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

In internet years, it seems like ancient history. But it really wasn’t long ago when it was taken for granted that on line 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 illusive. How come? 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 some weeks ago, and the world has changed. As of May 12th, internet e-commerce stocks, as a group, were rated 197 out of 197 industry groups followed for stock market performance by Investors Business Daily over six months. It wasn’t many months ago that they were among the leaders.   As a group, their stock prices have declined by 48% since January 1st.
Mr. Dot Com surf retailing executive, they’re valued that way now.
What have people figured out that’s made this happen?
It costs a lot of money to develop and maintain a quality web site. Instead of hiring $8.00 an hour sales people, you need $80,000 a year programmers and have a hard time finding them. Caching! You still have to carry inventory and take the associated inventory risk. Caching! You still have to get the product to the customer, and you can’t do that over the internet. Caching! You still have to provide customer service, including handling returns, and sometimes that means actually talking to the customer on the phone. It seems to be necessary, according to the conventional wisdom, to have not only product, but content. In other words, you’re not only an etailer, but also an ejournalist, and that adds some costs as well. Caching!! Caching!! Caching!! Oh, and of course you need to spend some money on marketing to establish your brand. CA-CA-CA-CHING!!
Lands End, the mainstream catalogue retailer with a great web site and killer customer service, earned $48 million on sales of $1.319 billion for the year ended January 28, 2000. Of course, they spent $190 million on producing, printing and mailing catalogues. But except for that expense, how is a retailer’s cost structure different from Land’s End? It isn’t.
Lands End internet based revenue totaled $138 million during the year, or 10.5% of total revenue. To put it bluntly, if they didn’t mail those catalogues, 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 mailing those catalogues.
How much? Well, I guess more than $1.639 billion. That’s how much Amazon sold in the year ended December 31, 1999 and they lost $720 million for the year. It’s interesting to note that Amazon’s gross profit margin was only 18%. Lands End, cool or not, had a gross profit margin of 45%. That’s pretty cool to me. If Amazon had Lands End’s gross profit margin, they would still have lost a couple of hundred million, however.
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 itself with its own brand name on it. Amazon is selling stuff it buys 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 website and building a community. The devil, as they say, (and the expense) is in the details. 
Quiksilver had $444 million in revenue for the fiscal year ended October 31, 1999. If, just to pick a number, Quik has 25% of the surf soft goods market, then we’re looking at an industry, at wholesale, that’s something less than $2 billion, 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 etailer is creating any new customers just by being an etailer. He’s fighting over existing customers, in an over retailed environment where he can only succeed largely by taking customers from competitors, of which there are a whole lot. And he’s trying to do it selling products that are probably differentiated from his competitors largely by marketing using a brand name that isn’t as well known.
Before the days of the internet, what percentage of total soft goods sales did catalogue companies do? If dot coms get that percentage of the surf industry soft goods 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 an investment in a dot com.
One statistic I saw a few years ago, which may or may not be relevant, was that catalogue and telephone sales of skis had never exceeded 5% 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 etailers can optimistically get twenty percent of total sales, or something less than $400 million. How many companies can that support? 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 are both established companies that make money.
My personal opinion is that etailers of surf soft goods won’t even approach 20% of the total market. They may not get over five. But even if they can get to 20%, 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 with supporting their brick and mortar retailers. Dot coms competing with retailers who already know how to handle customer service and fulfillment, 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 to recognize that it’s their product, they are in control and an etailer is just another retailer they may choose to sell too. Or not.
The etailers’ answer, I expect, would resolve around “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, though there are lots of theories.
Some of those theories will prove to be the correct ones, and those etailers 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 and on line. Whatever the successful model is, it’s going to change dramatically as broadband finds its way into more homes.
My bottom line on surf industry dot coms is that unless a lot of revenue comes from sources other than product sales, it’s hard to see a viable financial model. 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 along the lines of or