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Speaking Out

Jan. 1, 2003
E-BUSINESS REALITIES FOR DISTRIBUTION CHANNELS By now, it should be clear to all but the most naive proponents of e-commerce that distributors will not

E-BUSINESS REALITIES FOR DISTRIBUTION CHANNELS By now, it should be clear to all but the most naive proponents of e-commerce that distributors will not disappear. Despite impressive press releases to the contrary, the vast majority of start-up e-businesses are floundering as they seek to attract a critical mass of buyers and suppliers. The combination of existing channel relationships and Internet-resistant buyers has brought a new degree of market sobriety to e-business in the supply chain.

One venture capitalist of an industrial MRO site was reluctantly forced to admit: "We thought buyers would want to surf the Web for industrial supplies, but they had other priorities." Translation: Business customers care more about getting the right product at the right time than about saving an incremental few percentage points on price.

In my research and consulting, I have analyzed e-commerce business models in many distribution channels and supply chains. That work highlights patterns that are likely to hold true for most channels. Here are three "e-business realities" you can use to predict the ultimate success or failure of e-commerce in the industry.

Reality No. 1 - No one deserves to get rich sending the XML equivalent of an e-mail.

Internet-based intermediaries in the distribution channel fall into two basic categories. Some focus on matching buyers with new sellers online. Others focus on facilitating electronic relationships between buyers and sellers that have an existing trading relationship.

In both models, the online companies avoid the logistics, physical distribution and after-sales service functions of the supply chain, relying instead on traditional distributors. These companies hope to siphon off the information- and order-processing functions, and the associated profits, from distributors.

As payment for this service, these online companies are attempting to charge fees to sellers ranging from 2 percent to 5 percent of gross sales. While this appears low, it represents more than 50 percent of a typical distributor's net margin. Basically, these exchanges are saying to a typical distributor: "Give me your operating margin for the privilege of taking an order that you may have gotten anyway."

From a functional perspective, these companies do not actually deserve fees based on gross transaction revenue carried by the system. Most importantly, transaction fees do not reflect the technology cost structure of an online exchange. For example, transmitting a $10,000 order through a technology system does not cost appreciably more than transmitting a $100,000 order. However, the exchange could still levy an additional transaction fee on the marginal $90,000, even though its cost to process the order has not increased by the same amount.

Do you pay the telephone company a higher per-minute charge when taking a $100,000 phone order than when taking a $10,000 order? Of course not. Online companies that use XML to communicate an order from buyer to seller should be held to the same standard. Furthermore, electronic transaction facilitation does not replace the value or functions of local sales, fulfillment and service.

Competition is quickly lowering transaction fees down to marginal cost. Exchanges are already seeing transaction fees drop to as low as one-quarter of 1 percent. Transaction fees should either be based on the net profitability of the order received by a distributor, or be replaced by a processing fee that more closely approximates the costs of providing the software-based service of an online facilitator.

Reality No. 2 - FOL. (First owner loses.)

Builders of luxury hotels are quite familiar with the adage: "First owner loses." In a typical situation, a real estate entrepreneur finances and builds a lavish hotel - imported marble, world-class chefs, over-the-top service and so on. Yet few hotel patrons are willing to pay the outrageous room rates necessary to finance the up-front build-out costs. Eventually, the entrepreneur (first owner) and his lenders sell the hotel for ten cents on the dollar to a savvy bottom-fisher who ends up making money because his capital cost is so low.

This parable bodes the future for many online sites in various wholesale distribution channels. Consider that many start-up supply chain e-businesses have raised $150 to $200 million to fund the creation of their "total channel solution." Just earning back the cost of capital for initial investors will require cash flows in excess of $20 million for multiple years.

Consider the industrial distribution channel. Our calculations indicate that total combined net profits of all industrial MRO distributors are between $3.5 billion and $5 billion. Since most e-commerce companies only perform a small number of channel functions, they are only entitled to a small portion of the net profits of existing supply chain companies that currently perform those functions - the distributors.

Given falling transaction fees and hyper-competition between me-too sites, total combined annual revenue for e-business facilitators in industrial distribution may be only $100 million in 2003. Any individual e-business will claim a share of that total, making it difficult for first owners to generate the cash flows necessary to earn back the cost of capital.

As a result, online exchanges may lower the costs of doing business for their users yet be unable to transform those savings into profits for themselves. We expect many e-businesses to sell their companies for a fraction of the total capital expenditure required to build and create the site. Assuming the technology is not already obsolete, the second (and third) owners will have a better chance of generating actual economic profits.

Reality No. 3 - Distributors have the real first-mover advantage.

The business plans of many online companies in the distribution channel are predicated on bringing together thousands of buyers and sellers in fragmented markets.

But distributors have been aggregating customers and suppliers for many years. Despite consolidation and e-commerce, well-run independent distributors and dealers continue to thrive due to their great skill at maintaining high levels of locally delivered customer service and support. Even the largest Fortune 500 customers continue to patronize mostly private, family-owned distributors.

In theory, customers may attach loyalty to the exchange that's providing the mechanism to find suppliers and order product, rather than attaching loyalty to the distributor performing the actual warehousing, value-added selling or order fulfillment. In reality, buyers are reluctant to disrupt systems that work, even if those systems are uneconomic and somewhat inefficient.

The experience of distribution consolidators provides insight into these customer dynamics. Some distribution consolidators have attempted to burst into new geographic areas by slashing prices for the first couple of months just to gain market share. This strategy appeals to the least loyal, most price-sensitive customers. If the local distributor is doing a good job, then they work to keep only the customers buying on value. They realize that a company's relationships with its customers are built not solely on the price of its goods and services but on its perceived value.

The same customer dynamics will apply as e-commerce companies attempt to interject themselves into distributor-customer relationships. The laws of economics have not been repealed because of the Internet.

Distributors should preserve their first-mover advantage by investing in e-business and e-commerce tools that build and maintain customer loyalty. A Web presence should be more than an electronic catalog and pictures of the warehouse. It should represent an opportunity to create an integrated experience for your customers that links traditional sales and communication channels with the power of shared information.

The real threat from e-commerce is customer confusion, not disintermediation. Customers and manufacturers are also struggling to understand the true opportunities of e-commerce. Manufacturers are simultaneously investing in their existing channels alongside new online channels. Online companies are creating more noise with their venture-capital-supplied marketing dollars.

Make no mistake - online activity in wholesale distribution will grow dramatically. Over the next five years, we will enter the "clicks and bricks" revolution, in which e-businesses will become integrated with more traditional distribution business models.

Distributors can regain the channel initiative by combining high-quality fulfillment and customer service with online information and ordering. Customer expectations and capabilities will set the pace for the industry's evolution, creating opportunities for savvy distributors to participate fully in the revolution.