In addition, it addresses updated cash positions and burn rates for e-commerce companies as the holiday season approaches.
Crossing the chasm vs. reaching maturation
The e-commerce sector reported earnings-per-share results that on average beat street consensus EPS estimates by 3 cents, or 11 percent. By contrast, the sector reported a shortfall in revenue relative to consensus estimates for the second quarter of approximately $1.4 million, or 2 percent below estimates.
We believe revenue shortfalls were driven by lower marketing, the negative media environment, less aggregate marketing spending across the sector, and a slower consumer spending environment overall. The shortfall in second-quarter revenue, in our view, is not an indication of slower growth because of e-commerce's hitting maturity in several categories, but merely a result of unfavorable conditions in addition to the natural lull that follows initial hyper-growth in the adoption life cycle of a new innovation.
We think the summer and fall of 2000 for e-commerce reflects the typical early stage in the adoption life cycle as online shopping is caught in the chasm, which is characterized by faltering sales as the transition from early adopters and enthusiasts to mass market takes place.
Accordingly, the 2000 holiday season will be important in improving the customer experience to the 100 percent solution (customer satisfaction) required to cross the chasm and begin to reach the mass market as opposed to the 85 percent solution that is acceptable to early adopters and enthusiasts.
After studying adoption (S curves) and diffusion curves, we have ascertained that most leading companies are just entering the vertical portion of their growth S-curve, which reflects hitting critical mass and entering mass-market adoption and the beginning of reaccelerated growth (see chart).
E-commerce and the adoption life cycle
It is commonly held by noteworthy strategists and researchers that mass-market or critical-mass adoption begins to be achieved at 20 percent to 25 percent household penetration. Contrary to what is widely believed, we have not hit mass-market adoption for online commerce at just 17 percent household penetration at the end of 1999. In contrast, Internet usage has achieved mass-market adoption with 40 percent of households online, which is above the 20 percent to 25 percent level indicated by Geoffrey Moore, author of "Crossing the Chasm" and "Inside the Tornado."
We think the mass-market adoption for Internet usage is often misconstrued, leaving people to believe that online commerce has also achieved the sweet spot of acceptance from the mass market. E-commerce in 1999 had only 17 percent household penetration, below the 25 percent mass-market level. Current forecasts for penetration levels call for approximately 28 percent of U.S. household by the end of 2000, indicating the beginning of mass-market acceptance.
Thus, we believe the summer and fall months for e-commerce growth represent the lull, and the holiday season represents an important time to begin to cross the chasm and exit this period of faltering sales. The holiday season, which is typically when the largest percentage of new customers shop, will be a critical test in whether e-commerce companies can satisfy the 100 percent service requirements of the mass market.
It will not be enough that one or two leading customer-centric companies, such as Amazon.com and eToys, provide a 100 percent solution, but that the majority provide a 100 percent solution for e-commerce to become adopted by the mass market.
There is significant level of research published by the likes of Geoffrey Moore, Theodore Modis ("Predictions") and Everett Rogers ("Diffusion of Innovation") that illustrates the timing and requirements for new technology adoption as well as the S-growth curve rates that are replicated.
Specifically, Geoffrey Moore in the aforementioned works describes mass-market adoption as requiring a 100 percent solution for customers. The early market consisting of technology enthusiasts or early adopters and visionaries (the majority of the current 17 percent penetration rate of online shoppers) are willing to accept an 85 percent solution. An 85 percent solution (or less) is what consumers have experienced in consumer e-commerce in that they get strong service in some areas of buying but not in all areas. For example, some companies are great at selection and easy navigation but are poor at fulfillment.
A 100 percent solution for a consumer means the ability to go online and buy at a fast, easy-to-use Web site with great navigation and selection, efficient information, convenient order features, security, and so on, and then to receive a product and be able to return it with ease. We would argue that we have not achieved this 100 percent solution broadly for consumer e-commerce companies. Thus, the online shopping proposition, while acceptable to early adopters and enthusiasts, has not widely penetrated the sweet spot of the opportunity of the mass market.
Updated cash positions and burn rates for the holidays
We have focused on cash positions through the holiday season because it will be a key gating factor in determining which companies will continue to get access to capital in 2001 based on holiday performance. This holiday season is not likely to be characterized by "hype" or exuberant spending to drive top-line results at any cost as was the case last year, but will be about execution, displaying progress toward achieving scale, and profitably meeting the needs of customers.
Since the fourth quarter of 1999, seven of the 28 publicly traded companies have accessed the markets, and many have cut discretionary spending to conserve cash positions based on current capital market conditions. Based on these revised cash estimates, 27 of the 28 companies will have sufficient cash through the holiday season, while at least 15 companies are still likely to need to raise capital by holiday 2001. This could prove challenging for those companies that do not deliver a solid holiday season consisting of solid growth, scalability of the business model, exceptional customer service, and controlled discretionary spending.
Each company's cash position by the end of 2000 is approximated by subtracting the operating losses in each quarter (the cash burn rate) from the previous quarter's cash position, adjusting for any financing in the interim.
Companies with sufficient cash
Cash remains king as those companies with access to capital continue to separate from the competition.
While a company may have a solid strategy, the inability to access the capital markets reduces the ability to execute such a strategy. Models that have high fixed costs because of early infrastructure build-out with nascent revenue scale to cover fixed costs are the most vulnerable. Why? Several rounds of financing to achieve profitability is no longer acceptable in the public markets. Therefore, while a strategy may be solid, the company will be suffocated by its inability to increase revenue enough to cover fixed costs because of a lack of spending capacity.
We see three different scenarios emerging:
1. Companies with a sound model and strategy with a differentiated, scalable, profitable profile that will continue to get funding;
2. Companies with a sound model and strategy with a high cash-burn rate that cannot be reduced because of high fixed costs (possibly because of building out infrastructure early or simply the high-cost nature of business). These companies require multiple rounds of financing that the capital markets do not have an appetite for; and
3. Companies with poor business models that lack a sound strategy or companies that have a plausible model but have failed to execute are not likely to receive funding.
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Anthony Noto is the lead consumer e-commerce analyst at Goldman Sachs. His coverage of the e-commerce sector includes Amazon.com, Ashford.com, Barnesandnoble.com, eBay, eToys, 1-800-Flowers.com, PlanetRx, Priceline.com and Webvan. Noto joined Goldman Sachs from Lehman Brothers, where he was part of the Institutional Investor All-American Team covering the broadline retailing sector. Before Lehman Brothers, Noto was a brand manager at Kraft Foods and a captain in the U.S. Army as a telecommunications officer.
Noto was the No. 1 graduate in mechanical engineering from the U.S. Military Academy and received his MBA from The Wharton School at the University of Pennsylvania.