A New Era of Bright Hopes and Terrible Fears

Companies that can ''blast you out of your place'' abound

By Robert D. Hof. With Kathleen Kerwin in Detroit, Peter Burrows in San Mateo, Calif. and Diane Brady in Greenwich, Conn.
Business Week

October 4, 1999

When we try to comprehend something as vast, amorphous, and downright scary as the Internet, it's no wonder we grope for familiar historical precedents-the railroads, the interstate highway system, the telephone network. But none of those really captures the Internet's earthshaking impact on the business world. For that, we must take the advice of Internet commerce pioneer Jeffrey P. Bezos, chief executive of Web superstore Amazon.com Inc., and go much further back in time.

In the Cambrian period, 550 million years ago, something snapped. In the space of less than 10 million years--a geologic instant--there was an explosion of multicelled organisms. Strange new life forms appeared, some with teeth and claws: the world's first predators. These species were so varied and numerous that their basic makeup underlies nearly all life today. Says Bezos: "Evolution tried every conceivable path--really fast."

Tumult and Confusion. That burst of new life both wondrous and dangerous is precisely what's happening in business today. Out of this primordial technological swamp called the Internet are emerging new companies, business models, corporate structures--even new industries. It's a time of such tumult and confusion that no one can agree on what's happening now, much less on what's coming next. In the five years since the World Wide Web made the Internet usable by mere mortals, everything we thought we knew about business seems questionable.

Just two years ago, for instance, Yahoo! Inc. (YHOO) was still a Web search index with a silly name, founded by two grad school dropouts. Since then, it has evolved into a major media company that commands a $40 billion market capitalization--more than Viacom Inc. (VIA.B) just paid for CBS Corp. (CBS) Money-losing startups such as Amazon.com (AMZN) and eToys Inc. (ETYS) command multibillion-dollar market caps and make chumps out of corporations with multibillion-dollar revenues, such as Barnes & Noble Inc. (BKS) and Toys 'R' Us Inc. (TOY) Executives at venerable manufacturing powerhouse Hewlett-Packard Co. (HWP) talk of giving away multimillion-dollar computers for a cut of customers' e-revenues. And unknown upstarts with headscratching labels such as vertical portals, infomediaries, and e-markets threaten to hijack the leadership of countless industries, from plastics to financial services.

Some of these new corporate creatures, for all we know, are barreling down an evolutionary dead end. But the most innovative are likely to prove the commercial equivalent of mammals, which started out small and rodentlike but proved swift and highly adaptable. "They can blast you out of what you thought was your place," frets J. Daniel Nordstrom, CEO of Nordstrom.com. "You can never assume you own your marketplace on the Net."

Consider how the Net differs from microprocessors or other disruptive technologies that have gone before. It's a ready-made marketplace--essentially $1 trillion worth of network connections, computer power, and limitless databases full of information. And it's available largely free to anyone with a phone line and a personal computer. Anywhere in the world. Anytime, day or night. In short, the Net offers an entry point to all comers in every market and industry.

Understandably, all this flummoxes traditional executives who have spent their working lives building companies with real assets, real factories, and real profits. "I don't understand the valuations," Wal-Mart Stores Inc. (WMT) CEO David D. Glass growls of the online upstarts. And Ford Motor Co. (F) CEO Jacques A. Nasser, while admiring Bezos' passion, admitted his befuddlement about Amazon's strategy when he talked e-business to a group of Ford executives in June. "His business model boils down to 'Buy at 100 and sell at 80,'" he quipped, drawing peals of laughter. "If you heard it, you would sell tomorrow."

Perils. But Nasser knows the Net is no laughing matter. The Center for Research in Electronic Commerce at the University of Texas figures the Internet economy already amounts to $301 billion if you include online sales of industrial and consumer goods and services as well as the equipment and software to support e-commerce. That's not far short of the $350 billion auto industry. With growth like that in just five years, the commerce on the Net will be as perilous for many businesses--and entire industries--as it is profitable for others. A half-dozen, from financial services to utilities, will feel the strongest early shock waves. There's hardly an industry that isn't undergoing an upheaval in how it deals with customers and partners, organizes itself, or defines its essential purpose. Says Mark T. Hogan, group vice-president of General Motors Corp.'s (GM) e-GM Internet unit: "We've come to realize that if we don't move with Internet speed, we could become extinct."

All of these consequences flow from one inescapable fact: The Internet puts the customer in charge as never before (Manufacturing, page 103). Until the Net, buyers faced huge obstacles to extracting the best prices and service. Research was time-consuming, and everyone from producer to retailer guarded information like the crown jewels--which it was. Notes Gary Hamel, chairman of the management consultancy Strategos and a Harvard business school research fellow: "For many companies, customer ignorance was a profit center."

Enlightenment sets a new chain of events in motion. Now, buyers can find on the Net a wealth of information on just about any product or service. And if they don't like what they see from one company, another--or three dozen others--are only a click away. But while buyers have a stick, sellers have a carrot. On the Net, sellers can identify individual buyers and collect an unprecedented amount of information on their purchase patterns. Already, software programs can analyze this data along with that of other customers and suggest a book or music CD that a customer might also like--with surprising success.

Ultimately, the Net may usher in products that have been customized for each and every customer. San Francisco-based startup planet U, for instance, is using the Net to help packaged-good companies and supermarket chains target their coupons to individual shoppers. Using loyalty cards to track purchases, supermarkets send the information over the Net to a printer, and a unique package of coupons is mailed out to each customer. Even the amount of discounts on each product can be varied according to how much customers usually buy. Although the coupons cost two to four times as much to print, customers try the products as many as 10 times more often.

Pennies Count. For most sellers, buyer power is likely to present a lot more challenges than opportunities. Nowhere is this more apparent than in the exploding number of sites where auction fever has taken hold. On eBay Inc.'s (EBAY) online trading community and other consumer sites, auctions are as much a form of entertainment as anything. But on sites such as FreeMarkets OnLine Inc. and e-STEEL Inc., where buyers bid on tons of coal and metal, a penny here and a penny there is about corporate survival. Increasingly on the Net, list prices are nothing more than the starting point for negotiation.

Why? The computing power of the Net allows prices to be negotiated instantly and mechanically, making haggling more cost-effective than ever. So for the first time since fixed prices became the norm a century or so ago, a raft of dynamic pricing methods--from auctions to buyer cooperatives and even barter sites--is gaining much wider currency than in the physical world. With the help of eBay, some 15% of consumer e-commerce, or about $1.4 billion, went through auctions in 1998, according to market watcher Gomez Advisors.

Traditionally, auctions aren't done for the benefit of buyers. Sellers realize that by gathering as many buyers as possible in one place, they can provoke heated bidding and thus drive up prices. These days, though, a number of new companies are reversing the auction process in favor of the buyer. Priceline.com Inc., for instance, lets buyers trade away convenience--exact departure times for flights--in return for a lower price than airlines would ever offer at retail. Going a step further, startups such as Accompany Inc. and Mercata Inc. pool groups of buyers so that the more people who agree to buy a product, the lower the price goes.

Even those methods look clumsy compared with what's coming. Some experts believe that software such as ''bots,'' or automated shopping agents, will soon proliferate on the Net. Not only will these software robots search out deals on behalf of buyers, they will be authorized to make purchases automatically if they find the right combination of price and features. In five years or so, your phone might instantly sort through rates as you place a call, choosing the lowest rate on the fly.

Gearing up to serve this newly empowered customer turns the classic business model on its head. Suddenly, factories, trucks, salespeople, and other assets that once defined most companies' competitive edges become a liability. Through the Internet, virtual upstarts can reach customers faster for a small fraction of the cost of stores and salespeople. In many industries, investors clearly view traditional factories and stores much the same way they view deregulated utilities' outdated power plants: near-worthless stranded assets. On the Net, speed trumps mass almost every time.

To see why, do the math on Amazon.com vs. Barnes & Noble. Sure, Amazon is spending into the red to grab customers. But it still holds a formidable inherent cost edge over a rival such as Barnes & Noble. It's currently posting an annual sales rate of $1.2 billion, equal to about 235 Barnes & Noble superstores. But because of the incredible efficiencies of selling over the Web, Amazon has spent only $56 million on fixed assets such as computers and warehouses, while B&N has spent $472 million on its 1,000 or so stores. Moreover, Amazon's investment in new warehouses can support $15 billion in sales, estimates Thomas Weisel Partners analyst Christopher Vroom.

That's why its $21.2 billion market capitalization crushes B&N's $1.8 billion valuation. No wonder retailers, both real and virtual, worry about "getting Amazoned." Warns Cisco CEO John T. Chambers: "Amazon vs. Barnes & Noble will happen in every industry."

This wrenching revelation is forcing a fundamental rethinking of what a company does. Increasingly, savvy companies avoid building expensive, time-consuming in-house capabilities. Instead, they form partnerships that coalesce and dissolve for each new project--a process research firm Forrester Research Inc. calls "dynamic trade." Many companies are even allowing customers and partners access to their innermost operations, blurring the lines between corporations.

No company has gone further down this road than networking equipment giant Cisco Systems Inc. (CSCO) It handles 78% of all its orders over the Net and never even touches half, or $4 billion, of them. Cisco develops product, manufacturing, and testing specifications, but by using the Internet, the orders shoot directly to contract manufacturers. Cisco owns only 2 of 30 plants producing its network switches and routers.

The unprecedented flexibility the Net provides to tap resources outside the company is forcing many to rethink their very raison d'etre. What are we better at than anybody else? If we aren't the best at shipping, won't a rival who uses the best shipper gain an edge over us? Some experts predict a round of corporate divestitures as companies answer the questions. "'Honey, I shrunk the company' is what the CEOs will do," says Kirk Klasson, director of strategic solutions for consultant Cambridge Technology Partners.

Then comes the task of applying a little imagination to what's left. Even the most heavyweight manufacturers, for instance, may be able to reinvent themselves as service providers instead of box pushers. Hewlett-Packard hopes to use the Net to remake itself from a computer manufacturer into an "e-services" company. Instead of selling multimillion-dollar computers, it's offering to provide the computing power over a network for a monthly fee--or in the case of an e-commerce site, charge a percentage of the customer's transaction revenues. Ann Livermore, CEO of HP's $14 billion Enterprise Computing Solutions, reckons such fees could account for 80% of the division's revenues eventually.

In redefining themselves, companies are also transforming their own industries. Hamel of Strategos recently spoke to grocery chain executives in Europe, who were worried about Wal-Mart Stores invading their territory. Hamel told them it was much worse than that: They're also in the gunsights of engineering services behemoth Bechtel Group, which is spending $1 billion to build out a massive logistics warehousing and distribution system for online grocery upstart Webvan Group Inc.

It's a frightening prospect, not knowing who your enemies are until they've already struck. What car dealer five years ago would have suspected a software company such as Microsoft Corp. (MSFT) would be one of their biggest competitors today? Could banks have guessed two years ago that online stockbroker E*Trade Group Inc. (EGRP) would siphon off their retail customers' accounts so easily? Sun Microsystems Inc. (SUNW) Chief Scientist Bill Joy even suggests a credit-card company could offer PCs free to people who promise to buy online using their cards. Muses Joy: "Maybe the leading computer brand of the 21st century will be Visa."

In industry after industry, the interlopers are swarming like locusts. From plastics to steel to consulting services, hundreds of upstarts such as PlasticsNet and e-STEEL are setting up new, independent marketplaces online. Ultimately, they hope to become the nexus for commercial activity in their industries. And as they gather detailed information about what buyers and sellers want, they could become more indispensable to each than conventional middlemen such as distributors.

Less Friction. But wasn't the Net supposed to do away with middlemen? After all, producers and customers can now connect directly. It turns out that on the Net, buyers need middlemen to sort through the vast new choices of suppliers. And suppliers need to be where masses of buyers gather--which usually isn't on individual company sites. Like eBays for business, these middlemen--variously called infomediaries, vertical portals, or e-markets--are using the Net to instantly connect buyers and sellers anywhere.

Because there's none of the friction of phones, faxes, or in-the-flesh meetings, these Net middlemen can gather together vast numbers of buyers and sellers. Ultimately, this efficiency is likely to push profit margins down to the commodity-like levels of electronic marketplaces such as Nasdaq. But because of their central position, says Charles H. Finnie, an analyst with investment bank Volpe Brown Whelan & Co., these middlemen will control a quarter of the world's transactions between businesses by 2002. Says Finnie: "Most of the major industries will get turned on their ear."

Altra Energy Technologies Inc. of Houston is typical of these new creatures. Before the online marketplace was started three years ago, buyers of natural gas had to rely on cumbersome phone calls and sending faxes to sellers. That limited them to only a few potential deals and a lot of potential price manipulation by sellers who might know a particular buyer was desperate for supplies.

Winner Take All. Now, Altra lets buyers trade anonymously on the Net with thousands of sellers. Since it's so much more efficient for buyers and sellers, it has quickly emerged as the main place to trade online, handling 40% of the industry's natural gas liquids. This year, transactions on the site will rise to $12 billion. Says Altra Chairman E. Russell Braziel: "It's a winner-take-most business."

These middlemen are demonstrating an irony of the Net. Yes, it's a marketplace with low barriers to new entrants--but only if you get there first. And with few clues to legitimacy online, brands provide even more pull than in many traditional businesses. Then there is the snowball effect: Once a Web site gathers a mass of buyers, in flow the sellers--whose products then draw more buyers. It's a fast-moving virtuous cycle that quickly builds one dominant player. Think Amazon in retailing or eBay in person-to-person auctions. All that portends even more consolidation online than in the physical world. "There will be thousands of winners on the Internet," says Morgan Stanley Dean Witter analyst Mary G. Meeker. "But there will be only a very few really big winners."

Becoming one of those big winners is particularly hard for established companies. While online upstarts got massive market caps going after the next big Net idea, Charles Schwab & Co. endured the wrath of Wall Street when it cut online trading commission fees in 1995 and gave up $150 million in commission profits. But it paid off. Now, its market share is more than double industry upstart E*Trade, and its $30.6 billion market cap tops Merrill Lynch's by more than $4 billion.

Business has never been about avoiding tough choices. What's different this time around is that experience may be the worst teacher of all. That's unlikely to change until technology slows down--and there's no sign of that. No wonder even successful managers have the feeling that something fanged and scaly is sneaking up on them. "I don't think we've seen the biggest changes at all," says Dell Computer (DELL) CEO Michael Dell. Those adrenal glands we developed eons ago could come in very handy.

Copyright 1999, by The McGraw-Hill Companies Inc. All rights reserved.