The Dot-Com Equation: What Does it Take to Make Money?

In Internet years, it seems like ancient history. But not long ago it was taken for granted that online retailing represented a new paradigm in selling to consumers. Maybe it still does — or will.

But so far, making money as an online-only retailer has proven elusive. Why? How many pairs of surf trunks do you have to move at a “normal” margin before you show a profit?

“It doesn’t matter!” one surf retailing dot-com executive was heard to say. “These companies aren’t valued that way.” Of course, that was weeks ago, and the world has changed. As of May 12, 2000 Internet e-commerce stocks, as a group, were rated 193 out of 197 industry groups followed for stock-market performance by Investors Business Daily over six months. Three months ago, they were number 29. As a group, their stock prices have declined by 50 percent since January 1.

But what have people figured out that’s made this all happen?

**** Costs ****

It costs a lot of money to develop and maintain a quality Web site. Instead of hiring an eight-dollar-an-hour surf grommet, you need an 80,000-dollar-a-year programmer and may have a hard time finding them.

Cha-ching!

You still have to carry inventory and take the associated inventory risk. Cha-ching! You still have to get the product to the customer, and you can’t do that over the Internet. Cha-ching! You still have to provide customer service — including handling returns, and sometimes that means actually talking to the customer on the phone.

It also seems necessary — according to conventional wisdom — to have not only product, but content. In other words, you’re not only an e-tailer, but also an e-journalist, and that adds some costs as well. Cha-ching! Cha-ching! Cha-ching! Oh, and of course you need to spend some money on marketing to establish your brand.

Cha-cha-cha-ching!

So, are there examples in the real world of these inherent difficulties of e-tailing? Lands’ End, the mainstream catalog retailer with a great Web site and killer customer service, earned a total of 48-million dollars from sales of 1.319-billion dollars for the year ended January 28, 2000. This included both its e-commerce and catalog business.

Lands’ End spent 190-million dollars on producing, printing, and mailing catalogs. But except for that expense, how is a dot-com retailer’s cost structure different from Lands’ End?

It isn’t.

Lands’ End Internet-based revenue totaled 138-million dollars during the year, or 10.5 percent of total revenue. To put it bluntly, if they didn’t mail those catalogs, they wouldn’t have a viable business. Of course, Lands’ End isn’t exactly known as being cool, cutting edge, and appealing to the younger generation. Still, they’d have to do an awful lot of Internet business before they could stop clogging up your mail box or weighing down your postman.

How much? Well, I guess more than 1.639-billion dollars. That’s how much Amazon sold in the year ended December 31, 1999, and they lost 720-million dollars for the year. It’s interesting to note that Amazon’s gross profit margin was only eighteen percent. Lands’ End — cool or not — had a gross profit margin of 45 percent. That’s pretty cool to me. If Amazon had Lands’ End’s gross profit margin, however, they would still have lost a couple-hundred million.

Part of the difference in gross margins comes from the fact that Lands’ End is just better and more experienced in fulfillment and customer service than Amazon. But the biggest difference is that Lands’ End is selling product it makes, with its own brand name on it. Amazon is selling stuff bought from other brands. Lands’ End has cut out the middleman. Amazon is the middleman.

It looks like there’s more to making money in e-commerce than a cool Web site and building a community. The devil (and the expense), as they say, is in the details.

**** Competition ****

Quiksilver had 444-million dollars in revenue for the fiscal year ended October 31, 1999. If, just to pick a nber, Quik has 25 percent of the surf softgoods market in North America, then we’re looking at an surf-apparel industry, at wholesale, that’s less than two-billion dollars — though growing.

If you’re a dot-com in the surf industry, with the expense structure described above, how much business do you have to do before you can turn a profit? Where are the customers going to come from?

It doesn’t seem to me that the surf e-retailer will create many new customers. He’ll be fighting over existing customers — in an over-retailed environment — where he can only succeed by taking customers from competitors (of which there are a whole lot).

Before the days of the Internet, what percentage of total softgoods sales did catalog companies do? If dot-coms get that percentage of the surf industry softgoods market, can they make money? Are there any specific advantages conferred by the Internet that will increase that percentage? I don’t know the answers to these questions, but that’s what I’d be asking if I was considering investmenting in a dot-com.

One statistic I saw a few years ago, which may or may not be relevant, was that catalog and telephone sales of skis had never exceeded five percent of total sales in a given year. Just for fun, let’s hypothesize that because of the cool factor, or their content, or technology, surf e-tailers can optimistically get twenty percent of all softgoods sales — or something less than 400-million dollars. How many e-tailers can that support when you factor in their overhead? Given the implied size of those companies and their growth prospects, can they expect to attract adequate capital? PacSun and Quiksilver have both experienced some softness in their stock prices due to concerns about their ability to continue to grow quickly. They’re both established companies that make money.

My opinion is that e-tailers of surf softgoods won’t come close to twenty percent of the total market. They may not get more than five. But even if they can get to twenty percent, how does the financial model make sense to investors looking for fast growth, big returns, and a public offering?

Another competitive issue for dot-coms is that established brands will ultimately figure out how to reconcile selling their product on-line while supporting their brick-and-mortar retailers. Dot-coms will be competing with retailers who already know how to handle customer service and fulfillment, and who already have their infrastructure in place and aren’t all that far behind in Web development.

Once the Internet frenzy wears off — as it seems to be doing — I expect brands will recognize that it’s their product customers want. And while the free trips to the South Pacific are nice, it’s the brands that are in control, and an e-tailer is just another retailer they may choose to sell to. Or not.

**** Community ****

The e-tailers’ answer to these concerns will resolve, I expect, through the term “community.” It has become the rallying cry for Internet retailers who see creating a community as the focal point of their strategy for getting eyeballs, and hopefully, customers. It’s a good strategy. In all non-Internet businesses, it’s called marketing — the process of identifying your customers and building a relationship with them.

On the Internet, the concept of community implies it’s not adequate to look at the dot-com’s revenue model just from the point of view of product sales. There are opportunities to generate revenue through advertisement, sale of content and information, and strategic alliances. How do you create these other sources of revenue? How much revenue can they generate? I don’t know. Neither does anybody else — although there are lots of theories.

Some of those theories will prove to be the correct ones, and those e-tailers may prosper.

**** And So … ****

At the end of the day, I wonder if the whole retail world — in the surf industry and in most other industries — won’t just be a fluid amalgamation of brick-and-mortar stores and online e-tailing. Whatever the successful model is, it’s going to change dramatically as broadband finds its way into more homes.

The bottom line is that unless a lot of revenue comes from sources other than product sales, it’s hard to see a viable financial model in these surf e-tailers. I suspect the inevitable result is that the need for sales volume will drive most of them to compete in the broader action-sports market, where the likes of Earthsports.com or FogDog.com are already operating.luid amalgamation of brick-and-mortar stores and online e-tailing. Whatever the successful model is, it’s going to change dramatically as broadband finds its way into more homes.

The bottom line is that unless a lot of revenue comes from sources other than product sales, it’s hard to see a viable financial model in these surf e-tailers. I suspect the inevitable result is that the need for sales volume will drive most of them to compete in the broader action-sports market, where the likes of Earthsports.com or FogDog.com are already operating.