Internet Anxiety
Part in envy, part in fear, Corporate America is embracing a radically new business model
For years, Toys 'R' Us has struggled against giant discounters like Wal-Mart and Target. But this past holiday season brought into focus an even more formidable threat: a tiny online retailer called eToys. The Net startup's $30 million in sales last year equaled that of maybe two--out of 1,486--Toys 'R' Us stores. But when it came to ringing up the online register at Christmas, eToys left toysrus.com in the dust. Even worse, eToys scored a market cap of $7.8 billion on its first trading day, in May, dwarfing Toys 'R' Us's $5.6 billion.
With visions of an Amazon.com-type rival emerging in his own backyard, Toys 'R' Us CEO Robert C. Nakasone went into overdrive. But rather than attempting to refine his online operation in-house, he has set it up as a separate unit. Nakasone formed a partnership with Silicon Valley venture capitalists Benchmark Capital, funded it with $80 million from his own coffers, and moved the budding online business from Toys' New Jersey headquarters to Northern California. ''Over time, we could have gotten it right,'' says Nakasone. ''But we don't have the time.''
Nakasone is not the only executive with an urgent desire to rush onto the Net. In industry after industry, Corporate America is suddenly feeling the uncomfortable gnaw of Internet Anxiety--a stomach-churning mixture of envy, resentment, and increasingly, just plain fear. ''It was easy for people up front to dismiss online business as the flavor of the day,'' says Frank J. Drazka, managing director and head of technology investment banking at PaineWebber Inc. ''But in the last year there have been a lot of board meetings in which management was asked, 'How do we compete against the newbies on the block?''' Driving those meetings, says Drazka: ''The threat of extinction.''
The phenomenon started, of course, with those incredible, indefensible, often downright insane valuations investors began bestowing on their ''dot.com'' favorites around the fall of last year. After all, with the Goldman Sachs Internet Index (GIN) climbing a phenomenal 453% between last September and its early April high, who wouldn't get a little green watching from the sidelines?
But what began as simply the lust for a red-hot stock has turned into something far deeper recently--something even the 34% nosedive of Net stocks over the past two months has done little to dispel. More galling than Internet stock prices is the way Net companies are allowed to operate. In the Net's through-the-looking-glass world, earnings hardly seem to matter, investors have been happy to hand over buckets of money to speed development, and the lucky devils running Net businesses are getting filthy rich besides. Meanwhile, even at their current levels, Net stocks have proved to be powerful currency that gives Internet companies a huge advantage when it comes to making acquisitions or hiring the best talent.
''WAMPUM.'' At a fundamental level, there's a clash of business models under way, and the new model springing up among Net companies bears little resemblance to the old rules by which most managers have learned to play the game. To the dumbstruck executives at conventional companies--who have spent their careers forced into slavish obeisance to Wall Street's incessant demands for a penny or two more in earnings per share--it's all a bit much.
A prime example? Look no further than the adventures of Margaret C. Whitman, who went from being a senior manager at Hasbro Inc. to a billionaire Internet exec in just 14 months after joining online swap meet eBay Inc. With a net worth on paper of $1.1 billion, Whitman now boasts personal wealth almost twice the size of the $503 million family stockholdings of her former boss, Hasbro Chairman Alan G. Hassenfeld. It took the Hassenfelds 75 years to build a business with a $5.7 billion market cap. After nine months as a public company, eBay is worth more than three times that. ''That drives Alan crazy,'' says Gary Jacobson, a onetime top-ranked toy analyst who--surprise!--spent several months recently trying to launch his own Net startup. ''A lot of people are seeing things like this and saying, 'I want my shot.'''
Hassenfeld declined to speak to BUSINESS WEEK, saying through a spokesperson that he doesn't recall commenting on Whitman's wealth. But listen to the comments of other blue-chip CEOs and a certain note of surprise comes through. No slouch himself when it comes to pumping up his stock price, General Electric Chairman John F. Welch jokingly derides lofty Net stocks as ''wampum,'' while IBM Chairman Louis V. Gerstner Jr. scoffs at the new Net companies as ''fireflies before the storm''--they shine now, but will eventually dim out.
Mock the phenomenon as they may, however, these two are far too smart not to recognize that something more important than soaring stock prices is going on. Simply put, there's a revolution under way, and mastering the Net has moved front and center on Corporate America's agenda. The Internet model, with fewer hard assets, a direct pipeline to customers, and freedom from the hierarchical management structure of most of Corporate America, offers a new level of speed and operational efficiency for those who master it--and huge dislocations for those who don't. ''I don't think there's been anything more important or more widespread in all my years at GE,'' says Welch. ''Where does the Internet rank in priority? It's No. 1, 2, 3, and 4.'' By yearend, every one of GE's 200 odd businesses will be able to do E-commerce transactions. Eventually, billing, quality monitoring, and other things now done on paper will move onto the Net.
Certainly, established companies can bring considerable strengths of their own to the online battle. Strong brands, customer-service expertise, and management depth will help. And with their positive cash flow and borrowing power, they could find that the financing advantage swings in their favor if the market for Net stocks continues to weaken.
But for the time being, it's the Net business model that's ascendant--and throughout Corporate America, executives are suddenly waking to the realization that those who don't move fast to get in on the game risk having their lunch eaten by tiny rivals who may have barely existed just a few years ago. In industry after industry, fledgling Net companies have transformed the way business is done and snatched market share from their much bigger, established rivals. Retailing and financial services got whacked first. Now media, entertainment, telecommunications, and health-care companies are feeling the heat.
DAY OF RECKONING. Old-line industries such as autos, oil, and utilities could be next, warns market researcher Forrester Research Inc., which believes that brokers in these industries--either independent or owned by the established players--will set up more efficient online sites for reaching customers. ''Americans perfected a business model that became the most important in the world,'' says Lawrence A. Bossidy, CEO of industrial-products giant AlliedSignal Inc. ''But it's obsolete now because it requires too much working capital. The Internet allows you to be far more virtual with customers and suppliers. If I don't embrace the Net, I can't reduce those investments.''
Or you could be cut out altogether--disintermediated, in Internet parlance. That's what spooked John Steffens, vice-chairman at broker Merrill Lynch & Co. He held out for months, arguing that Merrill's superior service and market savvy would allow the world's largest brokerage firm to trump nascent online rivals (page 93). But then the unthinkable happened: Merrill began to lose business to Charles Schwab and E*Trade. In an abrupt about-face, Merrill announced on June 1 that it would rush to build an online brokerage service in six months. With the titan of broker-generated sales conceding the online threat, any company that relies on a traditional sales force will now have to do some soul-searching.
Elsewhere, too, the past few months have seen a dizzying series of announcements and deals as other mainstream corporate giants have raced to solidify their Web strategy. Faced with the potentially catastrophic threat of digitized music available over the Web, BMG and Universal have created online CD seller getmusic.com. In the media and entertainment world, it seems, nearly everyone from Walt Disney to NBC to TCI is scrambling to create separate Web stocks in a mad rush to get some Internet currency. Even before Merrill's announcement, other brokerages had been hustling to prepare for the Internet. Donaldson, Lufkin & Jenrette Inc., for example, floated a tracking stock (page 98) tied to its online efforts.
Those who don't attempt to navigate the Internet may be taking the biggest risk of all. Almost overnight, the Net has become a huge part of the economy. A recent study by the Center for Research on Electronic Commerce at the University of Texas, commissioned by Cisco Systems Inc., found that the Internet economy grew at an astonishing annual 174.5% rate from 1995 through 1998. At $300 billion today, that rivals sectors like telecommunications and autos.
YOUNG AND HUNGRY. Anyone who doubts the vibrancy of this new world need only follow the money. Net-based IPOs and deals are restructuring the corporate landscape. Through June 10, 66 Internet companies went public, up from 40 in all of 1998, according to Securities Data Corp. So far this year, they've raised $5.5 billion--fully 25% of the $21.9 billion raised by U.S. public offerings, compared with 6% of the total raised by all IPOs last year. And though the IPO parade could slow if the Internet stocks don't regain their footing, it is worth remembering that Net-stock valuations remain stratospheric compared with the blue chips. The GIN's average p-e is a breathtaking 674, dwarfing the 34 averaged by the companies in the S&P 500 index. Moreover, armed with their high-priced stocks, Internet highfliers continue to be aggressive acquirers. In the first five months of 1999, Internet outfits have snatched up companies worth $48 billion, according to Securities Data, up from $28 billion in all of 1998.
Until now, many of those deals have involved Net companies buying up other Net companies in a dash to capture market share. But the disparity of valuations between pumped-up Net stocks and their real-world brethren has allowed Net businesses to begin buying up rivals with real-world assets--making the Net companies a threat to more established players. Take Yellow Page ad agency TMP Worldwide Inc., which garnered a Net-like stock valuation by relentlessly promoting its online job-search site, monster.com. That helped its stock rise from $15.50 to a high of $93. Though the stock has since dropped to $56, TMP has used that currency to consolidate a foray into the head-hunting business by snapping up LAI Worldwide Inc. From out of nowhere, it's suddenly breathing down the neck of established rivals such as Heidrick & Struggles Inc. and Korn/Ferry International Inc.
Stories like that have awakened many executives at old-line companies to the need to develop a little Net currency of their own. ''If we have a currency, we can be consolidators instead of the consolidatee,'' says Fredric G. Reynolds, chief financial officer at CBS Corp.
The issue of Internet currency is also closely linked to one of the most intractable problems lurking beneath Internet Anxiety: Will brick-and-mortar companies still be able to attract good people? The ability to hire and keep top-notch employees, of course, goes to the heart of any company's ability to prosper and grow. But without the lure of high-flying stocks and big options gains, traditional companies are hardly playing on a level field.
Just ask Disney's Michael D. Eisner. The Internet ambitions of the entertainment giant he runs have been hampered by a revolving door in the online unit. Executives arrive, earn their stripes online, and get snatched away to run their own show with a startup that can offer a big equity stake. The latest to leave: Internet honcho Jake Winebaum, who gave up one of the best perches in media to run his own Net outfit in partnership with Sky Dayton, a 27-year-old entrepreneur. Dayton, with whom Winebaum often went snowboarding, founded ISP giant Earthlink Network Inc. ''There's real-world wealth and Internet wealth,'' says Winebaum, who made a fortune selling a group of magazines to Disney. ''I'd like to see what Internet wealth feels like.''
JUMPING SHIP. Disney isn't the only company watching as online upstarts seduce some of their most talented executives. As the Web matures, Net companies are finding they need new skills, from logistics and distribution to marketing. Recruiting isn't a hard sell when the Net seems to mint a fresh set of millionaires with each IPO. ''Comments like 'someone's brother went over to work for Excite as an assistant marketer and is now worth $10 million to $20 million' and so on--that noise is already seeping in, and we are nervous about it,'' says Alan Kaye, head of human resources at toymaker Mattel Inc.
Still, money is not the only reason talent is moving to the Net. Some top execs have looked around at the speed with which the Net is transforming the economy and have decided that a move online is a simple matter of survival. Neil S. Braun left a job at the pinnacle of broadcasting as president of the NBC Television Network to take his chance on the Internet. With $100 million in backing from Net investor CMGI Inc., Braun is launching iCast to develop video and audio services for the Web. ''The Internet will be the growth medium for the rest of my career,'' says Braun, 46. ''Not to be part of it would be an incredible missed opportunity.''
If poaching can't be stopped, some have stepped up the efforts to fight back. Federal Express Corp., whose expertise at computerized logistics has made it a prime hunting ground for hungry E-biz startups, is hoping a more balanced work environment will help it to keep its remaining high-tech workers. Unlike the work-around-the-clock ethos Silicon Valley demands, FedEx offers flexible schedules, telecommuting, and on-site degree programs through a local university--all at a leafy campus 18 miles from its Memphis headquarters.
As tough as it is to attract and hold on to talent, traditional companies face an even bigger challenge when it comes to deploying capital in an online initiative. Net-based rivals have created a new model for doing business that rewards them for plowing every cent into development--even if it means losses. Real-world companies, however, are still expected to show earnings growth quarter after quarter.
For those tied to the earnings-driven way of doing business, there are anguishing choices to be made about how much to invest in a still-emerging medium with huge up-front costs and profits that remain only theoretical. ''In getting from A to C, B is hell,'' says Avram C. Miller, who guided Intel Corp.'s Internet investments as vice-president of business development before forming his own consultancy. ''B is where your revenues decline and your profits go down. But there may be no way for large companies to get to where they need to be in the future without going through this valley of death.''
It's not just about shrinking earnings--it's also about having the stomach to take money away from other businesses within the company that are actually generating cash. Take the case of Charles Schwab, which has been one of the most successful in its migration to the Net. An early challenge managers of the fledgling unit faced back in 1995 was fighting the expanding international unit and others for corporate-investment dollars. ''We had hard decisions to make,'' says Dawn G. Lepore, Schwab's chief information officer (page 88).
Even Wal-Mart Stores Inc., which brought retailing into the computer age, is groping to find its way in the new environment. ''No one seems to understand that there is not a general consensus as to what's going to happen on the Internet,'' says CEO David D. Glass. He says the best estimates he has found for total retail sales transacted over the Internet next year range from $10 billion all the way up to $100 billion. That makes it all but impossible for him to figure how much Wal-Mart, with sales of $138 billion, should invest.
TOUGH SLOG. Making matters worse, the Internet is not a world that tolerates caution or deliberation. In a medium where brand-name recognition is everything, losing the ''first-mover advantage'' can be a handicap. That's the big lesson Corporate America learned when Barnes & Noble Inc. got blindsided by Amazon.com Inc. Despite huge capital expenditures and massive advertising since then, Barnes & Noble remains barely more than one-tenth Amazon's size online.
It's hardly surprising that Barnes & Noble wasn't first to the party. Selling direct on the Net, after all, required it to cannibalize its own core franchise. That's a problem a lot of other conventional companies will face as they contemplate an online push. By cutting out the middleman, the Net makes it possible to reach buyers faster and cheaper. But for many, taking advantage of those efficiencies will mean going into direct competition with themselves or their distributors.
Any company that tries to minimize cannibalization risks losing the customer altogether to more aggressive outsiders--as Merrill Lynch learned to its chagrin. Similar issues torpedoed former Compaq Computer CEO Eckhard Pfeiffer. He was ousted on Apr. 17 in part because he was unwilling to cut out his distributors and sell computers direct online. Compaq's sales stalled anyway when customers went to rivals' online sites. E-commerce players like CompUSA Inc. and Staples Inc. figure the only course is to forge ahead and not fret about cannibalization. ''Right now, someone else is trying to get that customer, and that's Dell and Gateway,'' says Stephen B. Polley, CEO of CompUSA Direct. ''We have to be just as aggressive.''
Another thorny issue that established companies face is the question of how to structure their online unit. Should it be kept in-house or spun off? The answer has profound implications for everything from a company's ability to offer its best employees options to how deeply it can integrate the Net into its core business.
SPLITSVILLE. Given the potential Net IPO's still have for big runups, it's no surprise that investors--as well as employees who work for online units--are increasingly pressuring managers to cash in by floating a separate stock. But if few would quarrel with the joys of stuffing the corporate coffers, it's often far from clear that spinning off an online unit is the best choice strategically. That's one reason, for example, why Microsoft Corp. hasn't spun off its MSN portal. A separately traded MSN with its array of E-commerce and online content sites might gain a big market cap in its own right to help it compete against Yahoo! and AOL. But it would leave Microsoft on the outside looking in as software becomes more tightly integrated with online content.
Those issues are behind a debate that is now raging inside SABRE Inc., the big computer-reservations system majority owned by AMR Corp., parent of American Airlines Inc. Travelocity, the popular online travel site, is just a small part of SABRE, which has a current market value of $8 billion. Yet Priceline.com Inc., a far smaller, money-losing rival to Travelocity, has a market cap of $13 billion. That has some investors pushing for a separate tracking stock for Travelocity. With estimates of its value ranging up to $10 billion, says SABRE CEO Michael J. Durham, ''you start forgetting how to spell 'synergies.'''
So how can real-world companies pick their way through the competing demands of investors, employees, and their own business imperatives? Catalog retailer Fingerhut Cos. may offer a model. Already famed for its database expertise, Fingerhut began buying up promising Web ventures such as PCFlowers and MountainZone in 1998. But rather than take full control and an earnings hit as these embryonic businesses struggle toward profitability, Fingerhut buys stakes of less than 20%. Keeping below that threshold lets Fingerhut avoid having to recognize losses at those ventures. To make sure it doesn't miss out on the upside, Fingerhut holds options to raise its share if the companies start showing a profit. The minority positions also allow Fingerhut to attract and reward E-workers with stakes in their own ventures. ''It's a very good structure for a company like ours, which is earnings-driven,'' says President Will Lansing.
Lansing isn't the only one in search of a solution. And as older companies adjust to the new technology--and learn to exploit it--they should be able to counterpunch with some formidable strengths of their own. Says GE's Welch: ''There are advantages for existing companies: They have the business processes, they have the fulfillment capabilities, they have the brand recognition, and they often have the technology.''
Some have already begun to exploit those advantages. QVC's Internet shopping subsidiary, iQVC, racked up a respectable $50 million in sales last year by piggybacking on QVC's existing order-fulfillment and customer-service operations. That lets QVC sell a lot more items than it can showcase each hour on TV. Says Jeffrey F. Rayport, an associate professor at Harvard Business School who praises QVC as a case study in hybrid business models: ''They stood back and said, 'What is it we can do uniquely for our customers offline and online?' and then built around that.''
Still, the anxiety unleashed in the past year is likely just a taste of what's ahead. The two competing business models have only begun to clash, and the new rules have yet to gel. ''No one can tell you today what the impact of any move on the chessboard will be,'' says PaineWebber's Drazka. The only certainty: The earlier you get in on the game, the greater your chances of winning.
By Nanette Byrnes in New York and Paul C. Judge in Boston, with bureau reports
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