Online Merchants: How The Winners Did It

Convenience, huge selections, and a few electronic twists give these Netrepreneurs an edge

Two and a half years ago, Pierre M. Omidyar decided to launch a Web site. Inspired by his fiancee's passion for collecting Pez dispensers, the Silicon Valley entrepreneur hit on the idea of building a flea market in cyberspace--where people could buy and sell anything to anybody. There was one snag, though. How could he persuade complete strangers to trust one another enough to hand over merchandise or cash without ever having met?

Omidyar's solution was to devise a system where buyers and sellers can rate their experiences with different traders. eBay Inc. assigns a point for positive comments, zero for neutral responses, and minus 1 for negative feedback. If someone racks up a score of minus 4, they're not allowed to use the service anymore. That provided the assurance people needed to feel comfortable trading with one another--and it helped Omidyar's eBay become the largest person-to-person auction site on the Web, selling $100 million in merchandise in the first quarter of this year. "I trust someone to send a check after they've bought something, and they trust me not to send them a box of rocks," says Bruce Nicklin, who sells computer parts on the site.

Omidyar isn't getting rocks, either: eBay has been profitable nearly from the start. In the first quarter of this year, revenues hit $6 million, as much as it generated all last year. He's in good company. Dell Computer, E*Trade, Columbia House, Eddie Bauer, and 1-800-Flowers: These are just a few of the big-name brands that are turning the Web into a profit center. And for every household name, there are dozens of mom-and-pop sites that are making a go of it in cyberspace.

SURF CITY. It wasn't always that way. For three years, even as the number of commercial sites exploded, from 2,000 in early 1995 to 414,000 this year, there was one statistic that didn't budge: Only 30% of E-commerce sites were profitable, according to market researcher ActivMedia Inc., which has been surveying Web sites since 1994. And the lucky few that were operating in the black didn't generate eye-popping returns. That situation is changing. By the end of last year, 46% of online stores were operating in the black, although the bulk of those remain small shops, says ActivMedia.

What has changed? For one, the number of people roaming the Web's virtual aisles has jumped, from 14.3 million in 1995 to 41.5 million at the end of 1997, according to Cyber Dialogue Inc. But that only goes so far in explaining how some cybermerchants have risen above the gaggle of online stores to become such standouts. What is their secret to success? And how do Netrepreneurs who pioneered E-commerce maintain their edge as the giants enter the game?

In cyberspace, successful shopkeepers start by doing what all good merchants do: They offer customers a special reason to stop by--either to get the widest selection, the greatest convenience, top-notch service, the best products, or deep knowledge of whatever they're selling.

Then they add an extra digital twist. That can mean playing into the psychology of the Net--the way eBay and online auction site Onsale tap into cybershoppers' penchants for bargains, competition, and interaction with other buyers and sellers. Or it can mean using the Internet's unique ability to provide personalized service, the way 1-800-Flowers Inc. will send you an E-mail reminder of your wife's birthday, or Inc. will recommend a book you might like. "The pattern of all the successful Internet companies is that they're doing things that can only be done online," says Jeffrey P. Bezos, chief executive of Amazon.

Amazon has fine-tuned the art of online selling. It has done that by beating its real-world rivals at their own game. In the bookstore business, chains such as Borders Inc. and Barnes & Noble Inc. have cleaned up by building superstores and stocking them with a huge selection, often at discount prices. Because it operates in cyberspace and doesn't actually stock much inventory, Amazon can go the superstores one better: It boasts 3 million titles, including those that the giants would probably never stock--say, a fly-fishing guide to Montana from an obscure publisher.

The bookseller is now expanding the inventory it holds to cut delivery time to customers and reduce its shipping costs. Because it can monitor sales so easily, Amazon can avoid getting stuck with as many returns as conventional booksellers. And for phase two: Starting on June 11, Amazon plans to extend that approach to a new market--music CDs. By offering CDs, the company wants to make the most of cross-selling and upping the size of each individual sale. Amazon's revenues ballooned to $147.8 million last year from $15.8 million in 1996. Profits, however, are nonexistent, as the bookseller plows money into marketing and expanding its business.

QUICK-CHANGE ARTISTS. Amazon illustrates another lesson of successful Web selling: Online merchants must continually reinvent themselves in this fast-changing medium. The best Web sites use the Net to solicit feedback from customers, then apply it to making the site easier to use or adding new features. Sporting-goods retailer Recreational Equipment Inc. (REI) encourages visitors to its Web site to send suggestions. Those ideas are helping shape an overhaul of the site to be completed by October. Microsoft Corp., too, is constantly revamping its family of Web sites. All told, ActivMedia says that $1.5 billion will be spent this year enhancing commercial Web sites.

Staying ahead also means evolving along with the Web. The big navigation sites, such as Yahoo! Inc. and Excite Inc., started out making money from advertisers that wanted to reach the millions of Web surfers who frequent their sites. Now, these companies are angling to be tomorrow's trading centers, collecting fees or a cut from merchants that want placement on their sites. Commerce accounted for 22% of last quarter's revenues for Yahoo!, which is expected to rack up its first full year of profits this year. And on June 8, it paid $49 million for ViaWeb Inc., a maker of software for setting up online storefronts that will allow Yahoo! to help small merchants get up and running and connected to the Yahoo! site.

No company better understands the value of reinventing its Web approach than Dell Computer Corp. The PC maker is on a jihad to make its site superconvenient. Already the No.1 online merchant, Dell in May decided to revamp its site so customers can configure their dream machine online, then store the selection for up to two weeks. That allows customers to compare prices elsewhere before buying and gives the Web site an added advantage that earthly storefronts aren't likely to match. "You have the opportunity to do things online that you couldn't do offline," says Scott Eckert, director of Dell Online. Dell, which has seen its online sales swell from $3 million a day in November to $5 million in May, expects its online business to make up 50% of total revenues by 2000.

What Dell, Amazon, and others have learned is that their business models must be as dynamic as the Web itself. A niche marketer with a strong franchise may try to become a superstore. A superstore, faced with shrinking margins, may delegate more tasks, such as managing and shipping inventory, to its suppliers. And many Web sites are evolving into New Age middlemen, matching up buyers and sellers.

What are the veterans of Net commerce finding that their customers want? In many cases, it isn't lower prices so much as convenience. REI generates 35% of its online orders from 10 p.m. to 7 a.m., when no REI store is open and no mail-order operator is available. REI's online sales are growing 20% to 30% monthly and are expected to surpass sales at its 100,000-square-foot flagship store in Seattle within the next several months--and turn a profit. "The goal is to provide any product any place at any time," says Matt Hyde, the manager of REI's online store.

BRANCHING OUT. Convenience--along with rock-bottom fees--is behind the booming business being done by online brokerages, such as Charles Schwab & Co. and E*Trade Group Inc. The edge: Customers can buy and sell securities from their own homes or offices without a broker. "We've got branch offices in 22 million PCs," says Christos M. Cotsakos, CEO of E*Trade, which pulled in $6.1 million in profits in the quarter ended Mar. 31, double that of a year ago. It's the same story at hundreds of other Web sites. From 1-800-Flowers' online sites, which did 10% of the company's overall sales of $300 million last year, to sites such as that streamline the process of buying a home, convenience is king.

But convenience alone is not enough. Another critical feature is selection. Because cybermerchants aren't limited by shelf space and often don't hold inventory, they can offer more products than would be possible in any store. Amazon bills itself as "Earth's Biggest Bookstore," while Barnes & Noble calls its site the "World's Largest Bookseller Online."

eToys Inc., a Santa Monica (Calif.) startup, wants to be the giant in its category. It already offers 2,200 toys, ranging from pricey Steiff stuffed animals to the latest mass-market goodies from Mattel Inc. By October, eToys hopes to dwarf Toys `R' Us Inc. stores by offering 4,500 different items. The broad offering is helping to drive sales: eToys is on track to hit revenues of $10 million to $15 million this year. It expects to be profitable at $75 million to $100 million in sales--though officials decline to say when.

Garden Escape Inc. has brought the same kind of mind-bending selection to home gardening. By working closely with 40 suppliers, the Austin (Tex.) company offers 12,000 products and plants. That has helped it grow to $1.2 million in annual sales over the past year, figures Paul Noglows, an analyst with Hambrecht & Quist. He projects the company will break even on sales of $44 million in 2001.

Garden Escape also has worked hard to build a loyal online clientele by creating a warm and cozy community on its Web site. It offers 24-hour live chats, a weekly gardening quiz, and discussions with the site's "garden doctor."

Music sellers CDnow Inc. and N2K Inc. also cater to their customer communities. By combining their technology with software from Net Perceptions Inc., both sites create databases to store and cross-reference data about consumers' tastes. Customers can use these "recommender services" to get suggestions for CDs, based on what other consumers with similar tastes have bought. With such personalized attention, N2K has achieved a high repeat customer rate that accounts for 55% of its revenues.

Of course, one of the best ways to succeed in merchandising is by offering a great price. A handful of sites stress bargains. CDnow offers top-selling compact disks for 30% below average retail prices. Amazon sells books for up to 40% off the cover price. Cendant Corp., an online shopping club that offers everything from cars to books, also competes squarely on price. Members pay an annual fee of $40 to $70 in return for 10% to 50% discounts from suggested retail prices and a guarantee that Cendant will match any rival's price.

NUTS AND BOLTS. But true savings are rare on the Web--surprising, considering how much Web merchants claim they can save in costs by operating in cyberspace. Many manufacturers won't let cybersellers undercut their retailers, while many retailers with Web commerce sites don't want to undercut prices in their stores. A recent Harris/BUSINESS WEEK poll found that only 12% of E-merchants offer lower prices on the Web than on terra firma. Even the discounts offered by Amazon and CDnow are largely erased by shipping costs.

Still, price competition is expected to heat up as more merchants flock to the Web and consumers get tools that let them price-compare with the click of a mouse. Consider the online brokerage business, where price competition is already fierce. Commissions on stock trades have plummeted to less than $10 a trade in some cases. And the cost of developing and maintaining the technology needed for a sophisticated site is skyrocketing. So is the cost of luring new customers--many online brokerages spend $250 or more in marketing to nab each new customer. "It doesn't sound like a great business to be in," concedes Blake Darcy, chief executive of DLJdirect Inc., an online trading site. "But the big players can create enough of a scale."

Darcy should know: DLJdirect, which has been rated by Gomez Advisors Inc. as the No.1 financial site, has some 450,000 customers with $6.5 billion in assets. And it has been profitable since the late 1980s, when it was called the PC Financial Network and offered on the Prodigy online service.

The upshot: Merchants that have succeeded with seat-of-the-pants entrepreneurialism will have to learn to manage the nuts and bolts of a growing business, like keeping their supply chains efficient. One reason Garden Escape is well positioned is that it has cultivated tight links with 40 different suppliers that tap into its system to receive and fulfill orders. And Columbia House Co., with its club membership, has hit a mix of handling its own shipping and working with distributors that has led to profitability and its forecast of more than $50 million in sales this year.

Indeed, how cyberstores use electronic-commerce techniques will be critical to their fortunes. Web sites such as Columbia House's Total E let distributors ship CDs directly to the consumer. Others, such as eToys and Amazon, prefer holding some inventory because they get shipments faster and pick up bargains from suppliers. That way, they can ship some products in 24 hours rather than 48 or 72 hours. "If you can't fulfill at Web speeds, you won't be successful," says Gartner Group Inc. analyst Alyse D. Terhune.

In the Internet Age, instant gratification can be had--and is increasingly expected--with the click of a mouse, 24 hours a day. The digital zeitgeist is summed up by a new startup called Streamline Inc. The Web service, based in Westwood, Mass., and backed by chipmaker Intel Corp. and software giant SAP, lets harried shoppers order groceries, arrange to have their dry cleaning picked up, have a hot meal delivered, or have their old bottles and cans whisked off to the recycler--all from a single Web site.

Jill Levinson, a Streamline customer in Boston, where the service is initially available, can't believe what a difference it has made. "You run into another customer, and you both say, `Oh my God, hasn't this changed your life?"' Sounds like another winner.