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The state of electronic exchanges

Business-to-business e-commerce is fraught with peril for buyers and sellers alike. An exclusive survey of 1,800 e-marketplaces shows what it takes to win.

Over the last two years, journalists, scholars and self-proclaimed experts have written volumes about business-to-business e-commerce. Thousands of newspaper articles, dozens of popular business books and countless online newsletters examine the phenomenon from every angle--save one. None of these sources has conducted a rigorous examination of the new business model we call e-marketplaces.

We define an e-marketplace as a forum that leverages the Internet to facilitate commerce among businesses. Such a definition encompasses a wide range of entities: independent dot-coms financed by venture capital, industry consortia backed by pooled funds and private networks created by individual companies.

Such e-marketplaces burgeoned during the last five years, but a shakeout has begun. The fate of individual firms, however, will depend on the strategic decisions they make over the next year.

This year, Booz-Allen & Hamilton teams identified 2,233 publicized e-marketplaces and profiled 1,802 of them in detail. Our examination offers insight into the drivers of success and provides a baseline for monitoring the inevitable fallout over the coming year.

By examining the key data on service offerings in combination with the
market size, we have concluded that independent e-marketplaces risk extinction. Our research documented three ownership models and six basic service offerings across 24 traditional industry segments. By examining the key data on service offerings in combination with the market size, we have concluded that independent e-marketplaces risk extinction. Founded in the heady days of Internet mania, most face huge ongoing technology investments, price erosion and limited liquidity resulting from their failure to create a clear value proposition that appeals to either buyers or sellers.

The e-marketplaces formed by consortia appear to have the strongest base, but they risk being hobbled by conflicting agendas among their founding companies. If they can survive the machinations of their founders and integrate the services required in a particular industry, consortium-based e-marketplaces are most likely to blossom into defensible full-service operators.

Finally, private networks sprouting from the in-house systems of many major companies represent a threat to both independents and consortium-based e-marketplaces. Operated for the exclusive use of the single owner, private networks may consume resources that could otherwise support the independents.

A model of evolution
There are three basic ownership models for e-marketplaces: independents, consortia and private networks.

The majority of e-marketplaces were developed by independent entities. The vast majority remain private, dependent on venture-capital funding to finance their. With so many competitors, and with venture funding increasingly scarce, most privately held independents will quickly disappear.

The consortium model, in which various industry players combine forces to create a common forum for the exchange of goods and services, has received broad press coverage. Yet these e-marketplaces account for fewer than 5 percent of the total. This small group receives a wealth of attention because of its typically deep-pocketed founders and the often unique conditions that allowed competitors to band together to develop their own e-marketplaces.

Private networks represent an even smaller proportion of e-marketplaces. The most common function of private networks is online cataloging to facilitate sales from the sponsoring company, but some networks also support such supplier-focused services as supply-chain planning and design collaboration.

Our profiling efforts show that some industries have far too many e-marketplaces. For example, 106 center on the transportation-and-logistics industry. With such a large number of exchanges in a relatively small industry, most of these competitors will disappear. In larger industries with relatively few exchanges, the competitive pressures will be less intense. Although effective execution of differentiating strategies ultimately drives success or failure, e-marketplaces in industries with relatively few exchanges have the best chance for survival.

The highest failure rate, however, likely will be among the 170 generalist e-marketplaces, which lack the base provided by a well-defined vertical market. These generalists focus on a specific, narrow functionality like auctions and forego a particular industry focus. An industry-focused player that tailors generic software to the nuances of a specific industry will have better odds of generating enough value to cover its cost. In examining the service offerings of the e-marketplaces, we discovered six core services--information exchange, digital catalogs, online auctions, logistics services, supply-chain planning and design collaboration--plus numerous niche and specialty services. One might expect the penetration rate for a core service to be high, as individual e-marketplaces adopt a mix of services in order to attract the greatest membership. Yet penetration rates vary widely, from a high of 65 percent to a low of 4 percent.

Nearly two-thirds of the e-marketplaces offer information-exchange services. Such a high penetration comes as no surprise: Information exchange costs relatively little and helps build a sense of community among the membership.

E-marketplaces in industries with relatively few exchanges have the best chance for survival. Digital catalogs have the second-highest level of penetration. Though more costly than simple information-exchange services, digital catalogs offer a much clearer value proposition to customers and suppliers.

Online auctions, offered by 55 percent of the profiled e-marketplaces, represent the third service offering. With consistent reports of double-digit savings for buyers, online auctions provide an easily measurable value proposition in e-marketplaces.

Beyond online auctions, the penetration rates for service offerings drop dramatically. Logistics--facilitating the physical flow of goods within a firm or between a firm and its suppliers and customers--ranks fourth. Managing the wide variety of transportation modes and linking the fragmented carrier market offer a rich value proposition to many customers. At the same time, smoothing the physical movement of goods rather than just the data flow offers a more difficult challenge than the top three services, a difficulty that helps explain the relative paucity of players.

Supply-chain planning tools help companies share sales and production forecasts over the Internet. Such collaboration reduces uncertainty in planning, which in turn decreases the need for inventory safety stock.

Design collaboration ranks the lowest among our core services. Of greatest interest to e-marketplaces serving original equipment manufacturers (OEMs), design collaboration allows these manufacturers to work with their first-tier suppliers to share the workload in product development.

Though the specifics vary dramatically, 45 percent of the e-marketplaces offer some other form of service. These value-added services appear to be an area where players can differentiate themselves.

Looking at services
Rather than simply examine the penetration rate of individual service offerings, we also decided to look at the service mix proffered by the exchanges. The segmentation provides a richer portrait of the evolution of the e-marketplace phenomenon and hints at which firms are most likely to survive the shakeout.

Total Procurement: The largest cluster encompasses companies that concentrate on digital catalogs and online auctions, the two core Internet procurement services. The majority of this segment also offer information exchange services.

Catalog Buying: A quarter of the companies in the sample classify as Catalog Buying operations. Two-thirds of this segment provides information-exchange services in addition to digital catalogs. Private networks represent a disproportionate percentage of this segment: Although private networks constitute only 3 percent of the e-marketplaces in operation, they account for 6 percent of the Catalog Buying segment.

Auction Houses: E-marketplaces focused primarily on online matching of buyers and sellers constitute one-fifth of the profiled population. These companies focus on auctions and do not offer digital catalogs, though a small percentage offer other services. Because online auction functionality, pioneered by FreeMarkets, dates to the earliest days of business-to-business e-commerce, several Auction House e-marketplaces have six years or more of experience--an eon in Internet time.

Collaboration Facilitators: Although Collaboration Facilitators occupy a much smaller slice of the surveyed population, they represent an emerging trend. Most early e-marketplaces focused on online auctions, and many of them found that service too one-sided to attract a sustainable community of buyers and sellers. Accordingly, they added other services likely to attract suppliers. The Collaboration Facilitators segment goes a step further, abandoning the tensions inherent in the procurement and price-negotiation processes and focusing on aiding collaboration between buyers and sellers. Both supply-chain planning and collaborative design tools encourage cooperation between buyers and sellers. As a result, they attract participation from both sides of the commercial transaction. Concentrating on win?win options, these e-marketplaces do not offer auction services.

Full Service: Full Service exchanges represent only 5 percent of the e-marketplace population. A company needs deep pockets to develop information exchange, digital catalogs, online auctions, logistics services, supply-chain planning and design collaboration. Although all the core services achieve a high penetration in this segment, only six entities offer all six services. The Full Service cluster has the highest percentage of consortium sponsorship. Although consortia represent less than 5 percent of the total e-marketplace population, they account for 19 percent of this segment.

Specialty Services: The entities in the Specialty Services segment offer only two core services: information exchange and logistics services. In fact, some players in this segment may not qualify as e-marketplaces by others? definitions. But because they leverage the Internet to facilitate commerce among businesses, these Specialty Services providers meet our definition. By and large, companies in this cluster provide information or other niche services of value to a single industry. The narrower scope of this segment provides a smaller potential revenue base; 6 percent of its constituents have already failed.

Survival of the fittest
Constant change seems to be the only certainty in business today, and the e-marketplace phenomenon offers an example accelerated beyond even the normal hectic pace of our times. Out of the 1,802 e-marketplaces we profiled, dozens failed even as we compiled our survey. As in all periods of upheaval, failure will predominate, although some exchanges will succeed wildly. The three groups that have the most at stake in the coming shakeout--consortium participants, independent e-marketplaces and mid-sized corporate buyers and sellers--have different expectations of survival.

Consortium Participants: Immediate transaction volume from committed founders gives the consortium e-marketplaces an initial advantage, but two factors will drive their success or failure. First, a successful consortium will need to create an integrated suite of services that becomes the industry standard.

Second, a small set of founders must remain committed to the survival of the consortium and ensure the financing and usage fees that keep the e-marketplace afloat while it builds the desired capabilities. A small number of founders--such as the five large automotive OEMs backing Covisint--offers the greatest likelihood of committed support. On the other hand, packaged-goods e-marketplace Transora, with 49 founders, risks dilution.

As in all periods of upheaval, failure will predominate, although some
exchanges will succeed wildly. Alternatively, there?s a breakaway strategy that redefines the industry. Imagine a consolidation among the multiple exchanges in the retail industry in conjunction with a third-party logistics provider to tackle services beyond the software tools described previously. Such a combined entity could offer to take control of the full distribution network and logistics between consumer-products manufacturers and major retailers and create a new entity--one offering digital and physical outsourcing of the goods along the chain. The combined entity could eliminate hundreds of separate distribution centers operated independently by the manufacturers and retailers. Such a move would be riskier than the shared resource model, but could offer rich rewards by freeing billions of dollars in assets for the retailers and manufacturers.

Independent e-marketplaces: With venture capitalists now more cautious and the IPO market effectively closed, independent e-marketplaces must become focused on the bottom line to conserve cash. Launching new services in a field-of-dreams model is no longer affordable. In fact, even sustaining some services may destroy value. Auction services continue to offer the most immediate returns to customers, and the best chance for extracting value in the short term. Unfortunately, online auction systems and support face rapid commoditization, making them increasingly tenuous revenue streams over the long run unless an e-marketplace has built industry expertise that is deep enough to differentiate it from the competition.

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We do not believe that independent e-marketplaces can succeed in the Full Service model. Though some consortia may eventually create seamless links among the services and thereby dominate an industry, such aspirations would be impossible for an independent. Even the Total Procurement players may discover that they have bitten off more than they can chew, largely because the transactional focus of digital catalogs requires a great deal of investment but delivers relatively low benefits.

Among independents, niche players should have the best chance of survival. If an independent lacks a strong membership and offers a vague value proposition, we recommend seeking a deep-pocketed consortium, ideally one in need of fresh resources looking to embark on a breakaway strategy.

Mid-sized corporate buyers and sellers: Most mid-sized companies sat on the sidelines as the initial e-marketplace game unfolded, and their conservatism has paid off. The time is ripe to exploit the e-marketplace investments financed by the venture capitalists, software vendors and corporate behemoths. Even the successful e-marketplaces need more buyers to take advantage of the increasing returns and scale advantages available in many e-business platforms.

A savvy mid-sized company should be able to extract favorable terms from competitors seeking to expand. At the same time, committing to a particular e-marketplace requires a fair amount of due diligence. Joining any e-marketplace implies significant investment in changing internal practices to extract the real value. Reengineering a business to work with an e-marketplace that goes under in six months will prove to be a worthless investment.

Launching new services in a field-of-dreams model is no longer affordable. In fact, even sustaining some services may destroy value. Similarly, many mid-sized companies have gotten the short stick as a seller in an e-marketplace. Though most have suffered through margin pressures from online auctions and consortium buying programs, the tide is turning. The large corporate buyers now recognize that online auctions will yield decreasing returns over time and may even become disadvantaged once weaker players exit and eliminate excess capacity. Accordingly, e-marketplaces have shifted their focus from aggressive procurement tactics to the collaborative tools supporting supply-chain management and joint product design. These provide opportunities for mutual gain through waste elimination rather than simple margin shifting.

You can expect greater adoption of independent seller-driven solutions in the future, particularly by mid-sized companies that avoided the hype of e-procurement but now see the potential benefit.

Next steps
In the end, companies large and small need to step back and rethink their e-business strategies and the role of e-marketplaces.

The early participants made major investments in a market lottery that appeared to produce only winners, but now companies need to return to the more pedestrian task of implementing the powerful technology of the Internet.

Armed with clear strategies, independents can pick their spots or exit gracefully, as appropriate. Mid-sized companies must accept that e-marketplaces represent more than a passing fancy and develop clear strategies to win as both buyer and seller in this new world.

In all cases, the answer lies in the economics and industry dynamics as uncovered in a thoughtful and well-executed business strategy, and not in the media or the market, both prone to overreact to the momentum of the times.

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Reprinted with permission from strategy+business, a quarterly management magazine published by Booz Allen Hamilton.