Death By Dot Coms

"Arguably the single most graphic example of the telegraph's superiority over conventional means of delivering messages was to come a few years later, in October 1861, with the completion of the transcontinental telegraph line across the United States to California. Before the line was completed, the only link between East and West was provided by the Pony Express, a mail delivery system involving horse and rider relays. Colorful characters like William "Buffalo Bill" Cody, and "Pony Bob" Haslam took about 10 days to carry messages over the 1,800 miles between St. Joseph, Missouri and Sacramento. But as soon as the telegraph line along the route was in place, messages could be sent instantly, and the Pony Express was closed down."

"The Victorian Internet", p.59, Tom Standage, Walker Publishing, 1998

Putting the Web in Context: As a regular reader of these pages, you may be aware that I have a simplistic view of what causes periodic economic depressions. Massive shifts in the supply-demand-production equilibrium. It has been
precisely these shifts, which I explored in a paper a while back that you can read by clicking here, that wreak periodic havoc on the grand designs of social engineers. The examples that make the case:

In 1832 a panic hit the US and was caused by the emergence of automation in the linen business. As textile prices dropped like a free-falling safe (through the early 1840's) the supply-demand equilibirum wasupset to the breaking point and a panic ensued.
In 1873, the rightful freedom for 7 million Blacks, liberated by the Civil War, coupled with the front end of a huge immigration from Europe, that caused excessive labor in northern cities and pricing power collapsed as working wages fell. Nautrally, financial panic ensued. The over-supply of labor echoed in the 1897 panic, too.
In 1929, the crash occurred when farmers, who had produced 7 million horses a year in 1920, planted excess grains as horse demand died in the 1920's thanks to Henry's Fords. This drove down commodity prices, and although low commodity prices fueled the Roaring Twenties, the back end of the deal was that the worst depression ever followed.

The General Case: Of course the great lesson of 1929 from today's perspective is that it is not the new technology that caused a crash. It was not the power loom, or the internal combustion engine that killed prosperity in 1832 or 1929. It was the embodiment of the technology in a manner that upset the supply-demand equilibrium of markets.

Today's Case: It gets really simple. It was not the microprocessor that is about to bring us a crash. It is the
embodiment of the microprocessor in the networked computer that is changing the supply-demand equlibirum. This is
why the markets must necessarily crash.

Death of Profits: Now we're down to the point that causes me to be out of bed, writing this down for you at this unGodly hour. Write this down on a piece of paper and put it in your wallet, e-mail it to friends, and try to spend about 10
minutes per week thinking about the simple implications of why profits are dead. Just two simple concepts.

     Pricing power is a function of demand and the number of participants.
     The Internet allows the number of participants to increase to something approaching infinity.
     There are virtually no barriers to entry by new competitors on the web.

Pricing Power: The number of players determine profit potential of operating companies. A few examples. Let's start with big companies that own a technology lock, stock, and barrel. A monopoly has about as much pricing power as you can get. Let's go to my favorite economic analysis laboratory, the desert, and you'll see what I mean. Let me set the stage by telling you that we are out in the desert walking around, and yes, it's hot. You and I are getting damn thirsty.

The Monopoly case: In this example, the two of us stumble across one lemonade stand. We are thirsty and we both want the one glass of lemonade that is being sold. Trust me, this lemonade will become very pricey to us and very profitable to the owner of the lemonade stand. The limit on pricing is how thirsty I am and how much money I have. If thirsty enough, all my money could be spent out bidding you. The cost of lemonade to the stand owner hasn't gone anywhere, but the price received goes up (inflation, with lots of dollars chasing scarce goods). Income minus expense equals profit, so the profit goes through the roof.

A few Good Stands: Suppose, however, that we had come across not one, but two or more lemondae stands. The pricing power would diminish and stand owners would have to fight over our business. If there were three stands, and we only bought one lemonade each, that third stand would have to find some value-added or some clever deal to get his lemonade sold. Maybe he would put ice in his lemonade.

The Million Stands: Now march out of the desert thirsty with me one more time. This time we find not one or two or three, but over one million lemonade stands!

Ask yourself the question: will any of these stands make money, or will they all whore prices just to be around for the next person out of the desert who might come along some day?

That's the web.

Barriers to Entry:

The problem of the web in a nutshell is that there are not enough profits to go around and satisfy the web profit needs and the profit needs of traditional (bricks and mortar storefont) businesses.

If Safeway sees http://www.homegrocer.com coming, they know that they will having pricing pressure down the road if it's not already here.

The bottom line: The Internet is a wonderful and amazing tool that has the potential to make every business in the
country unprofitable because there are not sufficient barriers to entry.

When the rest of the world wakes up to this, which I expect to happen in some measure this fall, prices will come tumbling
down for equities. The world is about to go through a period of adjustment because the supply demand equilibirium has been upset. During the front end of this adjustment period, profits will go to zero (or negative) for the majority of players to wipe out the extra lemonade stands. Then, prices will slowly escalate and the number of participants self-selects to some smaller number. But, as in the depression of the 1930's, the displacement will be huge.

Remember the dust bowl pictures circa 1933 which I put up as a link a few weeks ago? That defined the last crash visually. This time look for a different sort of picture.

Looks for pictures of boarded up strip malls and falling urban real estate prices.

The dot coms of this world don't need a mall store front and thanks to FedEx and UPS, a company in the outbck or hinterlands can be more profitable than one in New York or LA.

Remember what Bob Dylan said about "The times, they are a chaaaaannnnng 'in."

Further Death by Dot Coms? Friday afternoon (9/17/99) I had a conversation about my Death by Dot Coms theory with my friend Zeek Pardo - A media mogul, in Seattle. His remarks are worth noting.

     "You could be on to something. Did you know that in the second quarter of
     this year, Amazon had something like 1.2 or 1.8 million customers worldwide (including
     me) and the company managed to lose $60 per customer?"

(Zeek read some stats in two Amazon stories about customer base and losses and simply did the math...)

     Zeek goes on: "You gotta realize they have more customers than a lot of
     small countries have people and these guys can't even manage to break
     even. And that's just in the second quarter."

Here's his second favorite "Death by Dot Com Story".

     "Most regular folks don't know that Amazon's ad budget is $130 million per year of other
     people's money. Those people are investors. This is very crucial:
     They have always been a cyberspace company - they have not retail
     outlets. Why? Because they said bricks and mortar were where it is at.
     This is a 100% cyberspace baby. They have big PR firm..and they keep
     their name in the news. So out of $130 million in ad budget, how much
     do you suppose they actually spent on advertising in cyberspace? Remember, they
     are entirely a cyberspace company, right? Why would you need old media,
     right? How much of the $130 mil do you figure is internet advertising?"
     ----
     me: "God, I dunno Zeek, ah...$50 million?"
     ------
     Zeek: "You're sorta close...wanna guess again?"
     ---
     me: "Oh, $48 million?"
     ----
     Zeek: "Getting warmer. Come on...go for it."
     ---

me: "Oh God, Zeek, $30 million??"

     ---
     Zeek: "You're almost there..".
     -----
     me: "Oh my, $5 million?"
     ---

     Zeek: "Closer. Let me make it easy for you, George. Out of their entire $130
     million advertising budget, they have so much confidence in the internet
     as a mass communication and persuasion vehicle that they spend a
     whopping 1.92% of their budget on the Internet. I think that works out to about $2.5
     million."
     ---
     me: "And the rest?"
     ---
     Zeek: "Old media. You know, that old fashioned radio, television and print stuff like I
     use for my clients. And my clients by the way don't lose $60 bucks a customer per quarter."

Touche! That's what happens with a couple of ex big city news directors compare investigative reporting skills.

Let me see...two glasses of lemonade divided among 4,000,000 lemonade stands. how many will make money?

Ure's Intenet Profitability Theorum: If there are more sellers than buyers, no one will make a profit.

Reader Feedback:

From Howard Hill of the Long Waves Group:

"It isn't on their web version, but this week's NY Observer column by Chris
Byron (column titled Back of the Envelope) updates his Internet Index (now
$317 B market cap), and uses your exact phrase, lemonade stand, to describe
theglobe.com, a company that admits that its secondary IPO prospectus
misstated the number of unique visitors to its web site. No one is willing
to say what the right number is. However, in his very sensible "back of the
envelope" calculations, Byron points out that this company seems to have
gone from losing about 65 cents per pair of eyeballs to losing $1.90 per
(overstated) pair of eyeballs in less than a year. The business model, as
you might guess, is to be advertiser-supported with those irritating banner
ads.
In case anyone cares, the initial offering was at $9 per share (invitation
only, if you don't mind), and the stock traded up to $97 per share the first
day out, giving the institutional investors ample opportunity to unload.
Current price -- $20 after adjusting for a 2-1 split. The bleeding is
accelerating, and filings indicate that the chairman was able to part with
25% of his holdings in the secondary."

From a Reader in Toronto:

"I am an avid follower of your page. I disagree with some of your ideas. In
particular I think that while your pricing pressure theory is fine I do not
think it is the Internet that will kill it. Rather it is open markets.
Although I too favor free trade the fact is that with a world population
explosion and the end of the cold war approximately three billion new
consumers have come onto world markets over the last twenty years but only
about a tenth of that number has the money right now to buy the products
all of them make. I think it is becoming glaringly obvious that there are
critical imbalances in the world economy that only a depression can solve.
What is shocking to most people is that we need a collapse and a
depression. The reason is that depressions squeeze out the inefficient
competitors entirely.
As for Amazon dot com the problem they face is this. If it was possible to
log onto a data base and download a book for less than it cost at a
bookstore people would stop attending at Barnes and Noble. The fact is that
it is cheaper and a better shopping experience to attend at a Mega Book
Store and drink cappuccino and browse through the stands and check out
various books.
However, your pricing pressure theory is working out in the Internet
itself. You used the word Whoring to describe price pressure. That is an
interesting description because it applies to what is happening to the
porno sites. The king of hard-core, that Warshawsky guy they write about in
all the financial papers, has already gone bankrupt once on the Internet
and he now has a larger war chest and is still losing money though it is at
a lower rate. Basically the majority of porno channels are in trouble.
There is what the Japanese refer to as "excess competition". What the
market needs is a shakeout. Probably in the case of pornography censorship
will limit access, and take out the weak players. In other words a
depression in supply.
In the case of the world economy there is already an excess of supply and
probably over the next few years the world will move to a trading block
system. NAFTA EU ASEAN and everybody else. Probably the most open trade
will occur between EU and NAFTA because those two blocks already are in a
rough balance on trade anyway. I feel sorry for the others who will be cut
out. Lets face it is in Americas best interest to build up Mexico in order
to solve the illegal immigrant problem. There is no political advantage in
building up the Indian economy. So the solution will be trade barriers
against India and trade credits for Mexico and so it goes. The EU is
already pursuing that course. For Japan however the solution will be
different to some extent. The Japanese will have to become the anchor of
ASEAN and in all probability will have to open their tightly controlled
markets in order to get trade moving and build up the ASEAN block.
Just my two Pesos

From an East Coast reader shopping for a new car:

"When you said..
Pricing power is a function of demand and the number of participants.
The Internet allows the number of participants to increase to something approaching infinity.
There are virtually no barriers to entry by new competitors on the web

I couldn't agree more.
George, I had my first cyber, car buying experience yesterday. I Previously went to the dealers lot to test drive the
Isuzu Trooper and make my best deal. Then I came home and accessed Edmunds, got 5 dealers within 100 miles.
The end results were I paid 3% over invoice after a $3000 dealer incentive...in a nut shell I saved over $1850.00
compared to my best efforts in person at the showroom.
This is happening everywhere...who will survive?

Death By Dot Coms: You have been warned.

-George Ure, MBA

Return to Urban Survival Home Page ||| Return to Weekly Market Review