Egghead.com, Inc.

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Egghead.com, Inc.

1350 Willow Road
Suite 100
Menlo Park, California 94025
U.S.A.
Telephone: (650) 470-2400
Fax: (650) 473-6990
Web site: http://www.egghead.com

Public Company
Incorporated: 1988
Employees: 200
Sales: $207.8 million (1998)
Stock Exchanges: NASDAQ
Ticker Symbol: EGGS
NAIC: 45411 Electronic Shopping and Mail-Order Houses

Egghead.com, Inc. is a leading Internet-based discount retailer of computer hardware, software, peripherals, and accessories. For most of its history, the company operated a chain of specialty retail stores under the name Egghead, Inc. However, increased competition from mass merchandisers and consumer electronics “superstores” eroded Egghead’s sales and profits during the 1990s and forced the company to re-evaluate its strategy. In 1998, Egghead made the bold decision to close its “bricks and mortar” retail operation. After re-christening itself Egghead.com, the company opted to sell its products primarily through the Internet, as well as by phone and catalogue. In addition to running its eponymous web site—Egghead.com—the company also operates an Internet auction site (www.surplusauction.com) and re-sells computer hardware, software, and accessories at its off-price web warehouse (www.surplusdirect.com). Moreover, Egghead.com owns a 25 percent stake in Elekom Corporation, which creates electronic commerce applications. In 1999, Egghead.com’s Internet empire expanded again when the company merged with on-line auctioneer Onsale Inc.

A Consumer-Oriented Software Company is Founded

Victor D. Alhadeff founded Egghead in 1984. Alhadeff had been involved in an oil and gas limited partnership until a drop in prices drove him out of business in 1983. Shopping for software later that year he found that salespeople at computer stores spoke in technical jargon that often confused the average customer. Alhadeff had sold shoes while in college, and with this retail experience, he decided that he could sell software far more effectively using traditional customer-friendly methods.

Using $50,000 of his own money along with $1 million from local investors—including Paul Allen, a co-founder of Microsoft Corp.—Alhadeff opened his first Egghead store in Belle-vue, Washington. From the beginning, Egghead made an effort to make computer software less intimidating to the average consumer, projecting a warm image through the store mascot, a cartoon character named Professor Egghead. Salespeople received intensive training in order to become familiar with a wide range of software and explain it in simple terms. Egghead carried a wide range of software, as many as 1,300 titles, while its warehouse maintained a further 1,000. Customers were allowed to take software home for a 30-day trial period, and stores had up to four computers available for in-store demonstrations. Furthermore, Egghead featured extremely low prices, sometimes 40 percent off the list price.

With its unique approach to software retailing, Egghead’s sales rose quickly, and it soon was adding new stores. Corporate customers accounted for a major percentage of Egghead’s sales, and the company established a large direct-sales force in 1985. Soon it was selling to Fortune 500 companies like IBM and Boeing. Despite its growth, Egghead kept its costs down, investing its savings in new stores. The firm’s quick growth attracted attention and investor interest. Some investors were cautious, however, due to a controversy surrounding the bankruptcy of Alhadeff’s previous company, against which several investors filed suit claiming Alhadeff had misled them about the company’s finances.

Rapid Growth in the Late-1980s

In 1987, Egghead prepared to go public. The offering was called off at the last minute, however, when the U.S. stock market fell dramatically in October of that year. Alhadeff instead raised $25 million in credit from the U.S. Bank of Washington, and several million more from private investors, including Prudential Venture Capital, for a total of $47 million in venture capital invested in Egghead. Egghead’s sales came to $77.5 million in 1987, nearly doubling sales of the previous year. Perhaps more importantly, the firm had profits of $2 million, after losing nearly $1 million in 1985 and 1986. However, in the rapidly changing computer industry, the firm faced new competitors. B. Dalton Books was expanding its Software Etc. division, which had over 100 boutiques, many of them in the bookstores, and Babbages Inc., carrying similar merchandise, doubled its stores in 1987 to 58.

By early 1988, Egghead operated 107 stores in 13 cities and maintained $40 million of software inventory. In June 1988, Egghead finally went public, with an initial offering of 3.6 million shares at prices above 50 times the firm’s 1987 earnings. Egghead used nearly $24 million raised in the offering to add about 100 new stores and put the rest into working capital. In one nine-month period, 64 new Egghead stores were opened as the chain tried to saturate the market before it was filled by competitors. As a result of this growth, Egghead stores and corporate sales staff accounted for about ten percent of U.S. software sales in 1988.

Despite annual sales climbing toward $350 million, however, profits declined due to the swiftness of expansion. In addition to opening the new stores, Egghead added 60 salespeople to the direct sales staff of 132. That meant an addition of 1,600 total employees in one year, and new salespeople required extensive training. As a result, the firm’s administrative and selling costs doubled in a year and its operating margins sunk from 4.5 percent in 1988 to about 3.7 percent in 1989. Egghead tried to obtain maximum profits from its low margins by getting volume discounts from software manufacturers. That meant increasing inventory, however, which was both expensive and risky in an increasingly unstable software market.

This tumult lead to two straight years of losses for Egghead, and the company was forced to close 29 stores to cut costs. With large volumes of software flowing quickly through its warehouses, control over Egghead’s inventory system slipped and theft increased. In 1989, in the midst of this period, Alhadeff hired Stuart Sloan and Matthew Griffin to help turn around the company. Sloan, who became chief executive officer, had a background on Wall Street, where he had led the leveraged buyout of Quality Food Centers Inc. in 1986. Griffin, who replaced Alhadeff as chairman, had made millions in real estate. The two put internal controls into effect that made each store manager responsible for the performance of his or her store. Retail store managers were sent monthly profit-and-loss statements for their stores, while district managers were sent statements for their areas. Furthermore, Sloan and Griffen refocused company efforts on selling software directly to corporate customers, who accounted for 60 percent of sales. The moves strengthened Egghead’s bottom line.

During this time, however, a new rival was emerging: chains of computer superstores that matched or beat the prices of Egghead’s software and also sold computer hardware. Egghead responded by strengthening its promotional machinery. When Microsoft’s MS-DOS 5 operating system came out, Egghead promoted it extensively, and sold it for $39.99, which was 60 percent lower than the $99.95 list price. Seeking to take advantage of its higher level of customer service, Egghead invested $3 million into training its sales experts. It also added 300 items to the store’s inventory, increasing the selection in the average store to 1,600 items.

The Early 1990s

Egghead was profitable again by 1990, with sales of $519 million and profits of $15.4 million. However, a growing recession was affecting the sale of personal computers as well as PC software, and computer superstores were becoming more popular. Furthermore, hardware manufacturers were beginning to offer free software with hardware purchases, circumventing software retailers altogether. As software became more standardized and easier to use, Egghead’s customer service became a less significant advantage, and other retail outlets, such as bookstores and office supply stores, began to stock software. Attempting to boost sales, Egghead began promoting and licensing business applications by Computer Associates, the country’s second largest software firm. It signed a $3.5 million contract with SalePoint Systems to shift its point-of-sales (POS) software to IBM’s OS/2 operating system. The POS system linked the firm’s stores, distribution centers, and headquarters. Most software products were bar coded by version when the firm received them, helping its sales and distribution.

By the end of 1991, the firm had 205 stores in 20 states and sales of $665 million. It remained profitable, with earnings of $15.7 million. As Egghead continued to expand rapidly, opening 12 stores and closing two during the first quarter of 1992, earnings again declined. Furthermore, the company made a costly error when it overstocked Microsoft’s new Windows 3.1 software, predicting heavy demand that never appeared, in part because several computer manufacturers had already loaded the program onto their hardware as an added feature. Egghead fought back with an aggressive marketing campaign and planned to open between 20 and 40 stores by the summer of 1993.

Software industry price wars intensified during 1992, driving margins still lower, and Egghead brought in a new management team in early 1993. Timothy E. Turnpaugh, previously vice-chairman and operations manager at Seafirst Bank in Seattle, became president and chief executive. Griffin, who had resigned the year before, was replaced by Richard P. Cooley, a director and retired chairman at Seafirst.

Company Perspectives:

We receive more than 7 million customer visits per month. Each customer has a unique set of needs and budgets. To accommodate our diverse customer base, Egghead offers a variety of services and benefits.

Egghead’s problems could not be solved simply by changing management. As fierce competition continued to batter the company’s bottom line, Egghead’s earnings for the fiscal year of 1993 plummeted 56 percent from 1992. In the wake of these dismal reports, Egghead once again brought in new leadership. Turnpaugh was named chairman in July 1993, while Terence Strom, the former chief of electronics retailer Best Buy Co., was chosen as Egghead’s new president.

Strom quickly trimmed the company’s workforce and led Egghead into the rapidly growing catalogue sector with the purchase of the mail-order business, Mac’s Place. He also cut software prices by five percent in an effort to make Egghead more competitive with electronics superstores. Although cheaper software prices drove Egghead’s sales for fiscal 1994, the company’s profits suffered as a result. Upon reporting a net loss of $500,000 for the year, Turnpaugh resigned. Strom and former Egghead vice-chairman Ronald Erickson jointly assumed leadership of the company.

The Mid-1990s

Since Egghead’s boutique software stores continued to lose sales to one-stop-shopping superstores such as Fry’s Electronics, Strom stewarded the company through a major shift in strategy. In July 1995, Egghead announced that it would open larger stores more akin to its giant competitors. While the typical Egghead outlet was only about 2,000 square feet, Strom planned to build 10,000 square foot stores that would now offer computers and peripherals to go along with the software that had been the company’s traditional focus. That same year, Egghead formed Elekom, which concentrated on business-to-business electronic transactions.

Though 1995 proved to be a successful year for Egghead—due in part to brisk sales of Microsoft’s newly launched Windows 95—Egghead’s profits sunk once again in 1996. Egghead had shed its direct sales unit, depriving it of the revenue generated by software sales to corporate, government, and education clients. Moreover, the transition to larger-format stores had proved costly, and the company reported a net loss of nearly $11 million. In January 1997, Strom announced his resignation, and George Orban, a long-time Egghead board member, took the reigns of the troubled company.

In an effort to improve Egghead’s profitability, Orban closed nearly half of the company’s 158 stores and pulled out of a number of markets altogether. According to the February 24, 1997, edition of PC Week, Orban believed that Egghead had “expanded into too many geographic markets—more than it could afford to advertise and distribute in.” At the same time that Orban decreased Egghead’s retail presence, he poured money into the company’s Internet business, which had begun to sell software directly to customers over the world wide web in November of 1996. “This business is in its infancy, but it is showing promising growth and consumer acceptance,” Orban told the Washington Post on February 1, 1997.

In May 1997, Egghead further bolstered its on-line operations by acquiring Surplus Software, which sold computer hardware and software directly to consumers through catalogues and the Internet. This purchase marked a diversification of Egghead’s business plan. Previously, the company had simply aimed to supply the latest software at the high end of the retail market. However, with Surplus Software, Egghead entered the “off market” sector of the industry. Consumers of “off market” products were less interested in the newest generation of program and more so in obtaining outdated but still functional products at lower prices. Through Surplus Software, Egghead purchased “distressed inventories” (outdated products or overstock) from manufacturers and resold them to consumers over the Internet. By November 1997, Egghead had three Internet sites operational. In addition to selling discount computer products on its Surplus Direct web site (www.surplusdirect.com), Egghead also launched a consumer auction web site (www.surplusauction.com), whereby consumers made bids on refurbished or off-price technology products. The company’s flagship web site (www.egghead.com) offered a range of hardware, software, and accessories. At the same time, Egghead spun off its Elekom division into an independent company, albeit one in which it retained a 25 percent stake.

A New Focus Emerges in 1998

While Egghead’s “bricks and mortar” retail sales remained weak in 1997, its Internet business thrived. Between the first and third quarters of the 1997 fiscal year, traffic at Egghead.com increased from 600,000 to over six million customers. Recognizing which direction offered it a better chance at future profitability, Egghead made the bold decision in January of 1998 to close its remaining 85 retail stores and become exclusively an Internet business. To reinforce this new direction, the company changed its name to Egghead.com. “We decided on the Internet, which is growing much more rapidly than the retail channels,” Orban told the surprised Spokesman Review on January 29, 1998. By shuttering its retail operation, Egghead stood to reap substantial savings. In addition to reducing its workforce by 800 employees, the company also was freed from both leasing and construction costs. Moreover, distribution expenses would be only a fraction of what they were, since the individual Internet customer—not the company—paid merchandise shipping costs. Even more promising for Egghead was the potential profits e-commerce offered. Industry insiders predicted that Internet sales in computer hardware and software products would grow from $2 billion in 1998 to $11 billion in 2000.

Key Dates:

1984:: Victor Alhadeff founds Egghead.
1988:: Egghead makes its first public stock offering.
1995:: Egghead creates the Elekom Unit.
1997:: Egghead acquires Surplus Software and spins off Elekom into an independent company.
1998:: Egghead closes its retail stores and concentrates on Internet business.
1999:: Egghead merges with Onsale Inc.

While market analysts applauded Egghead.com’s brave move, the company’s transition to an Internet-only operation was fraught with challenges. “We expect to invest heavily in marketing and technology and therefore expect to incur substantial operating losses in the foreseeable future,” Orban announced to the Spokesman Review on May 6, 1998. To develop its Internet presence, Egghead.com entered into several alliances with major Internet portals. For instance, in February 1998, Egghead.com became the premier computer and software merchant on Yahoo! Internet guide. Its efforts were successful. Egghead’s three web sites collectively ranked sixth among major Internet commerce sites as measured by Media Matrix in May 1998.

Although Egghead.com reported significant losses in fiscal 1998 and 1999 ($50.2 million and $34.4 million, respectively), the company’s outlook was positive. As the Portland Orego-nian explained, “in the developing e-commerce world, the bottom line [was] replaced with new performance indicators,” in which Egghead.com “scored well.” The company’s inventory costs had plummeted as expected from $100 million to about $14 million. With over 40,000 products for sale, Egg-head.com enjoyed seven million customer visits per month.

Demonstrating its continued desire to strengthen its position in the on-line market, Egghead.com merged with a leading cyber auctioneer in November, 1999. This new partner, Onsale Inc., sold a variety of computer hardware and software products, as well as vacation packages, consumer electronics, and fitness equipment. Onsale’s AtCost site was rolled into the Egghead.com site, while Surplus Auction and Surplus Direct were moved to Onsale’s auction area. With the merger, Egghead, com had the size and strength to leverage better prices from its providers. Even more promising was the fact that Egghead.com could cease its price war with Onsale (which had undermined both companies’ profits) and could compete more effectively with the likes of Gateway Computer and Buy.Com. Egghead.com moved its headquarters to Onsale’s offices in Menlo Park, California. Orban was named chairman of the new company, while Onsale CEO Jerry Kaplan became president of Egghead.com.

Principal Subsidiaries

Surplus Software; Elekom Corp.(25%).

Principal Competitors

Beyond.com Corporation; BID.COM International Inc.; CNET, Inc.; CompUSA Inc.; Cyberian Outpost, Inc.; Dell Computer Corporation; Micro Warehouse, Inc.; Multiple Zones International, Inc.