VerticalNet: Survivor or another dot-com disaster?

Ravi Aron, who teaches operations and information management at Wharton, thinks VerticalNet has a lot going for it but faces high hurdles.

7 min read
Imagine you are the purchasing agent for a sewer and water contractor and you need a truckload of fire hydrants. How do you get them?

You could pull out an industry directory, locate a few dozen suppliers, track down the right person to talk to at each, send your specifications, wait for bids to come in, call again for better deals, haggle over specs, argue over delivery dates, demand guarantees, worry over the supplier's ability to come through and whether the guy you negotiated with can really speak for his bosses.

Or you can go online with VerticalNet and solicit bids from 55 potential suppliers with a few mouse clicks, then close the deal with a few more.

It seems like an easy choice, and VerticalNet, the 5-year-old Horsham, Pa., business-to-business exchange, is betting that thousands of companies hunting for products and services will agree. The company operates Web sites that serve as online catalogs, or "storefronts," for thousands of companies in 57 industries, ranging from fiber optics to solid waste to bakery and dental supplies. Need landing gear for a jet? You can shop for it on VerticalNet.

Sales have soared. Revenues for the quarter ended Sept. 30 leaped to more than $73 million, compared with $5.2 million a year earlier. The quarter's revenues beat analysts' consensus forecasts by $12 million. Revenue comes from advertising, fees for executing users' transactions, and subscription charges for users' pages.

But losses are growing, too--from $26 million in the third quarter of 1999 to $76 million in this year's third quarter. And shareholders have been pummeled. The company went public in February 1999 at a split-adjusted share price of $4. The stock peaked at $148 last March, then began a precipitous decline to current levels around $14.

Last summer the company brought in some high-powered help, naming Amazon.com president and chief operating officer Joseph Galli VerticalNet's new chief executive. In a sign of the high value the market put on Galli's work at Amazon, that company's shares dropped 14 percent the morning his departure was announced. Unfortunately, his arrival at VerticalNet hasn't boosted that company's shares. They are trading around a quarter of their near $57 price when the Galli hire was announced July 25.

One of Galli's first moves was to organize the company into three units: VerticalNet Markets, home of the industry Web sites and company storefronts; VerticalNet Exchanges, where companies can buy and sell goods and services; and VerticalNet Solutions, which sells software to companies that want to set up their own online exchanges. Many Wall Street analysts cheered the moves.

Early in November, Todd C. Weller, analyst at Legg Mason Wood Walker, reissued his "strong buy" recommendation on the stock, predicting it would go to $100 within 12 months. Of analysts surveyed by First Call, 28 rate the stock a "strong buy" or "buy," one rates it "hold," and none rate it "sell" or "strong sell."

see A News.com webcast: Dot-coms: Down and out? Many observers attribute a large part of VerticalNet's stock decline to the downdraft that has hit many dot-coms this year. Some of these stocks are sure to rebound someday. Does VerticalNet have what it takes to become one of the success stories?

Staying power?
Ravi Aron, who teaches operations and information management at Wharton, thinks VerticalNet has a lot going for it but faces high hurdles.

The company is fortunate to be one of the first to create such an online business-to-business marketplace, allowing it to learn the ropes ahead of many competitors and to start building toward a critical mass of users, he says. As a rule of thumb, such an exchange must control at least 20 percent of its market, by dollar volume, to succeed, he notes, adding that by the time the industry matures, the three biggest exchanges are likely to control 70 percent of the market, leaving little for the competitors. It's too soon to know whether VerticalNet will be among long-term heavy hitters, Aron says.

Echoing many observers, Merrill Lynch analyst Henry Blodget argued in a recent report that while VerticalNet's storefronts are useful, the company will be truly successful only if it can offer users ways to buy and sell online, generating transaction fees similar to stock brokers' commissions. At present, many VerticalNet users shop online but complete their deals the old-fashioned way, by phone.

Blodget said Galli is well aware of this and is moving quickly to expand the "commerce centers" that form this part of the business. But Blodget warns that it is far more difficult to operate effective commerce centers than storefronts, which account for most of VerticalNet's traffic today. Blodget believes that at present, VerticalNet doesn't have enough storefronts and commerce centers to create a critical mass. This means that the company will find it tough to offer users opportunities to do business that are extensive enough to convince them to pay for the service after free introductory periods end. Blodget expects half of the free users to drop out when they have to pay.

VerticalNet shares dropped 24 percent in a single day early in October after another Wall Street analyst announced that a survey of VerticalNet customers revealed deep dissatisfaction, mainly because sales through the site were too skimpy. The analyst predicted that many customers would refuse to renew once they were required to pay.

Galli quickly responded, saying a number of new features would help customers streamline transactions. A few weeks later, VerticalNet announced it would spend $133 million to buy SierraCities.com, an online credit rating and financing company. Galli said the acquisition would improve online transactions by allowing VerticalNet users to assess trading partners' creditworthiness, to establish credit and financing, and to arrange payment.

Galli has stated that the company can meet sales and profit targets even if only half its subscribers renew, and he has predicted VerticalNet will be profitable by the third quarter of 2001.

Variety is key
Aron points out that VerticalNet must move quickly to offer more ways of pricing products and services that can be bought on its sites. Most transactions currently use fixed prices like those found on consumer sites. But business transactions, he says, often entail other pricing approaches, including auctions, requests for proposals, and "dynamic pricing," in which prices quickly change to reflect shifts in supply and demand, as on a stock exchange. "VerticalNet does have some aspects of dynamic pricing," he said, adding that it needs more.

see special report: Head-on collision Experience with a variety of exchanges has shown that simple systems in which sellers merely advertise fixed prices give their primary benefit not to sellers but to buyers, who simply use the systems to comparison shop. Sellers, then, don't have much incentive to use such systems, and they are especially reluctant to pay transaction fees to exchange operators.

For the sellers and exchanges to benefit, the exchange must be perceived as adding some extra value, Aron says. In addition to dynamic pricing, this can entail other functions that make transactions easier and cheaper--everything from assuring the buyer's credit to handling payments, arranging delivery and tracking shipments.

Aron calls this "deep linking"--a money-saving and hassle-reducing benefit for which sellers will gladly pay. He says VerticalNet must expand its current services of this type to compete with two companies that have them: Ariba and Commerce One.

Still another issue, he says, is competition from the very companies VerticalNet seeks to serve. In February, for instance, the Big Three carmakers announced they were forming an online parts-buying consortium. Many other companies are following suit, individually and in groups. This is likely to happen in any market dominated by a small number of big buyers, Aron says. Such companies have the resources to set systems up, allowing them to keep the efficiencies and cost savings to themselves rather than paying an outsider like VerticalNet.

Gaining confidence
At the same time, big suppliers may be concerned that doing business on VerticalNet could cannibalize their other distribution networks, Aron says. An independent distributor that has invested time and money to serve a big seller, and become a dependable conduit for the seller's products, may kick up a fuss over the lost business. A supplier can't afford to have its distributors lose interest in pushing its products.

Aron thinks, however, that VerticalNet is in a good position to create syndicates composed of companies that contribute to deals without being the central players--the finance companies, credit verification outfits, bond rating agencies and other participants in complex business transactions. Packaging such functions, as VerticalNet intends, could be a valuable service that does not run afoul of buyers' and sellers' other interests, he says.

"VerticalNet's model beautifully fits in with syndication," he notes.

As a software and Internet company, VerticalNet can adapt quickly, he says. Once the initial investment is made, it is cheap and easy to take on more customers and adapt to serve new industries--far easier than it is for an Old Economy company that must build warehouses and factories.

And VerticalNet's business is far more diversified than that of many other companies, on or off the Web. It is not dependent on any one business or industry; it serves thousands of customers.

"Even if VerticalNet can remain standing in only one out of every four markets the company is in, it will still have significant revenue," Aron says. "Whether it will be a sensational company, we don't know. But there is no reason to think it cannot be a strong company a year from now."

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