The valuations of European business-to-consumer (B2C) companies soared to ridiculously high levels at the beginning of this year, fell back as most people expected, and then remained stagnant for a number of months, until the sharp drops of recent weeks.
Most of us are struggling to predict what will happen next to this volatile market. However, a recent report from the global Internet equity research team at investment bank JP Morgan tries to set out some of the fundamentals of the European B2C market. It focuses specifically on European ISPs and portals, which it believes are the major constituents of the B2C sector in Europe.
The report makes four key conclusions:
The Internet phenomenon is here to stay
"The Internet is not a technology but a platform which connects every networked device and will force convergence by delivering voice, video and data through one channel. B2C is not an inherently bad business, it is just hugely difficult: the only assets are intangible; narrowband infrastructure sucks; the marketing is hellishly expensive; and getting the technology right is problematic. Broadband should act as the catalyst for a new economic model driven by increased user utility. Specifically, content subscription packages will become a key source of revenue for portals and vortals."
Three tiers of players are emerging in Europe
"Tier one represents scaled multi-platform portals, which we believe have the strategy and leverage to go it alone.
Tier two comprises businesses we consider need to build strength either in multi-platform capabilities or in online content. We expect these businesses to be net buyers of assets. Tier three includes those companies that we believe lack scale and need to ally with other players, connectivity or content backed, to enable them to compete."
The major European ISPs/portals remain overvalued
"Valuations discount growth but ignore the risk in creating online businesses. At a median of £2,735 per current subscriber and £1,819 per current user, there is a major dislocation from US peer valuations and revenue /profit potential.
"Even the best of breed US portals - Yahoo, for example - trade in the region of only £705 per user. The valuation of the telco-backed ISPs/portals - Tni.it and Wanadoo in particular - will depend increasingly on their SME/SOHO/B2B (small and medium enterprise/small or home office/business-to-business) strategies."
All the players - online and offline - have overestimated their ability to create online properties "Offline players have windows of opportunity, not structural advantages, created by their brands and cash piles. 'Dot.coms' have no legacy positions to protect and know how to use the medium but cash is short and their ability to raise new funding is limited.
"We expect a continuation of the trend towards the creation of global convergent powerhouses in the coming months alongside smaller online-offline partnerships designed to lower customer acquisition costs, develop brands offline and build technology and site functionality advantages.
"In our view, global entertainment companies - the broadband content providers - hold the key to the next phase of the Internet's development. However, entertainment industry economics face a severe test in the coming months as the traditional gatekeeper role is threatened with 'dis-intermediation' and the economic model shifts to non-exclusive, subscription-based agreements with online aggregators and risk-sharing agreements with talent. Whether the major entertainment companies embrace the shift, try to hold it up, or ignore it is critical for the Internet's broadband development."
The report is very clear about what it sees as the criteria for success in the online world. One of the main characteristics of the B2C sector is that there are very few physical barriers to entry, apart from the ability to physically distribute products.
Thus, the JP Morgan team predicts that winning in the online world will be all about building "intangible competitive advantage". The chief battlefields will be in the area of marketing and technology.
Marketing and technology costs will gradually replace other expense items such as the cost of raw materials, distribution and some personnel costs.
In fact, the importance of these intangible assets in measuring a company's worth will mean that balance sheets will have to be audited by a new breed of "brand professional", that is skilled in valuing know-how, intellectual property rights and brands, the report finds.
Key success factors
The JP Morgan report identifies seven key success factors needed to operate in the online B2C environment.
1. Use the interface
The Internet is not a mass medium. It is basically a point-to-point medium that creates mass through the aggregations of millions of point-to-point connections.
"Grasping this difference and all it implies for increasing the addressability of the user base is central to winning," the report points out.
2. Enhance the functionality of the interface
Winners will need to increase the functionality they offer, either through technology-based or content deals. They will make their offering more attractive by aggregating content and providing effective filtering tools, personalising content so that it is customised for individual users and making it accessible over a variety of platforms, such as mobile phones, games consoles and TVs.
3. Scale quickly
Successful companies will need to scale quickly. They need to scale in terms of products - by offering more products a company can attract more users to its site, observe their buying habits and build up more of that vital customer data. Amazon.com has grown from being an online book retailer in late 1997 to offering books, music, videos, auctions, software, electronics, household goods and beauty products by the summer of 2000. Once product scale is big enough, it will drive up traffic. Traffic scale is essential to provide liquidity in a marketplace and establish proper pricing mechanisms. Finally, balance sheet scale will be imperative. "Surviving the next few years is half the battle", the report says.
4. Build experience-based brands
Mass TV and print based advertising is hugely inefficient. Companies are advised to develop winning brands using what marketers call "experiential branding". Every interconnection between the user and the brand creates a positive or negative experience. This experience is partly based on price, but mostly on service. Managing this experience successfully is much more effective, but also much more difficult. Your main weapons in building a brand are Web site design and functionality, effective use of customer data and offering new types of value proposition.
5. Build whatever physical advantages exist
The two main physical advantages for Internet companies are distribution and the development of patents through technology. Offline retailers, especially mail-order companies, have a big advantage through their existing distribution infrastructures. In terms of patents, a surprising amount has already been patented on the Web. Amazon has patented its 1-Click ordering system, which requires only one click of a mouse to purchase a book or CD. Likewise, Open Market has patented the use of electronic based shopping carts on the Web.
6. Be savvy, innovate and execute
Companies can create windows of opportunity by developing a proprietary technology or a pricing mechanism, but these are never irreplicable. Portals like Yahoo! have been very good at observing pioneers like eBay's auction service and then coming up with their own product some months later.
7. Survive narrowband
The current narrowband infrastructure "presents the worst possible set of operating characteristics for Internet businesses". It is congested, slow and difficult to use, says the report, and it is more suited for B2B-based transactions than entertainment-based B2C ones.
JP Morgan suggests three strategies for online B2C companies to ensure they survive until broadband Internet infrastructure arrives: