THE VALUE PATH FROM
.COM TO .PROFIT
.Com is about being open for business on the Web.
.Profit is about making money as a business on the Web.
And they are not at all the some thing.
How does a firm generate value to its customers and, at the same time, make a profit? To our minds, that is the one question concerning business on the Internet that is now worth writing and reading about. All the other standard questions about the Internet are either already resolved or irrelevant. The issue is how to get from .comopen for business on the Webto .profitstaying in business for the long term. For example:
Question: Are we really in a new economy with the Internet at its core?
Answer: Yes. In fact, today we really need only three adjectivesmore, bigger, and fasterto describe what's happening with business via the Web: revenues, customers, marketing expenses, security concerns, innovation. investment, price deals, and financial losses.
Question: Will the Internet change our industry?
Answer: Of course. When the Commerce Department issued its first quarterly assessment of the size of Internet sales in March 2000, it concluded that they amounted to just 0.64 percent of total retail sales. It excluded travel reservations and commissions for services such as securities trades, which would bring the figure up to around 1 percent. That 1 percent has changed the basic rules of competition in almost every industry inless than five years. What will be the impact when it's 3 percent?
Question: How large will sales on the Internet be in five years?
Answer: No one has a clueand it's an irrelevant question.
Indeed, the standard questions are all irrelevant because of more, bigger, and faster and because of the impact of the 1 percent. All we can be sure of is that Internet business will grow and grow faster than the reaction time of most companies. That means that it doesn't matter if business-to-business commerce in 2004 is $7 trillion versus the reported $145 billion in 1999 or just a tenth of that. The management issue is, What do we do now to get on the value path to .profit? What do we do now, regardless of any forecast, so that we aren't taken by surprise any more?
It has become more and more clear that most .com firms are lost in the crowd. They need much more than a Web site and catalog. A cautionary tale here is Value America, whose stock price dropped from $55 in April 1999, when it went public, to just over $4 twelve months later. The Washington Post commented that "Value America's unraveling is particularly prominent because it had been touted as a paragon of the New Economy ... [and] seemed to have a unique handle on how to exploit the commercial possibilities of the Internet." Despite its "mushrooming customer base," its storefront-only approach to Web business created problems of supplier relationships, customer service, inventory management, and distribution that left it increasingly adrift.
Value America is not alone. The .com era was mainly about generating revenues. (Value America shot up from $134,000 to over $45 million in just one year.) But revenue generation is often the fruit of massive marketing and massive price cuts leading to massive losses.
If we are to move past .com, we need to stop talking about the Internet as the future of business and start talking about how to manage that business today so as to be effective as the future becomes the present. The starting pointgetting up on the Net, the race for .com addresseswas the easy one. The tougher one has been to create value for customers amid a flood of other .coms. In this new style of business-with-technology and technology-for-business, valuenot the Web site per seis king. It points to a shift in both the technology and its use that is at least as far-reaching as the comparable 1980s transformations implicit in the very term personal computer. The PC was viewed as literally personal, a standalone device that had no telecommunications links. It's hard now to imagine a PC that doesn't have these; perhaps if we were starting over, the term we would adopt might be "community computer" or "communications computer." The PC has moved way beyond its origins and is now a set of very interactive toolsmost documents, spreadsheets, PowerPoint presentations, and other "personal" uses of software are intended to be shared and communicated and the PC modem speed is at least as important to most users as its memory size.
The Web has changed at least as much as the PC in terms of its users and usesin a far shorter time. Its early advocates praised it because it had nothing to do with businessindeed, they monitored any effort to send e-mail that tried to sell anything and launched campaigns against it. Then, as more and more companies started their own informational Web sites and start-ups like Amazon pointed to the opportunities of online retailing, just as the PC became a personal communication hub, Web sites became a business contact point. The main metaphor was that of a storefront that could handle more and more types of transaction: cybermall captures the thinking. The .com economy was a new set of stores.
Value generation rests on far more than this shift. As life with the Internet is evolving, personal Web pages, personal services, personal offers, personal association, personal pricing, personal anything that establishes and sustains the relationship is what value is all about. Here personal may mean individual, family, company, community, interest group, professional affiliatesany segmentation that creates a you-us relationship rather than just a buyer-seller one.
There are more and more successful players in the value game, players that know how to build relationships, manage logistics, mesh their channels, and transform their financial capital and cost structures. They are the brands of the online economy. Some of them will take years before they see profits from their investments in customers and infrastructures. And (as the Value America example reminds us) there's no guarantee that today's high flyer will not be tomorrow's failure. Yet the evidence is in: companies that focus their business models on the value imperatives for competing in this crowded marketspace and not just on the .com elements of itthose companies are generating profits. Value to the customer and profit to the company is their equationand the subject of our book.
It's impossible even to guess at what percentage of large, medium, and small companies are in the race to .com, on the value path to .profitor have arrived there and are moving forward. Our own best estimate is that among the Fortune 1000, about half are still racing to .com, but well aware they need to move very quickly. Most business executives of those companies openly admit they don't quite know how to make this shift. In the United States, there are mercifully fewer and fewer top managers who dismiss the Internet as not relevant to their company; in our experience, that's not the case in Europe, Asia, and Latin America. A variety of forces have combined to block the same degree of progress: the high cost of local phone access to the Internet, lack of the venture capital for small and high-risk start-ups, a social climate that does not encourage risk taking, and lack of real telecommunications competition in many countries. That's changing fast but there is as yet no equivalent Internet economy in terms of size, growth, and breadth. Around mid-1999, many previously sleepy regions of the world took off in all areas of Internet business; 2000 has seen the same Internet IPO (Initial Public Offering) fever as has marked the United States since the mid-1990s. In From .com to .profit, we focus mainly on the United States because it is here that we have a long enough body of experience and a large enough number of successful companies to be able to draw on in deriving practical lessons for managers. In addition, the innovation outside the United States is following very much the same paththough it may well be a steeper and faster pathsince the new international entrepreneurs can draw on the U.S. experience.
For any firm only halfway through the race to .comwith Web sites, intranets, and some of its supply chain handled onlinethe technology issue is mainly one of infrastructure: of building it, renting it, operating it, or buying a position on someone else's platform. There's a lot of hard .com work to get done but that's a starting point only; the main agenda is business innovation. How does a firm transform itself in the business basics in order to be a player in .profit? How does it position itself for .everywhere, the time when the e-words and e-prefixes will all disappear, when we won't talk about electronic business or Internet retailing, for instance, just business and retailing? No one knows for certainwe don't either. But we do have a wealth of examples from companies that made very fast, very big, and very successful transformations. We present these not as Big Truths but as templates for our business readers to consider. You can find the parallels with your own company and the lessons to take from our examples. You can see how your situation is different and what that means for you in terms of getting down to business, what your challenges will be in turning value into profits. Now is the time to prepare, to embed the Internet in your logistics, relationships, channels, pricing, and processes so that your firm is well positioned for the future wave of business change.
CHANGE YOUR MIND-SET: FORGET .COM
Changing the mind-set is perhaps the single most important step for business managers to get moving along the value path. Seeing the Web site as in effect the generator of value reflects a .com mind-set; it looks back at the race to get a presence on the Net, concludes that Internet business is all about Web site design and operation, and that the priority is to get "on" the Web. .Com reflects the obvious: it was Internet technology that made Internet business possible. Companies that used it effectively gained a "first mover advantage" that either left established competitors stranded, as Amazon did to the entire bookselling industry, or created something entirely new, like eBay's invention of what might be termed the World Wide Yard Sale. Their success stimulated a race to get up on the Net. For a while it looked as if just adding the .com suffix to your business name guaranteed that venture capital firms would rush in to throw investment capital at you. This was all a variant of the old adage that if you build a better mousetrap, the world will beat a path to your door.
It didn't. It has been far harder and taken far longer to turn a Web site into a sustainable online business than early .com enthusiasts ever expected. There are indeed plenty of successes on the Web. Many of them are neither first movers nor Internet start-ups; of the dozen or so firms selling over a billion dollars of goods and services related to the Web, almost all are well-established blue chips, such as HP, IBM, and Intel, or already-successful high-growth firms, such as Cisco and Dell. So it can't be just the .com that explains their success.
There are plenty of failures on the Web, too. On the surface, many of them look similar to the successes. There's no obvious explanation, for instance, why one of the start-up Internet search engines, Yahoo, was able to turn itself into a power brand and quickly become profitable even though it doesn't charge its 100 million subscribers a penny, while its rivals, AltaVista and Excite, have had very varying fortunes. Why did major retailers like J.C. Penney and Sears bomb with their online malls despite their brand strength, while Amazon and eToys built a strong customer base in just a few years? Why did the upstarts win and the Fortune 100 players lose? Obviously customers saw value in Amazon and didn't in the retailers' offerings. Again, this can't be anything to do with the .com itself. Where is the value? What is the pattern?
THE SEARCH FOR VALUEAND THE VALUE DRIVERS
It's easy to talk about the obvious need to create value in Internet business. But what exactly are the factors that drive value? If it's not the .com, then what is it? Business on the Web is so newAmazon and Netscape are the useful mark of its inception, in late 1995that only recently have we accumulated enough examples to draw on to answer those questions. Just the first few years of operations of a dozen start-ups provided no reliable conclusions; we needed information that spans more time and covers a very wide range and number of companies in order to start teasing out patterns. But when, as now, there are so many companies, old and new, with so many plans, claims, and business models, the patterns are hidden in the overwhelming noise. Competing forecasts, hype, and the prevalence of .com thinking add even more hubbub.
Consider the (highly oversimplified) view of the Internet business landscape shown in Figure 1.1. This lists just a few of the well-known companies that are Internet players. It includes start-ups large and small, (Yahoo and Garden.com); Fortune 1000 firms that have become major Internet players (UPS, Cisco, IBM); business-to-business hubs (Ariba, Chemdex, FreeMarkets); and many others. It includes some initiatives that went broke (World Avenue, Nets Inc) and a few large firms whose first Internet strategies were less than a success (Levi Strauss); we could have added hundreds more to the picture. It includes portals, vertical hubs, reverse auctions, consolidators, ASPs, business-to-business (B-to-B) and business-to-consumer (B-to-C) firms, vortals, butterfly markets, aggregators. The very newness of the Internet business language in itself adds more obscurity to the picture.
Any commonalities among the many businesses shown in Figure 1.1, commonalities beyond the obvious fact that they're all "on" the Web, are not apparent. The figure looks not unlike jumbled Scrabble tiles waiting to be organized into meaningful words. We've been working for several years to gather more and more Internet business examples from experience and make managerial sense of themto find the words hidden in the tiles. Without value, a Web site is just a money drain or technology showcase. So what is value, as revealed by what has actually been happening in Internet business, rather than in hype, hope, and theory?
We've found the main patterns through our search. In every single instance, value comes from focusing the technology on a number of very basic elements of business that in themselves are not at all new, but that demand a sustained and comprehensive management commitment and follow-up. They are what we see as the value drivers that should shape any firm's choice of its business model. Get the imperativesthe must-dos of each of these driversright and you create value that can be turned into profit. Ignore them or conflict with them and you're just following a .com, not a value path to .profit.
It's not transactions or price that create the value that gets customers coming back to a seller. It's relationships, collaboration, and community. Early .com retailers thought that "hits" would generate customers. They generally didn't, as IBM found with its World Avenue online mall and MCI learned from its own now-defunct initiative. Others thought customers meant profits. They didn't. Companies are paying out large fees to portals for a presence on their sites or offering large introductory gifts or discounts in an effort to attract first-time customers. But they haven't thought through how to follow up that first transaction and generate long-term relationships. .Com has largely been about transactions. With very, very few exceptions, that's a path to sustained .loss.
Here are just a few of the many implications of the difference between a business model centered on relationships and one on transactions:
Relationship-centered business models generate very high incremental operating margins for repeat business and positive cash flows even when the firm is as yet unprofitable; in contrast, transaction-centered business models have lower infrastructure costs. Yet they must build high conversion ratesthat is, build up the fraction of hits on the site that turn into purchases.
Relationship-centered business models have high risk and potentially very high payoff; in contrast, transaction-centered business models are heavily reliant on price-cutting, discounts, and payments to portals.
Relationship-centered business models succeed when they offer superb operational performance in fulfillment and reliability; transaction-centered business models, even when they perform superbly, remain vulnerable to online players who give away their service or goods to attract relationship business.
Relationship-centered business models are creating new power brands; transaction-centered business models face loss of product equity to strong Internet relationship brand players.
These implications and differences are both dramatic and consequential to the entire success or failure of many Internet initiatives.
The relationship-versus-transaction distinction obviously points to very different business models. The same is true for the other value drivers hidden in Figure 1.1. If a firm can't see the deep patterns of what creates value, then its only real options in Internet planning are opportunism and reaction.
Opportunism comes from getting ahead of the change curve with some innovative idea, such as Priceline.com's reversing of pricing (from the seller sets the price to the customer sets the price). That can provide high payoff but at very high riskit also rests on the soundness of the underlying business model; no firm can now preempt the market via just a Web site. The Web encourages opportunism, which translates to creativity. The barriers to entry are low; the willingness of investors to take high risks on an idea, start-up team, or technology remains high. Investors are increasingly looking for more than just conceptsand it can be hard to tell the difference between a creative idea and a dumb one.
Reaction comes from follow-the-leader. That's lower risk but lower payoff in almost all instances. The lack of barriers to entry for new Web players means that if your company is racing to copy an innovation, so too are plenty of others. As portals became the main gameif not in town then in industry, Netspeak, and the business pressand as business-to-business electronic commerce exploded in 1999, we saw a flood of companies racing to follow the leaders. Again, if all they are doing is trying to catch up to another firm or imitate it, this will be just another site among follow-the-leaders. At best, reaction gets a player back in the game. More typically, it leaves the company with no differentiation that offers value. It's six clicks down the AOL or Yahoo menu or a trailing result of a search engine request.
This last point is one that companies need to be very vigilant about. There are more and more indications that we are seeing the largest and fastest erosion of brand equity in business history. In the "six clicks down" example, AOL is the brand. With Priceline, when customers state the price they are willing to pay for an item, Priceline chooses the brand for them. In business-to-business trading hubs, many suppliers' brands will be lostoffice supplies and commodity materials, for example. The implications of this shift are profound: a shift from product brand equity to relationship brand equity. We are already seeing in the revenue and repeat business growth of the Internet brand leaders how much this is worth.
Opportunism and reaction abound, thus clouding the picture even more for business managers. They create a flavor of the month and even a fashion showwhat's in and what's out? Last year's Internet innovation soon becomes this year's conventional wisdoma sort of e-truismbut by next year, it may well be recognized as incomplete or even wrong. For instance, an early .com e-truism was that the Web displaced bricks and mortar, with gurus forecasting the disappearance of retail stores, bank branches, and insurance offices. When that didn't happen, the e-truism became clicks and mortar: use the Internet to complement your existing channels and use your channels to complement the Internet. Blend those channels for success.
Charles Schwab ended debate about clicks versus mortar. Indeed it was a Schwab executive who first introduced the phrase "clicks and mortar." Schwab is the discount broker that originally was bricks and mortarsales branchesand telephones. It added clicks to become the Internet pacesetter in the securities business. In mid-January 2000, Schwab announced that it was adding a full-service firm to its online services, through an acquisition. So Schwab began with bricks, went to clicks and bricks, and is now buying more bricks. Meanwhile, it's overtaken most of the early clicks, like Ameritrade, and turned the top bricks players like Merrill Lynch upside down. Merrill Lynch, whose vice chairman publicly worried not so long ago that online trading could wreck the nation's financial safety, is going to clicks.
In 2000, the world moved on to mortar for clicks: companies whose core business was online started seeking out offline presence and partnerships. AOL and Yahoo made deals to be in Wal-Mart and Kmart stores, for example, and to give these retailers a presence on their electronic storefronts. More important, both the alliances explicitly aim at leveraging relationships with their own and each other's customers. While clicks retailers' sales grow, those that are the click offshoot of bricks often do better than expected. And as for the AOL merger with Time Warner, is that clicks and flicks?
This is all very volatile and confusing. There's so much going on that it's difficult for business managers to reach practical and reliable conclusions about what their firms should do. But there is a way to make sense of this and the many other dynamics of the Internet. Step back and ask what all the individual clicks, clicks versus mortar, clicks and mortar, and mortar for clicks companies tell us about general value drivers. The patterns really are there. For example, the winners harmonize all their channels on behalf of the customer. The losers get stuck talking about "channel conflict"whether or not to bypass their existing distributors, or even to compete with them. Worse, like many of the established full-service commission security firms, they evaluate their own and online channels as alternatives, instead of a whole, viewing the situation as a Hamlet-like "To .com or not to .com, that is the question" dilemma.
A fundamental of Internet business is that the customer chooses. Clicksthe .com innovationgenerated value to customers and revealed the limitations of purely online business. Smart firms took a look at where they could add value and remove limitations. Customers again responded, sending signals about their own value criteria. The brick firms started responding to that. The click firms began to see new opportunities in alliances with bricks. And in all this swirl of innovation and experiment, the picture is beginning to come clear.
Hidden within Figure 1.1and revealed in Figure 1.2are the general value driver patterns that we've uncovered after combing through many hundreds of examples. As you look at the companies in the top left-hand corner, for instance, what comes through consistently and pervasively is that their success or failure reflects relationship building, achieved through incentives and services that generate repeat business, personalization of the Web site and service, customization of offers, dynamic interaction with the customer, collaboration and focus on communities of interest to customer groups. Moving around Figure 1.2, we see a whole cluster of firms that have so leveraged logistics that they've changed the rules of supply chain management and operational efficiency, others that have transformed the very basics of capital deployment and payoff and of cost and margin structures.
There are six clusters of value drivers that explain just about everything we see happening in the Internet business space: logistics, relationships, channels, branding, capital and cost structures, and intermediation. This is not in any way a theory or "model" of Internet business. It's what's been happening since the Web took off, is happening now, and is the base for what firms are trying to make happen. The value drivers, not .com, are the base for long-term business success. That is, they're the signposts of the value path and the foundation of .profit.
IMPERATIVES FOR FUTURE VALUE AND PROFIT
We see value in Internet businessvalue for the customer and the companyas resting on a business model that responds to the value drivers. In other words, since value comes from these drivers, your business model has to feed into them and certainly not ignore them, or worse, conflict with them. From the six value drivers emerge the corresponding value imperativesthe management priorities for the business model.
Perfect your logistics. This imperative allows you to afford everything elsemarketing, price reduction, service, and technologyand positions you to exploit the other opportunities of Internet business. Internet logistics along the external supply chain and internal process chain is now close to a requirement for being a well-run firm. Halving of inventories and of overhead is a very practical target. It's no exaggeration to say that any business model that ignores the Internet logistics imperative puts the company at risk. The evidence for this is now overwhelming; logistics leaders dominate the average players along every dimension of operations.
Cultivate your long-term customer relationships. Nourishing your customer relationship is the only way to turn revenues into profits. Once you build a critical mass of repeat customers, add collaborators to your site, and cement relationship bonds via community, the margin advantage can be huge. If you focus only on the transaction without building the relationship base, all you have is huge marketing costs, price-based competition, and draining of financial capital. The fundamental reality of the Internet today is that the costs of customer acquisition are the equivalent of R&D for a high-tech firma major capital investment as the planned generator of value (though, like R&D, under accounting rules they are expensed). They are a claim on the futurea claim on value if they result in relationships that can be leveraged but a claim against revenues if they don't.
Harmonize your channels on behalf of the customer. In general, a combination of the best of person-to-person, customer-to-call-center, and online interaction outperforms any one of these. Customers choose among the channels, each of which has its own special advantages for them and for you. Give them the choices that best build and maintain the relationship. Forget about channel conflict; customers see only channel choice. Forget about channel control; customers make their own choice.
Build a power brand. The Internet is redefining the idea of brand. The new consumer power brands like AOL and Yahoo are relationship brands, not product ones. This changes the game. In the business-to-business area, start-ups have created brands as intermediaries that are in many instances stronger than most of the companies that use them (think of Ariba, FreeMarkets, and CommerceOne). In the business-to-consumer area, the consumers choose the winners: they determine the portals by making certain brands the cornerstone of their online relationship choices. Thousands of sites aim to become portals; customers choose just a few. Those so chosen become cash flow machines with almost unlimited space to extend relationships, collaborations, and communities to influence services and providers. In effect, these brands-turned-portals are stars with gravitational pull affecting the orbit of many planets and their moons.
Transform your capital and cost structures. In the longer term, .profit business is about the reversal of traditional views of balance sheets. All the items that are shown as financial assets on the left-hand side of the balance sheet are seen as what they really areheavy economic and managerial liabilities that tie up capital and drain economic value added. The firms that move toward negative working capital and minimize the invested capital per unit of revenue and profit gain a Price/Vision premium in their market capitalization, which in itself so reduces their cost of capital that they play in an entirely different growth game from their competitors. Even when such firms are losing money as reported in their earnings statements, they are often already cash flow positive and generating very high revenues on very low invested capital; that's a platform for levels of .profit that offline firms, however strong their earnings, can't hope to match within their standard business models and economic structures. Underlying all the volatility of Internet company stock prices, the losses that many of them are piling up, and their cost of marketing is the drive to build the long-term .profit financial structure that firms such as Cisco, AOL, Dell, and Yahoo have already attained. In the end, this is the real Internet business "revolution."
Become a value-adding intermediaryor use one. This slightly oddball imperative is largely complementary to the others. There's growing evidence that the next era of Internet business will be dominated by hubs: power brand portals and intermediaries. It will be they that control the interaction between suppliers and customers as dynamic brokers, information coordinators, trusted third-party advisers (value-adding intermediaries), and they that will be the places where customers choose to park on the Web (portals). Value-adding intermediation is niche-finding and niche-filling: through it, fragmented supply chains are linked and value roles are filled. This imperative moves in the opposite direction to most of the others, which is toward disintermediation, Everyone else will be a spoke into hubs. Business comes to the hubs. Spokes have to go and find that businessoften by paying to be on the powerful portals.
These imperatives are illustrated briefly in Figure 1.3 and discussed at length in the chapters of Part Two.
These value drivers and their imperatives are not business models per sebut they provide the templates for them and help you think through the following important problems:
How well does your existing business model respond to these demands and opportunities?
How sound are your Internet plans and operations in terms of their underlying implicit or explicit business model?
What can and should your business model be?
Very roughly, most firms that are not yet factoring the Internet into their business vision and priorities and have only a limited Web presence need to be focusing on the first problem. The management question for them is, Are we in or out of the value game? Those that are more committed and active in the Web arena need to ask if they really do have a business model or are just in the .com mode of thinking. The third problemWhat can and should our business model be?is the one for companies to address in order to move along the value path toward .profit rather than just meander around the Internet marketspace.
All business models are uniquecopycat strategies rarely work, as the .coms aiming to replicate Amazon, AOL, or Dell soon found out. Your own firm will place a different emphasis on each particular value imperative, depending on its ambitions, history, core competencies, target customer base. What we offer in From .com to .profit is not a dogmatic set of rules but useful and usable templates for building a business model for your circumstanceswithin a changing world. We offer a map and a compassand our advice and illustrations as to how to use them. To find the right path for your company, your most direct route to .profit, you need these plus an overview of the landscape and a good sense of your goal.
THE EXECUTIVE CHALLENGE
Our goal in From .com to .profit is to provide business executives with clear pictures. One of the advantages of the .com approach to Internet business has been that it could be handled as technology by technology people. .Profit has to be handled as business and technology and by business people and technology people.
In general it is not being handled much at all. A study published in early 2000 by the accounting and consulting firm of Deloitte & Touche showed that 70 percent of retailers have no formal e-commerce strategy. "While roughly one third of retailers consider their online store to be strategic, a majority have set up Web operations with no clearly articulated strategy, and are merely testing the waters to gauge Internet demand."
Another study of executives in nine industries found that 65 percent of management respondents viewed e-commerce as one of their most important initiatives but only 26 percent could point to one centralized decision maker in charge of it and less than half of these have control of the budget.
Top executives are facing a huge challenge here. Barnes and Noble's CEO, Leonard Riggiowho for a decade was one of the most creative and outstanding innovators in American businesstold the New York Times in an interview, "For the first time in my life, I can't see five years ahead the way I used to.... I can't see it clearly." He added, "It's not just the changes in the book business. It's the changes in retail, the changes in the way we live. I wake up and say that any business created before 1997 will be a fossil by the year 2010."
In this context, business managers don't need to be told how important the Internet is nor do they need theories, forecasts, or techno-future scenarios. They most need pictures of the value path that will help them lead their organization to the new world of good business. That's the purpose of our book.