E-Commerce: What Works–and What Doesn’t–on the Web

Leonard Shneyderman turned his first profit when he was 16 years old. It was 1986, a year after he and his family had emigrated from Moscow to Brookline, Mass. Shneyderman, then a high school sophomore, noticed that parking was tight in his neighborhood. So he made a deal with a local property owner to rent a vacant lot, subletting parking spaces to eager local residents, all before putting a penny down himself. The margins were high and profits so substantial that he was soon able to buy himself a black Volkswagen Jetta.

He also absorbed a lesson in doing business.

“I would never bother starting a business that wasn’t cash flow positive early on,” says Shneyderman, who went on to earn an MBA from Babson College in Wellesley, Mass., and work as an investment banker for GE Capital and PaineWebber. Shneyderman, now 30, and his older brother started an Internet company two years ago based on the same principles derived from the parking lot venture: Find a promising niche and proceed without spending a bundle. GameColony.com, which hosts fee-based tournaments in chess, checkers, gin and other games of skill, went live in February 2000?just before the Nasdaq took its dive and the dotcoms started to expire. But don’t expect the Shneyderman’s Newport Beach, Calif.-based company to go the way of Pets.com or Kozmo.com. In February, the Internet startup started showing a profit (albeit a small one), something neither Boo.com, Furniture.com, Kozmo.com, Pets.com, nor hundreds of other well-financed and well-promoted dotcoms ever did.

Shneyderman, the CEO, says the frugality that was natural to an immigrant has much to do with it. With $755,000 in original capital?$625,000 from venture companies Acorn Angels, D.K. Capital and Dover Capital, and $130,000 from his and his brother’s bank accounts?Shneyderman started GameColony.com, buying three Sun enterprise servers from a defunct dotcom for a total of $39,000, less than one-third the original sticker price. (The deceased dotcom had received $15 million in startup funding and shut down after nine months.) He signed up with Web hoster HarvardNet (whose Web hosting assets have recently been swallowed by Allegiance Telecom) for $1,500 a month for a T1 line, which can burst to a T3 line if volume increases. Then he hired five programmers from Saint Petersburg, in the former Soviet Union, to run the site. “They’re working very hard, and they’re making the equivalent of six times what an average Russian programmer makes,” Shneyderman says, adding that a windfall for them is roughly one-fifth of what their U.S. counterparts would earn for the same work. (The Russian programmers also receive housing and a small piece of the company.)

Onsite advertising is already covering GameColony’s $28,000 a month operating costs, and the company has recently launched tournaments with players from around the world paying to compete for prize money. (The fee-based tournaments were launched in July.) GameColony has 300,000 registered users in the United States, Europe and Asia. Players pony up an entry fee for each game, whether it’s checkers or gin, and the winner collects 80 percent of the kitty, leaving 20 percent for GameColony.

“I’m here to run a business,” Shneyderman says. “We don’t view ourselves as an Internet company?we’re a gaming company. The Internet just happens to be a perfect venue. Other dotcoms raised millions in capital and the money was wasted. You can make money on the Internet if you don’t spend a lot in the first place.”

Take that, Mr. First-Mover Advantage

While it’s now clear that most online business models were fated to fail (even Amazon.com, the avatar for all things B2C, had not as of June shown a profit), a group of consumer sites on the Internet, including GameColony.com, have been quietly counting their profits for months. That’s how recently it is that anybody?with the exception of eBay, Yahoo and a handful of catalog outfits?has turned a profit.

No one said making money by selling things over the Internet was going to be easy, of course. Those heady days when the CEO of Beyond.com could grab our attention by appearing in his skivvies on CNBC to demonstrate that customers could use his site in their home and in any state of dress or undress are ancient history now. And the carnage continues. At least 435 Internet companies?of which 47 percent were e-commerce ventures?have shut down since January, according to Webmergers.com, a San Francisco research hub for buyers and sellers of Internet properties. More telling, perhaps, is this statistic: Of the 494 Internet-related businesses that went public during the past five years, only 11 percent trade at more than their offering price, and nearly one-third trade at more than 80 percent below their offering price, according to Sandeep Varma, a vice president at the New York City-based consultancy Stern, Stewart & Co. And with the air whooshing out of the economic balloon, many brick-and-mortar companies are cutting back on their e-commerce spending, Varma says. Or, in the case of bookselling giant Borders, giving up entirely. In April 2000, the Ann Arbor, Mich.-based bookseller turned its Web operations over to Amazon.com.

Is it time then to trash your e-commerce plans? Not necessarily. While Pets.com’s pooch has been relegated to the back of the sock drawer, consumers are still looking to the Web to spend their money. In fact, consumer e-commerce revenues hit $44.5 billion in 2000?a 66 percent increase over 1999 levels?and represent 1.7 percent of all U.S. retail revenue, according to a May study, “The State of Online Retailing 4.0,” conducted by the industry group Shop.org and The Boston Consulting Group. The survey also showed that e-commerce revenue now accounts for more than 10 percent of total retail revenue in the computer product, book and travel sectors. (See “A Growing Slice of the Retail Pie,” above.) And this year, the survey predicts, online shopping will rise an additional 46 percent to $65.1 billion.

At the beginning of 2000, many companies embarking on e-commerce initiatives were obsessed with building market share, figuring that profits would follow sooner or later. Large corporations trembled as dotcom insurgents such as eToys and Amazon.com threatened to topple the Fortune 500, while business consultants and gurus lined up to sing the virtues of the Web. The Internet would drive down operating costs, wipe out all middlemen and disrupt the corporate hierarchy. It was…a paradigm shift! All that really mattered, the wise men said, was getting there first and getting big fast. And by the way, advertising would take care of the moneymaking side of things. But those retailers and service providers who focused on profits from the get-go have demonstrated that e-tailing has more to do with old-fashioned business sense?and the ability to ship boxes around the country?than with which outfit has the snazziest website or most innovative business model.

By looking at those few hearty sites that are actually making money, we’ve extracted four rules that can lead to profits on the Net: Be diverse, exploit your channels, be frugal and above all, keep your wits about you.

Profit Is a Many-Splendored Thing

When Fort Worth, Texas-based Travelocity.com got off the ground five years ago, its business model was simple: Sell airline tickets online and make money from advertising. That simple notion?profits will come from one primary source?has now proven fatal for scores of Internet businesses, including Disney’s portal Go.com and other content sites that put too much faith in online advertising. (Even Yahoo, which has shown a profit, has faced recent trouble because it relied too heavily on advertising as its primary source of revenue.) And yet, this spring Travelocity posted its first operating profit while its registered users rose to 27 million.

Travelocity’s success, according to CEO Terrell Jones, stems from its ability to diversify and keep revenues streaming in from different avenues. “Five years ago we were an online travel agency,” says Jones, who started his career as a travel agent and went on to become the CIO of Sabre, the Fort Worth, Texas-based software developer and travel reservations company. “Now, we’re a database-driven marketing and transaction company.” By that Jones means that Travelocity uses its customer database to sell travel merchandise, such as totes and suitcase sets, and promote travel clubs in which people pay to receive regular travel upgrades and other services.

Travelocity, which faces fierce competition from Microsoft’s Expedia, as well as individual airline sites and the airline consortium Orbitz, reported its first quarterly operating profit of $618,000 in April on sales of $73 million?compared with a loss of $5.6 million on sales of $35.7 million in 2000. Travelocity.com is one of several sites that are benefiting from courting diverse sources of revenue. Homestore.com in Thousand Oaks, Calif., offers lists of 1.5 million homes and 6 million rental apartments for free and has been profitable for the past three quarters. Much of Homestore’s revenue comes from advertising and listing fees charged to real estate agents, but the company also sells software that helps realtors keep track of clients.

“Most online businesses should consider migration from advertising to diverse models,” says John Marshall, senior vice president and head of digital strategy at Digitas, a Boston-based consultancy. “The truth is that most sites haven’t paid off. The focus now should be on ROI and profitability.”

Making a profit online in the travel sector is easier than in many others because an airline ticket doesn’t need to be shipped in boxes across the country and around the world. “We’re selling a virtual product. We don’t have the same problems a clothing retailer has,” Jones says. Indeed, Travelocity competitor Expedia recently reported an operating profit, and Southwest Airlines sold 30 percent of its tickets online last year.

Today Travelocity gets 25 percent of its revenue from advertising, with another 25 percent coming from airline commissions and the rest from reservation system fees and non-air travel, such as vacation packages and cruises. Travelocity uses targeted e-mail campaigns to promote the newer sources of revenue such as the vacation and travel packages, Jones says. The travel site is also branching out by selling travel gear and publishing Travelocity Magazine.

Unlike travel service customers, most homebuyers and sellers still want to work with an agent, and during the past year dozens of real estate sites have gone out of business. Homestore.com has been able to turn a profit by expanding its original homes-for-sales listing to a broad Web business that includes selling software to real estate agents as well as a service that generates leads for custom home builders. This year Homestore reported a first-quarter net income?excluding various charges?of $4 million on revenues of $118.4 million, compared with a pro forma net loss of $33.7 million on $57.6 million in revenues for the same period a year ago. And the Internet company predicts full year pro forma revenues of $500 million, compared with $230 million last year.

Mo’ Better Channels

It’s not surprising that catalog retailers such as L.L.Bean and Victoria’s Secret have prospered on the Web. After all, they had already mastered the tricky business of fulfilling orders and shipping boxes around the planet. They had call centers up and ready, and their customers were already willing to buy things without touching them. And they knew the value?in dollars and in loyalty?of treating customers with equal importance no matter which channel they shopped, store or catalog.

What is surprising is that so many traditional companies failed to learn from the cataloger’s experience when they were devising their e-commerce strategies. Instead, they were so focused on establishing their Internet presence that they failed to exploit their brands and their brick-and-mortar stores. “Those companies that tried to emulate dotcoms, like Toys “R” Us and Barnes & Noble, did a lousy job,” says Glenn Rifkin, coauthor of Radical E: From GE to Enron?Lessons on How to Rule the Web, which analyzes Internet strategies of large corporations, including General Electric and Staples. “They decided that brands would conflict, so they separated them and neglected to use either channel to promote the other.”

Meanwhile, the list of catalog companies making money online is long and growing. Eddie Bauer, which made a profit in 2000 and predicts the same for 2001, saw its sales rise almost 100 percent in the fourth quarter of 2000. From the start, Redmond, Wash.-based Eddie Bauer, owned by Downers Grove, Ill.-based Spiegel Group, allowed customers to return purchases made online to a brick-and-mortar store. Barnes & Noble, for example, only recently wised up to that customer-considerate strategy. “We saw early on that if we can get customers to shop in more than one channel, their overall loyalty goes way up,” says Sally McKenzie, division vice president for interactive media for Eddie Bauer. “Selling apparel online is pretty tricky?but it’s pretty tricky in stores as well.”

Sharperimage.com, like Eddie Bauer, has found that the more catalogs it mails out, the more Internet traffic the company gets. “Our catalog is far from a loss leader,” says Greg Alexander, senior vice president for IT at the Sharper Image in San Francisco. “It drives a significant amount of our Web business.” (See “Not Paper Tigers,” this page.) Alexander says Sharperimage.com has been profitable on its own since it launched in 1995. Sales have grown from $200,000 the first year to $60 million in 2000, or about 14 percent of the company’s total sales. One reason for success, Alexander says, is that it offers more items online than in stores or in the catalog, therein taking advantage of the fact that the amount of shelf space on the Web is, theoretically, infinite.

“We view the Web as just another channel for customers to learn more about Sharper Image products,” Alexander says.

A Penny Saved is a Business Preserved

When considering plans to expand overseas, Sharperimage.com thought about building a new platform that would allow consumers in Europe to buy products online in their own currencies. That had a certain logic, but according to Alexander, the new platform would have cost “tens of millions” of dollars. Instead, the company decided to sign up as a merchant with Yahoo, paying the portal a monthly fee (the size of which Sharperimage.com declines to reveal) to host its site in Germany, the United Kingdom and other European Union countries. Yahoo says it will host overseas online stores for a monthly fee that starts at $100 and rises depending on the level of inventory, says Nicole Kennedy, a company spokeswoman. “Getting an online business started in another country doesn’t have to cost a lot,” Alexander says.

Now that venture capital has largely dried up for e-commerce, successful sites are looking for ways to feed the bottom line. Venture investment in the e-commerce sector fell from $843.4 million to $68.5 million?more than 90 percent?in the first quarter of 2001 as compared with the first quarter of 2000, according to a survey by PricewaterhouseCoopers and Venture One. “From the technology perspective there are ways to achieve efficiencies,” says Ken Wei, vice president of strategy at Mainspring, a Cambridge, Mass., consultancy. In addition to seeking revenue sharing deals with portals such as Yahoo, e-commerce ventures can outsource their websites to offshore software programmers or outside consultancies. And although large companies may need an IBM or an Accenture to help develop their Web strategies and perform their integration work, smaller Web consultancies?such as Scient and Razorfish?that have suffered from the Internet downturn are offering some deep discounts, Wei says. Going with boutique Web consultancies may be risky given their precarious financial situations, but they could save you money, he adds.

Stupid Dotcom Tricks

In retrospect it all seems so clear: Don’t spend millions on Super Bowl ads when you can’t promise the customer anything more than he can get at the local pet store. Don’t offer to deliver candy bars for free. Don’t alienate your middlemen if you don’t have to (see “Make Friends with the Middleman,” Page 94). Don’t weaken your brand by separating business channels. In other words, don’t follow silly business models.

Pets.com spent $180 per head in customer acquisition costs, according to Stern, Stewart & Co.’s Varma. For fiscal 1999, the year before Pets.com folded, the e-tailer had expenses?including whopping advertising and marketing budgets?that were 9.2 times its annual revenue of $5.4 million. In the end, the exercise of mailing 10-pound bags of dog food across the country was expensive, and the dotcom spent far too much on its promotion given the number of customers who wanted the service in the first place. Pets.com also failed to differentiate itself from physical pet stores, Varma says, relying exclusively on price instead of offering special services or an unusual selection. (See “Some Bark, Others Whimper,” this page.) Now, the dotcom’s iconic mascot, the sock puppet, which it brought to rock star status with its $2 million Super Bowl ads, has become an emblem for fatuous failure and can be found for sale on Amazon.com for $8.96, marked down from a list price of $19.99.

Kozmo.com, the New York City-based company that delivered everything from Snickers to DVD players to customers’ doors, said it was close to profitability in certain markets when it was forced to shut down in April. In the end, however, profit margins were too thin and investors lost confidence. “The problem with Kozmo’s business model was that they could break even only when people made large orders frequently and people weren’t ready for that,” Varma says. Kozmo officials blamed the dotcom’s demise on heavy spending on expansion early on when it should have carved out a smaller niche and focused on fewer cities. “The Web can’t make a poor business model successful,” says Larry Perlstein, vice president and research area director for Gartner in San Jose, Calif.

But of course. Everyone knows that…now.