Business dilemmas raised by the dot-com shakeout

As dot-com mania subsides, some executives from traditional, so-called old-economy companies are secretly relieved--though they may admit this only to their closest confidantes. They can now view e-commerce as "only a bubble," and now that it has burst, they can return to doing business in their time-honored ways.

Are they right? Or is there more to e-commerce than just the financial frenzy that developed around the Internet, the way it has around most emerging technologies? The answers, says John Hagel III, chief strategy officer of Twelve Entrepreneuring, are no and yes.

Hagel should know. A former consultant with McKinsey & Co.--he was a leader of the firm's e-commerce practice--he is the co-author of such books as "Net Worth," which dealt with the emergence of so-called infomediaries as companies tried to gather information about their customers, and "Net Gain," which explored the ways companies can build relationships with customers through virtual communities.

He spoke recently at a meeting of the Wharton Forum on Electronic Commerce and discussed the principal trends he sees in the Internet economy these days.

First, Hagel drew attention to a dilemma that companies face as they try to move traditional business operations online. E-commerce introduces efficiencies by lowering interaction costs. The good news is that this process creates tremendous value. "The bad news is that while e-commerce reduces interaction costs for business, it also reduces these costs for customers," Hagel said. "Over time, customers become more powerful and capture more of the value embedded in industry value chains."

That shift of power in favor of consumers can create challenging situations for companies. "If a business is not focused on getting cost out of the value chain, it will be impossible to compete. But if that is all a company focuses on, it has a serious dilemma. It will be managing a smaller and smaller business," Hagel pointed out. He added that companies need to use e-commerce to drive economic growth by creating new products and finding new ways to add value to customers. This focus on growth will lead to a "restructuring and soul searching by companies about what business they are actually in."

Hagel also said that while several companies have plunged headlong into setting up business-to-business (B2B) sites, these business models involve greater challenges than people realize. Building liquidity and a critical mass of participants, for instance, are formidable hurdles. In addition, neutrality between buyers and sellers may not always be the best option for an intermediary trying to create a B2B site.

"Many companies have started with the notion of being neutral, like Switzerland. I believe those who will succeed in this space will go clearly to the side of buyers to extract more value from suppliers," he said.

Achieving and then sustaining profitability is another critical challenge for B2B sites. Hagel pointed out that as customers capture more value from transactions, even companies that have large sales volumes will face low profitability. They need to find ways to create other transactions around their buyers that can help enhance profitability.

In addition, companies that set up B2B sites may not become "natural owners" of the value generated by the elimination of market inefficiencies. Particularly in markets with highly concentrated buyers, it may be hard for independent third parties to capture most of the value they generate, Hagel said.

In contrast to the challenges that B2B models confront, Hagel sees several opportunities in business-to-consumer (B2C) e-commerce models. He explained that "we are moving into the third stage of B2C development." The first was developing appropriate content; the second was fighting for traffic. Now, companies are beginning to battle for profits.

Hagel said that to succeed in business-to-consumer e-commerce, companies have to find ways to develop sustained relationships with customers and generate value from those relationships. "Unless you are going to do something that is economically valuable with those customers, more traffic is an expense," Hagel said. "Many companies that won the fight for traffic are poorly positioned to win the fight for profits."

The key to unlocking traffic, Hagel said, lies in using customer relationships and profiles to generate value. This interactive focus has changed the notion of branding from the vendor-centric brands of physical markets to the customer-centric brands of electronic markets. The old brands said, "You can trust a product that comes from these brands." The new brand promise is, "You can trust me to bring together the right resources to meet your individual needs." The opportunity in these customer-centric brands is that, in contrast to the conventional brands owned by manufacturers, the new brands tend to favor intermediaries.

While the evolution of e-business is uncertain, the one certainty is that it will lead to industry shakeouts. Hagel pointed out that the emergence of open-architecture computing in the late 1980s destroyed an aggregate of $43 billion in shareholder value for established players such as IBM and DEC. At the same time, it created $30 billion in value for new players such as Intel and Microsoft. Where did the missing $13 billion go? "It was captured by customers in open architecture and increased choice," he said. "There was a net destruction of value and a huge shift of value to a different set of players."

The fallout from e-commerce could be much greater, Hagel said. "I predict we will see a shakeout that makes the current one look like small potatoes. On the one hand, it is a nightmare all traditional companies should fear. On the other hand, it is a huge opportunity to drive major new growth strategies and transform and reshape markets around the world."