Lessons from the cemetery

Just a few years ago, investors, managers and customers, like sheep, flocked onto the Internet bandwagon. Few people bothered to distinguish between a well-considered, proven concept and a "business plan" for e-name.com, hastily penned by a geek and a freelance hack. Those who did, more often than not invested in the half-baked idea because the potential for upside growth was higher.

In late 1999, when the Internet hype was supposed to be the thing, all online shops were losing money on every transaction.

Ivo Vegter, deputy editor, Brainstorm

Today, the reverse has happened. People have dropped the dot-coms they held like so many hot potatoes, and these days, a dot-com company name is a branding liability.

In this slightly irrational situation, a talk on whether there is anything new in the new economy, sub-titled, "Lessons from the cemetery", presented by Professor Josep Valor-Sabatier at Unisa`s School of Business Leadership, seemed intriguing enough.

Valor is eminently qualified. Besides being professor of IT at Spain`s IESE Business School, he holds a PhD in operations research from MIT, and an ScD in medical engineering and medical physics from the Harvard-MIT Division of Health Sciences and Technology. He`s been research fellow at MIT and visiting professor at the institute`s famous Sloan School of Management.

"Medical school taught me that one can learn much from cadavers," he begins, promisingly. "Usually, you wait a long time for a living thing to die, so it can be studied. But with the new economy, we only had to wait two or three years."

His examples - so obvious with the benefit of 20/20 hindsight - show that away from the hype and the fear of the financial markets and the mainstream press, many dot-com era ideas are chugging along perfectly nicely, making money for the few investors they have left. And many others stand as warning signs to current business leaders.

He summarises what hasn`t worked, and what has worked. Surprisingly, the second list is longer than the first.

Pure-play business-to-consumer (B2C) Internet players have not worked. Neither have advertising-dependent models of content delivery. Pure business-to-business (B2B) exchanges without the involvement of traditional players have failed, as have technology-driven sites.

The B2C market should have known better. One of the online trading houses ran a hugely expensive SuperBowl TV advert, which involved two men and a monkey dancing for 30 seconds. The payoff line? "We`ve just wasted $2 million. What have you done with your money today?"

Kind of stupid, isn`t it?

Well, they`re out of business now, as are the online traders that pay new customers sign-up bonuses of as much as $400. Compared with the $31 a brick-and-mortar shop pays to acquire a customer, the model was obviously broken from the start.

In late 1999, when the Internet hype was supposed to be the thing, all online shops were losing money on every transaction. The now-defunct eToys was the best performer in a quarterly report by management consulting boutique McKinsey in 2000, managing to limit the loss per transaction to a mite over $4. The average transaction value was $62. Webvan lost almost $13 per transaction.

It takes a financial genius like Valor to see through the smoke here: many transactions, times $13 lost per transaction, means you`d better not sell much. Webvan, mercifully, didn`t.

"You need an average order of $150 online to make money. In the real world, it`s $20, and while online sites do sell more per transaction, their average is about $80 - half of what is needed to make a site even marginally profitable," explains Valor.

Advertising-based online publishing models have also failed miserably. Click-throughs are negligible, audiences on most sites were low and the industry never did manage to sell the comparison between a Web site banner and a billboard. "Nobody clicks on a billboard, do they?" was a defence that contradicted everything they were trying to sell in the first place.

Because visitor numbers didn`t materialise ("There were too many channels on this TV," says Valor) and the price of advertising plummeted by more than 70% since 1996, business plans written in 1997 were shot to hell by 2001.

B2B exchanges suffered a similar over-trading fate. "These things are a disgrace," says Valor, with visible disdain. They acted on the assumption that real-world market operators were stupid, and wouldn`t react. They thought that market imperfections served nobody. But such imperfections, when you think about it, benefit sellers. You can sell a widget for $10, only if your customer can`t easily scour the world for people selling the same widget for $9, $8 and $7.

So sellers didn`t go for the B2B idea, and the liquidity these markets needed never materialised.

"At one point, 42 companies offered to be `the` B2B marketplace for steel in Europe. They all got financing. There was, maybe, space in the market for one. Today there are none," Valor states.

Now, a telling question: "How many of you used Altavista three years ago?" Valor asks. Most. Good. "How many of you use Altavista today?" Ah, none. "What do you use?" Google.

Altavista didn`t serve its customers badly. Nobody was unhappy with Altavista. But Google came to the market with better technology, and since the switching costs for products like search engines are - in monetary and emotional terms - zero, people switched en masse.

"Unless you have the best technology forever, you`ll lose your customers. I`d sell my Google stock too," he says. "There`s much more R&D money in search-related artificial intelligence outside Google than inside it."

If all this sounds depressing, he has a longer list of successful models. Infrastructure providers have, surprisingly, been successful. "Don`t look at their stock price. The stock just reflected inflated growth expectations," says Valor.

Commodity auctions have worked, as have transaction-based models. "Bricks-and-clicks" turned out to be the saving grace of several online retailers, and both e-marketing and e-procurement has worked well.

B2B auction sites have worked in cases where several traditional players have come together to promote it. A good example is the automotive supplies exchange set up by the big US car manufacturers. "The promoters can be suppliers or purchasers, depending on who wields the big stick," he says. Face it: when General Motors and Daimler-Chrysler say "we`re buying here", you`d better be "here" to sell your alternator mounting-screws.

Transaction models, where outfits like eBay aggregate fragmented markets with many weak players, have also proven to be a success.

The demise of eToys hides an interesting case study arguing for the bricks-and-clicks model. When eToys, over Christmas in 1999, became the undisputed online leader in selling toys - which were ideally suited for Internet sales - traditional retailers seemed to be in trouble.

Toys `R Us sales dropped 20%. Shaken, Toys `R Us proposed a merger with eToys. According to Valor, it was rebuffed with the comment: "In a year, I`ll buy your remains."

Believing the threat, Toys `R Us went to Amazon.com, and struck up a deal whereby the latter would handle the online shop front and payment systems, while the former would deal with order fulfilment and after-sales service such as product returns.

People quickly realised that the ability to physically return a broken Barbie was much more likely to get a whole Barbie under the Christmas tree than trying to do the transaction by mail. When Christmas came around again, eToys` sales plummeted. It cut prices by 75%, ran out of money, and went bust.

The upshot, however, was much lower margins for all the remaining players. Because stores now need to maintain an extra channel, their costs are up. So the only beneficiary of this battle has been the consumer.

"Shrinking margins is a constant," says Valor. "We`ll see this in many industries because of the Internet."

One of the oldest uses for the Web - brochureware - remains a success. It is cheap, convenient, and if you`re not there, you don`t exist, for many consumers. So e-marketing never suffered from the bust.

Valor then takes a look at the Internet and technology as it stands. The cost of technology will continue to decrease for at least another 20 years. Beyond that, a quantum leap is required, but there`s no reason to believe that biotechnology, quantum computing or some other revolutionary technology, won`t provide exactly that.

Lower transaction costs and improved company efficiency haven`t disappeared because investors lost faith in the Internet.

Another significant factor on the Internet is that the law of diminishing returns does not apply in the same way it does in the real world. The costs of increasing capacity in a linear fashion is pretty much linear - unlike in the real world, where much larger fixed investments are required to get beyond a certain optimal production level.

Valor concludes that the Internet will continue to transform business. Because online shops can`t really differentiate themselves, monopoly players (like Amazon.com) or regional monopolies will form. Ultimately, it may well be that logistics companies such as UPS or FedEx are much better suited to offering these services.

Finally, he addresses the digital divide. He says that bringing consumers online should be the last priority of a government. It is e-enabling, especially small businesses, that will make the difference. Once the consumer uptake happens, they`ll be there. If those businesses aren`t able to compete with foreign companies that do have an online business presence, those foreigners will "come in and steal your lunch", he warns.

And if consumers don`t go online - as Telkom`s experience of disappointing uptake of its rural roll-out of lines seems to indicate - nothing will happen except that the e-enabled businesses will be more efficient.

So all is not lost. There are valuable lessons in analysing the Internet boom and bust. One might even suggest that the speed of it all, despite shocking the world economy, was a boon for business managers. Today, only two years after the Nasdaq really started plummeting, shrewd businesses can start to apply the lessons, and prepare themselves for what will, inevitably, be a wired 21st century.