Reversal of Fortune - Industry Trend or Event

Industry Standard, The, Dec, 2000 by Amy Cortese

A lot of people are telling online retailers to get real. But e-commerce service providers say they have a better idea: Instead, get even more virtual.

Everyone from the sultans of Sand Hill Road to Santa's elves has given up e-tailing for dead. B-to-c? RIP. Pure-plays just can't make the economics work, goes the thinking. Their customer-acquisition costs are too high, their margins are too low. Instead, it's old-line retailers that will dominate online. They have brand recognition, scads of loyal shoppers, merchandising know-how and tons of cash. The pure-plays have been advised to get in bed with these retail dowagers or wake up and build stores of their own.

Certainly, click-and-mortar juggernauts like Walmart.com will be formidable competition. But don't give up on the pure-plays yet. The emergence of third-party fulfillment companies -- known as e-commerce service providers, or ESPs -- suggests there's a path to profitability not paved with bricks. ESPs help e-tailers succeed by pointing them back toward the Internet's original vision: virtuality. "For e-commerce to succeed'" says Bruce Smith, managing director at Archery Capital, a New York-based venture capital firm, "e-tailers are going to have to become more virtual."

If that sounds old-fashioned, that's because it is. Way back in 1995, retailers embraced the Web as a way to free themselves from the shackles of physical distribution. No more stores, no more warehouses. They could cut prices, attract legions of customers and -- best of all -- still make money.

That was the idea. But the first serious e-tailer, Amazon.com, quickly discovered that the reality of virtuality was quite different. Not only did Web retailers have to spend heavily on marketing to draw customers to their sites, they had to start acting like old-school retailers: taking inventory and constructing warehouses to stock it. Amazon in particular went on a massive spending binge - financed mainly by debt and the public markets - constructing warehouses, customer call centers and other infrastructure.

Five years later, Amazon is getting hammered by analysts for its free-spending ways. But the truth is the company had no choice. When it started, in 1995, it relied on third-party distributors to fill orders. The trouble was, what distributors do best is ship in bulk - truckloads of books to Borders, for example, not individual copies to consumers. To ensure high-quality service, which means keeping the right items in stock and delivering them on time, Amazon had to build its own fulfillment systems, especially as it expanded into new lines like toys and electronics.

Amazon now does some of the most efficient fulfillment in the business. But with already paper-thin margins, the company's massive capital investment has left it bleeding red ink. Amazon has lost some $1.5 billion to date, and profits are still nowhere in sight. Its sales growth is slowing even as it adds new product lines.

Is it time to write Amazon's epitaph? Jeff Bezos and his merry band of believers say spending big and deferring profits are necessary to provide top-notch service and create loyal customers. They insist that with scale will come profits. They point to America Online in the mid-'90s, then a favorite target of short-sellers: AOL lost twice as much money as Amazon on its way to becoming the powerhouse it is today.

SCALE OF THE CENTURY

Even if Amazon succeeds, the build-it-all-yourself approach won't work for every retail site. The economics of e-tailing simply won't allow it. Though customer-acquisition costs have come down, they can still run as high as $50 to $100 per customer; fulfillment can eat up between 15 percent and 60 percent of each sale. That leaves little room, if any, for profit. You can make up for slim margins with high volume if you're one of the lucky few. Otherwise, you'd better be hawking high-margin goods. Research done by McKinsey & Co. shows that an apparel site needs about $90 million in sales if it hopes to turn a profit. In lower-margin businesses, sales must be much higher: $500 million in electronics; $1 billion in books, CDs and other media. Only the top 15 percent or so of online retailers have sales over $200 million, according to Shop.org.

Bottom line: Success in e-tail is a function of scale. But building scale takes time and money. "If you have the luxury of capital and a long-term view," you have a chance, says Keng Lim, CEO of Escalate, a Redwood Shores, Calif., provider of e-commerce systems. "But every company can't afford to do it the Amazon way."

From his modest headquarters, Lim is busy building a different way. He's done it before - he helped pioneer the application service provider business with his last startup, Kiva. Now he's at the fulcrum of another potentially huge shift. Escalate is one of a new breed of companies pushing a model they say will rescue online retail. ESPs do everything required to process and fulfill a sale, from inventory management to picking and packing to order tracking. In other words, everything that happens after a shopper clicks the "buy" button. That frees the online merchant - be it pure-play, click-and-brick retailer or manufacturer - to focus on marketing and brand-building.