WHEREFORE ART THOU, PROFIT?

by Joe Gold, Senior Editor
OneChannel.net

Profit was once the most important word in the business vocabulary. No doubt it will be again. But in these Wild West days of an economy transforming to life online, profits have been put out in the back 40. What matters during this transition is grabbing share of mind and establishing a business with a firm enough foundation that it will outlast its competitors and reach the promised land of black ink.

How long before the promise of a rosy e-tail future requires proof through profitability?

The price of e-tail entry is so much lower, and the "neighborhood" you serve so large, turning a profit ought to be a snap, right? No high-rent retail locations, no construction costs and delays, no clerks with attitude, no fancy floor displays. Customers can shop in their underwear—or less. Store hours are 24/7. Traffic jams (at least the automotive variety) are irrelevant. What’s not to love?

A few—maybe you—will become big players down the road. Investors who missed the Microsoft bonanza have been generous in backing e-tailers that could generate Microsoft-like profits. In this second California gold rush, Silicon Valley is only the epicenter of commercial tremors that are rattling the world.

All we need to do is outlast the flood of competitors before the investors bet on who can still make it and who’s going to fall victim to the inevitable shakeout. The up-and-down on once soaring Internet stocks suggest that round one of the shakeout has begun.

For all those people who didn’t get on board the Microsoft Investor Express, e-tail and other promising technology issues offers another chance to latch on to a Microsoft-like economic engine that can eventually churn, churn, churn out the dollars.

Is this a glamorous business or are we afloat in a bubble that can’t help but burst?

A cautionary view

One person less than giddy with expectation is David M. Alschuler, vice president for e-business and enterprise applications in the Boston office of Aberdeen Research. "Retail is the most miscast rocket in the fleet," he said. "Retail has always been a cyclical business running on thin profit margins. The Web reorganizes the retail business model with different selling costs."

How long can e-tail continue floating in red ink? "As long as the capital markets allow it to," Alschuler said. He sees the market for tech stocks more than the e-tail promise that’s filling the bubble. "There is so much more demand for stock than stock available in traditional companies. There is something wrong with a company being valued as though they have achieved profitability. These companies have a hell of a lot of risk. Capital markets represent people’s fundamental belief that people want to hop on the bandwagon. If and when the bubble breaks, having a real business will be essential."

In the meantime, Alschuler recommends e-tailers stay focused on down-to-earth issues. "A reasonable expectation is managing a plan that makes sense, a business model that has average revenue equal to or better than average cost at some breakeven point. You can’t make money online until the cost is spread over hundreds of thousands of customers."

Alschuler finds the present market for stocks, especially dotcom stocks, a unique opportunity. "Right now the market is supplying the liquidity to buy customers. We’ve never seen a market like this. Window not just open, there are incredible amounts of resources available, and that slows the need for immediate profits."

Lose now, profit later

The prize for e-commerce winners is huge. In the long run, it’s worth enduring a few years of losses to ramp up to be a big player in a decades-long game. At least, that’s the judgment of those investors who continue pumping cash into dotcoms that show promise.

In ActivMedia’s sixth edition of its 193-page report Real Numbers Behind ‘Net Profits 1999, the company’s vice president of research, Harry Wolhander, says "Internet-generated revenues in 2000 will reach $226 billion, nearly six times the $38 billion observed in 1998. Typical growth rates for many mid-range players are even higher, and some companies will experience online revenue growth of over 2000 per cent. Naturally, e-commerce programs that see growth rates three to four times higher than average are going to budget more for Web site development today in order to handle the expected future business. These companies understand that success online will create the leading companies of the new millennium."

The report points out that "Web sites anticipating profitability in two to five years had far higher development budgets than sites that were already profitable or expecting profitability in the near term (averaging $59K, vs. $26K), a demonstration of their appreciation of long-term potential for the web, and commitment to success online."

Branding and buying

But at this point, Pets.com is reportedly collecting 43 cents and rival Petsmart.com 63 cents for every dollar they spend on merchandise and delivery. They are in that all-important "branding" phase. Certainly when your store doesn’t have a corner on a city block, when your competition is a click away, mind share is even more important than it is to the bricks-and-mortar guys whose edifices are a constant reminder of their existence. For virtual retail, getting mind share requires spending marketing money to generate the public relations buzz and advertising to create awareness.

What they get for their massive marketing expenditures are results measurable as hits, click-throughs, and visitors. But there will be a day of reckoning when sites have to out-market their competitors and make enough sales that they generate an actual profit. And again the question pops up: when?

Is 24 months enough?

Faisal Hoque is an entrepreneur and author of E-Enterprise: Business Models, Architecture and Components. He told OneChannel.net "You have to make an investment to create infrastructure and branding for a new product and service offering. Is 24 months enough of a time frame to do that? I would say so.

"By then you need to have some sign or some proof point" he says, such as how customers are reacting in terms of satisfaction, and traffic, but ultimately in sales. "At least some part of your business should be profitable. Within the next two to three years, if people don’t start showing profit, investors will question the basics. The reason you are in business is to make money."

Hoque acknowledges that "branding is a good thing, but whether it is effective or not does not come from people knowing your name. It comes from people actually buying or not. Pure play (online retail) does not make you anything special. At the end of they day you’re a business."

Business is in business to make a profit. But with venture capitalists to help a struggling new organization get up and running—and we at OneChannel.net fall into that category as well—the time from launch to going public can take longer. From there it’s up to the stockholders as to how much patience they exercise.

Concern over ongoing losses

Not everyone believes that investor patience can last much longer. AMR Research produced a report on retail application strategies predictions for 2000 that anticipates investors demanding concrete results soon, especially as the e-tail is replaces as the investors’ new darling.

"Most Internet retailers will spend the first months of 2000 retooling their business plans because their investors are unwilling to stomach ongoing losses, particularly after the holiday season showed glaring weaknesses in some operations," the AMR report projected. "As Wall Street satisfies its appetite for e-business investments on more promising business-to-business and e-commerce infrastructure markets, many Internet retail wannabees will be hard pressed to find cash to feed their money-hungry branding and marketing campaigns."

The AMR prediction becomes more dire: "Established sites will increase traffic and transaction volume and expand into more categories. By year’s end, only a few of the many hopefuls that cluttered the airwaves with ads in November and December will still be around, and most of the departed won’t be replaced."

Investor patience

How much patience is reasonable for an e-tail startup? "There is no answer," said Dr. Ezra Zuckerman, an assistant professor for strategic management at Stanford University, the spawning ground for the vast majority of Silicon Valley dotcoms.

"If the eventual opportunity is big enough, it would make sense for an investor to be very patient in waiting for profits. However, what seems clear is that when one looks at Internet stocks as a group, it is impossible for them to generate the level of profits that current valuations imply," Zuckerman said. "So while it may be possible to justify waiting quite a while for profits on a given stock, the amount of waiting (and the amount of money expected) for future profits implied in current valuations is ludicrous."

Professor Zuckerman said "Profitability clearly means less to investors these days, though that will not last. Remember, the proximate determinant of a stock's price is what the marginal investor will pay. What determines what the marginal investor will pay? For any stock, there must be a theory that interprets available information and translates it into a valuation. However, that theory is just that—it can be significantly at variance with reality. And to the extent that the stock is in a new, untested industry, so are the theories.

"Eventually though, the market learns to have a better—though always far from perfect—theory that looks at the same information and places a different value on it. It is my belief that this will happen to Internet stocks, but it is anyone's guess when this change will occur."

OneChannel.net was an online e-commerce measurement service that featured original editorial content.