Shake-Out, Dot-Com

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SHAKE-OUT, DOT-COM

For several years in the late 1990s, e-commerce companies, which quickly came to be known as "dotcoms," could hardly avoid having money thrown at them by investors looking to cash in on what was widely touted as the financial windfall of the New Economy. Vigorous investment sent the stock valuations of dot-coms sky high, far outpacing what would be expected of firms based on their fundamentals. But the ever-climbing stock markets seemed to confirm to many investors that the Internet era had pushed the economy into a new phase where traditional business logic and investment patterns were obsolete. Dotcoms were widely seen as being among the hallmarks of this new era in business, and many players rushed onto the scene in an exuberant bid to grab a piece of the lucrative action.

Sober-minded analysts, however, recognized that the good times couldn't last, and that the market was due for a correction. A number of factors led to the collapse. In addition to the much-discussed precarious structure of the pure-play, dot-com business model of the late 1990s, market analysts insisted that the high-flying tech market was significantly overheated and due for a fall. With competitive pressures growing out of proportion with any market demand and extremely weak financials, skittish investors began fleeing the dot-com crowd as quickly as they had joined them, and the stage for the e-commerce shakeout was set. That correction finally came in 2000; in March the technology markets plummeted, and for the rest of the year, once proud and seemingly invincible dot-coms struggled to survive. Hundreds of firms closed their virtual doors in 2000, taking tens of thousands of jobs with them. One leading dot-com benchmark, the Goldman Sachs Internet Index, finished 2000 about 67 percent below its level at the start of the year. Merrill Lynch estimated in late 2000 that three out of every four public dot-coms would shut down within five years.

THE BUILDUP

An inherent difficulty—though it certainly wasn't always perceived as such—for dot-coms was that most relied overwhelmingly, if not exclusively, on investor dollars to stay afloat. That is, they often had little viable means of self-sustaining income and were thus dependent on the whims of the stock market and the attractiveness of their ideas in the venture capital markets. According to some analysts, this exacerbated the shakeout when it finally came, due to herd-like investment behavior.

On the financing side of the equation, in addition to the stock markets, dot-coms had been overwhelmingly propped up with copious amounts of venture capital. The mid-and late 1990s saw venture capital spending skyrocket largely so as to take advantage of the new crop of promising technology and Internet-based firms. With the economy strong and plenty of cash to go around, venture capitalists were quick to throw money at many different dot-coms at a time, the logic holding that one big success would easily pay for all the failures. As a result, scores of dot-coms hit the market with little preparation but plenty of seed money. Since simply announcing oneself as a new dot-com was often enough to secure significant financial backing, the Internet was bursting at the seams with e-commerce firms, many of which didn't even have a viable product, much less a plan for long-term profitability.

Since capital flowed so freely to e-commerce players in the late 1990s, they were able to engage in extremely unorthodox pricing practices, undercutting competitors by wide margins in order to draw in customers but without actually making money on their sales, and frequently even selling their products below cost. As long as investors remained confident in the possibilities of e-commerce, companies could get away with this. Investors who continued to put money behind companies engaged in this strategy were convinced that, given the uniqueness of e-commerce, the financial shortcomings of such plans would pay off in the long run by the hegemony of the e-commerce model. When that failed to materialize, investors rushed out of the market.

In addition, the strategy followed by many dotcoms called for rapid growth at all costs in order to stake a claim on the market; they felt they needed to grab the market's attention first, and then institute a viable market plan. As a result, companies spent vast sums of money on television advertising and other means of getting their names in the public spotlight. The shakeout stopped this trend in its tracks, as companies had to overhaul their strategies completely and show investors they actually knew how to make money. The bulk of dot-coms, however, were unable to accomplish this to investors' satisfaction, and soon perished.

For workers, dot-coms offered a work environment markedly different from that in most traditional corporate offices. Casual, flexible, and on the cutting edge of business practices at the time, dot-coms lured many skilled information-technology workers looking to circumvent the standard corporate profile. And, of course, workers were drawn to the stock options, one of the main vehicles by which dot-coms attracted workers. In the midst of the booming stock markets, largely fueled by e-commerce companies, stock options often displaced salary and benefits packages as the chief priorities for prospective workers. When the stock market ultimately proved still beholden to the traditional business cycle in the early 2000s, stock options were no longer seen as the optimal path to employee wealth, and IT workers again placed their priorities on more tangible and predictable means of compensation.

Without their own inventories, warehouses, or distribution centers, dot-coms ran into a great deal of trouble with regard to fulfillment and delivery, about which they received no shortage of complaints. One major firm that did manage to survive the shakeout was Amazon.com, which spent a great deal on its own warehouses in the late 1990s and earned high marks for customer service, generating tremendous repeat business. As a result, the company demonstrated it could make money and remained attractive to investors. A 2000 study by Jupiter Communications found that only 41 percent of individuals who made a purchase online were satisfied with the service they received from dot-coms.

Meanwhile, as more traditional bricks-and-mortar companies began catching up to the dot-coms in establishing their own online storefronts and other Internet operations, their more stable capital flows and economies of scale forced the comparative attractiveness of e-commerce start-ups to diminish rapidly. The shakeout was postponed slightly simply because traditional retailers were reluctant to delve too deeply into e-commerce without a clear strategy for integrating it into their existing operations. In other words, bricks-and-mortar firms were wary of cannibalizing their own operations. Once those companies began to wake up from the shock inflicted by their dot-com rivals and develop their own brick-and-click strategies, it was only a matter of time before their greater leverage and long-term growth strategies starved out their online competition. When the brick-and-click sites became operational, there was a strong tendency for consumers to maintain their loyalty to conventional brands online.

Other warning signs were certainly in place. In 1999 Jupiter Communications reported that only 6 percent of all e-commerce sales represented new business, meaning that most of the online shopping was performed at the expense of catalogs and retail stores. In other words, e-commerce didn't represent so much a boon for new business as a medium for increased channel conflict. As the tension between this factor and the unsound e-commerce business plans increased, the cracks in the e-commerce facade began to show. By the end of that year, e-commerce players were pouring money into fancy advertisement schemes designed to push themselves ahead of the competition over the crucial holiday season, sensing that their fields weren't strong enough to support four or more companies striving for the same few dollars.

THE SHAKEOUT COMMENCES

As the 1990s drew to a close, it was increasingly clear to analysts that the e-commerce world was becoming dangerously overcrowded, with sectors struggling to support more players than the market could reasonably maintain. The beauty products, consumer electronics, pets, and other consumer-goods sectors all featured upwards of 10 companies—all of them with large piles of capital backing—competing for what were actually exceptionally small and unproven markets. Other sectors, including those trafficking in Web content, enjoyed fantastic initial public offerings only to go belly up as market realities caught up.

For example, in 1999, there were over a dozen variations on the pets e-commerce theme, and while some enjoyed the support of major pet-supply chains like PETsMART and Petco Animal, few of them could boast anything close to a sound business strategy. For instance, Business Week reported in March 2000, just as the shakeout was beginning, that market leader Pets.com was collecting only about 43 cents in consumer sales for every dollar it spent on supplies, and that was before other major expenditures such as advertising and distribution. The online operation at PETsMART, meanwhile, collected only 62 cents for each dollar spent on supplies. This scene was repeated in dozens of market sectors, leaving it to investors and consumers to separate the wheat from the chaff. For most market sectors, those e-commerce players that weren't ranked first or second were extremely hard-pressed to stay afloat, and as brick-and-mortar firms caught up with dot-coms in e-commerce strategy, that factor grew more pronounced.

One clear sign that consolidation was in the cards for the dot-com industry was the surprise announcement in January 2000 that America Online, the largest property on the Internet, would merge with the media giant Time Warner. This, perhaps more than any major business realignment, signaled that the exclusively Internet-based business wasn't destined to displace the traditional bricks-and-mortar firm; rather, the future of e-commerce was likely to witness a blurring line between the two. When, a few months later, the bottom began to fall out of the Internet economy and the well of venture capital suddenly ran dry, e-commerce players scrambled to make themselves attractive to potential suitors. The survival method thus shifted from the reliance on stratospheric market capitalization to absorption into a deep-pocketed traditional business. Suddenly, dot-coms found that profitability was for the first time a major factor in the evaluation of their firms.

Other companies, convinced that the B2C (business-to-consumer) model was a dead end, quickly transformed themselves to take advantage of the B2B (business-to-business) market. However, while the shakeout in the latter sector wasn't as pronounced or as dramatic as that in the B2C field, B2B soon found that it, too, fell prey to the backlash against e-commerce. Particularly in the realm of business-to-business exchanges, it was simply a matter of too many businesses and too little differentiation, leading inevitably toward consolidation. As a result, B2B exchanges en masse either scrambled for particular niches or sought out a buyer. According to Computerworld, more than half of the 900 B2B e-marketplaces in existence in mid-2000 were defunct by the end of that year.

MATURITY AND OTHER SURVIVAL STRATEGIES

The e-commerce explosion was largely predicated on the notion that, somehow, e-commerce companies, particularly pure-plays, were a qualitatively new kind of business, and thus needn't follow any of the traditional business strategies or market logic. Alongside this ethos, according to critics, came a heavy dose of arrogance. Perhaps typifying this characteristic was the online retailer Buy.com, one of the brashest of the pure-plays and the second-largest e-commerce retailer after Amazon.com. Led by its flamboyant chief Scott Blum, Buy.com eschewed nearly every type of traditional business sense and styled itself as a daring alternative.

The company built its business by selling computers, books, electronics, and other goods well below cost, undercutting competitors' prices. However, this strategy clearly wasn't designed with an eye toward profits, and the company held out hope that it could generate money via advertising. Moreover, Buy.com chose to cut costs by maintaining no inventory, rather choosing to outsource its entire order-fulfillment operation to logistics companies. This model couldn't be farther from traditional business sense, but the New Economy hype carried enough weight on Wall Street to lift Buy.com 's stock sky high with the help of heavyweight bankers such as Japan's Softbank.

The strategy seemed to work for a while, as the company amassed $125 million in sales in its first year, making it one of the fastest-growing companies ever. The company spent great sums purchasing other Web domain names with "buy" themes, such as "buymusic.com " and "buycars.com ." However, before long the company began to lose consumer confidence; its poor order handling, delivery, and consumer outreach—sparked in no small measure by its refusal to maintain any inventory—spawned dozens of Web sites devoted to bashing Buy.com.

Blum shortly after brought in a CEO to run dayto-day operations, and the firm, its future in doubt in the thick of the shakeout, began to change its character from the brashness of its early days to a more mature-and traditional-model. In other words, the firm took pains to map out for investors just how it planned to achieve profitability—in this case, by subtly raising its prices from their drastically low levels—and relied less for its revenues on flashiness and irreverence.

In Buy.com 's story were several lessons for e-commerce firms. In particular, those pure-play dot-coms without access to durable distribution and fulfillment operations, lacking a solid and dependable customer base, and with little brand recognition were hard pressed to survive, unless they managed to make themselves attractive enough for acquisition.

THE AFTERMATH

For some companies, however, the dot-com bust was an ironic twist on the market euphoria that preceded it. That is, where in the late 1990s a simple—dot-com—appended to a company name could send valuations sky high, in the early 2000s that same company could be grossly undervalued for the same reason. According to Business Week, hidden among the New Economy rubble at the end of 2000 were doubtless a number of dot-coms unfairly neglected by the market; such firms would eventually arise out of the shakeout with a durable business plan and thinner competition for cash, in the process reaping ground-floor investors enormous rewards. Thus, the dot-com shakeout produced, alongside its layoffs and shattered fortunes, a number of bargains.

The shakeout didn't mean, however, that consumers and businesses gave up on the idea of buying and selling online. Rather, the shakeout was the natural process of any new growth industry, which inevitably undergoes consolidation as consumers and investors learn to distinguish the wheat from the chaff. Where the e-commerce shakeout proved so dramatic was in the tremendous hype many of the failed dot-coms had received, the enormous sums of money that were made and lost in just a few years, and the short-lived notion that e-commerce wasn't bound to the traditional laws of economics or business sense. But the shakeout did little to dissuade companies from conducting business online, nor consumers from shopping in cyberspace. As companies increasingly integrate their online storefronts into their bricks-and-mortar operations, creating a seamless and complementary whole, and as more and more individuals attain Internet access, the number of e-customers is only expected to grow.