands of affiliate programs, says Michele Pelino, program manager of YankeeGroup’s Internet Market Strategies (www.yankeegroup.com). “But it takes resources to back these things and track them.”

Companies are learning that lesson. “Just because everybody who’s got a Web site calls you up doesn’t mean that’s the best use of your firm’s time,” says Neal Goldman, who gets 5 to 10 such calls a week as managing partner of online investment banker CapitalKey Advisors (www.capitalkey.com). “It is better to do stronger, deeper partnerships [than] a great many so-so deals,” he says.

CapitalKey, for example, offers its services through VerticalNet (www.verticalnet.com), a builder of B2B communities. Users of VerticalNet interact with CapitalKey on a page that resembles other VerticalNet pages, although it actually resides at CapitalKey’s site. The online banker pays both a placement fee and a commission for any business generated by VerticalNet traffic, and also pays to market the service.

While CapitalKey may sound more like a high-tech advertiser than a partner, managers at leading Web companies say all content on their sites, no matter what the source, affects repeat traffic. What’s more, E-tailers say there’s only so much screen space above the fold. “A lot of Internet destination sites really have to be pretty picky,” says Marcia Engles, vice president of the financial services group at online bill payment provider Transpoint. “They have a finite amount of real estate to present services to their customers.”

Blair LaCorte, senior vice president for strategic planning at VerticalNet, agrees. He scoffs at affiliate programs based solely on commissions or referral fees. “An affiliate program sounds so American, you know? ‘If you can bring me business, I’m going to pay you,’ ” he says. “In fact, it’s anti-American, because it [encourages] you to just throw a bunch of stuff against the wall — and not stick with your partner and not develop a relationship.” —Tim Reason