Rethinking the Internet

Everywhere we look, the once-limitless promise of the Internet appears to be

fading. The dot-coms that were supposed to topple industry giants have mostly

vanished. The last of the Net’s bluest-chips are on the ropes. No 1 e-tailer

Amazon.com can’t extract a profit from its $2.8 billion in sales, leading some

to predict it will run out of money. And in early March, one of the few

profitable web companies, portal Yahoo!, said it would badly miss sales

projections for the first quarter.

Internet stocks are in free fall, many of them lucky to top a buck a share–sending

billions of dollars of investment up in smoke.

And the collapse isn’t stopping at the dot-coms, as the once-untouchable

makers of the networking and computer gear that serve as the Internet’s

foundation are also on the run. In March Cisco Systems jolted the market with

its second warning of slower growth to come, announcing its first-ever

widespread layoffs. That followed a warning of slowing sales in late February

from Sun Microsystems, whose servers run countless web sites.

Now, the mounting woes of the Internet sector seem to be spreading to the

rest of the economy. Just as the rollout of the Internet helped fuel the boom of

the 1990s, the evaporation of Net euphoria is helping drag down consumer

confidence and corporate capital spending, not to mention the stock market.

Since the beginning of the year, the Standard & Poor’s 500-stock index is

down 12%, and the US economy looks ready to slide into its first tech-triggered

recession.

But look beyond the current economic and market plight, and a different

picture emerges. As with any new technology, the early years of the Net have

been a learning process–and here’s what we now know. First, the Internet was

supposed to change everything. That’s just plain wrong. The reality is, there

was no way that a single technology could fulfill such an extravagant promise.

Instead, it turns out that the transformative power of the Net is being felt

unevenly. There are plenty of industries and situations where the Net has the

potential to be revolutionary, as its most enthusiastic backers had predicted,

and their number will only widen as new technologies such as broadband come into

widespread use. But clearly in much of the economy, the Internet offers

incremental payoffs without substantially altering core businesses. Even in

industries where the Net can effect profound change, institutional barriers and

business inertia mean the big gains may not come for years.

Strip away the highfalutin talk, and at bottom, the Internet is a tool that

dramatically lowers the cost of communication. It  can radically alter any

industry or activity that depends heavily on the flow of information. In areas

such as financial services, the process is well under way. In other

information-intensive industries, such as entertainment, health care,

government, and education, the potential lies in the future. But it’s there.

The Net can not only dramatically reduce the cost of both consumer and

business transactions, but also improve coordination, both within and across

companies, while giving them direct contact with consumers. "The reality is

that e-business is a tremendous tool for cost reduction, to help you get closer

to your customer and for what used to be called Old Economy companies to apply

to our current processes," says Brian Kelley, vice-president of global

consumer services at Ford Motor and the architect of most of the auto maker’s

e-business initiatives.

Over the coming decade, the biggest gains will come from restructuring the

way work is done within companies. The Net can become the communications

backbone for everything from linking supply chains for speedy product

turnarounds to storing employee expertise so that co-workers can tap into

ready-made knowledge instead of starting from scratch.

Given the crucial role of communication and information, the long-term impact

on economic growth could be substantial. The Internet could add up to 0.4

percentage points to annual productivity growth over the next five years,

according to new research from the Brookings Institution. And this estimate

doesn’t take into account the further gains that would come should broadband

be affordably piped into every home, making interaction with the Internet far

richer.

If applied right, ultimately, the Internet could boost the rate of innovation

by increasing the speed at which ideas spread between companies, within

economies, and across countries. 

True grit

But the very strengths of the Net are also its limitations. Just because

communication is ubiquitous doesn’t mean it’s everything. The last five

years have taught us that in industries such as retailing, manufacturing, and

transportation, physical factors overpower the virtual. E-tailing turns out to

be more about which company is best at moving boxes around rather than who has

glitziest web site or the biggest virtual store on earth. Linking supply chains

over the Net cuts costs and improves response times, but ultimately

manufacturers succeed or fail if they develop good products and figure out how

to produce them at low cost and high quality. Online airline reservation systems

can improve customer convenience and boost the revenue yield per passenger, but

they can’t do anything about long delays caused by runaway congestion, too few

loading gates, antiquated air traffic control systems, and mechanical

difficulties on airplanes.

Even in areas where the Internet can play a central role, the big changes are

not going to come overnight, as investors have found to their chagrin. Some of

the information-intensive industries where the Internet could have its biggest

effect are also the ones where institutional and regulatory barriers are the

highest and vested interests are the strongest. In health care and education,

for example, the possible benefits from widespread use of the web are enormous,

but it’s going to happen in baby steps, over time. What’s more, it’s a

difficult, painful, and slow process to restructure companies and markets.

In the end, it turns out that the speed of Internet time has more to do with

the capital markets than with the pace of technology adoption. The enormous

amounts of venture capital available to startups drove companies to grow far

faster in a few short years than the underlying infrastructure or consumer

demand could support. In fact, the eventual benefits of the web should be

measured over a decade. "People had higher expectations for the next couple

of years than are likely to be realized," says Jeffrey Bezos, CEO of

Amazon.com. "And people have much lower expectations for the next couple of

years than are likely to be realized over the next 10 years." That may help

explain the current confusion about the future of the Internet.

Got Web?

That’s why Internet optimists are refusing to retreat. Analyst Mary Meeker

of Morgan Stanley Dean Witter is urging Net leaders such as Amazon, Yahoo, and

AOL Time Warner to band together in a ‘Got Milk?’-style marketing campaign

promoting the idea that the web is alive and well.

Such webfests, however, aren’t likely to change the minds of burned

investors or restore the once-buoyant expectations for the Net. For instance,

Merrill Lynch analyst Henry Blodget recently reduced his expectations for how

much retail sales will go online to only 5% to 10%, down from 10% to 15% he

envisioned just a few months ago. Even Bradford Koenig, head of the technology

banking practice at Goldman, Sachs, which underwrote many of the hottest Net

IPOs, has lost confidence in pure Internet companies: "The notion of an

Internet company is no longer viable."

But that’s too pessimistic. In fact, part of the problem was that much of

the investment flowed into areas where the Internet is incremental rather than

revolutionary. Take retailing. The hyped consumer dot-coms were supposed to blow

away their brick-and-mortar counterparts. But it turns out that the importance

of information and communication in retailing–the Internet’s forte–is much

smaller than the role of logistics. How much smaller? According to a Softbank

spokeperson, it takes between $15 million and $25 million to build a

top-of-the-line web site. Yet it costs at least $150 million to build a

warehouse and distribution system for a consumer web operation.

All across retailing, the Internet is no longer seen as the 800-pound

gorilla. For example, a year ago, the prevailing wisdom was that old-fashioned

auto dealers were going to be passe. But so far, that hasn’t turned out to be

true. "There hasn’t been the massive shift to buying cars online that we

thought there would be 18 months ago," admits Mark Hogan, president of

e-GM, the auto maker’s online consumer unit.

And there’s growing evidence that shoppers on the Net are supersensitive to

price, according to Austan Goolsbee, an economist at the University of Chicago.

The implication is that any profits e-tailers might make could be short-lived as



competition drives prices down on the web.

Perhaps the biggest surprise is the comparatively limited impact that the Net

may have on manufacturing. To be sure, there is no doubt that e-business has

become an essential part of any manufacturer’s toolkit. The use of the Net can

reduce inventories, take costs out of the supply chain, and eliminate

unnecessary transactions. Collaboration can also speed up product development,

e-marketplaces can lower the cost of components and other supplies, and detailed

info on customers can help customize products to snag bigger orders or even help

determine which customers aren’t cost-effective. At Procter & Gamble, a

web-based information-sharing network makes it easier to collect and evaluate

new product ideas from the company’s far-flung workforce of 110,000 people.

Nevertheless, at the end of the day, manufacturers are still in the business

of making things, not simply moving bits and bytes around. Wheels have to be

bolted onto the car, circuit boards have to be installed in the router–and

that has to be done physically.

To know how this limits the impact of the Net in manufacturing, look at the

example of Cisco, the communications equipment giant, universally regarded as

the poster company for using the web. Some 68% of Cisco’s orders are placed

and fulfilled over the web and 70% of its service calls are resolved online.

Cisco is in the process of linking all of its contract manufacturers and key

suppliers into an advanced web supply-chain management system, dubbed eHub

speeding up the rate at which information about demand is distributed to

suppliers.

According to Cisco’s own calculations, its payoff from its use of the

Internet amounts to $1.4 billion per year, or 7% of sales. If the rest of

manufacturing could even do half as well as Cisco in using the Net, that would

cut an impressive $150 billion from annual manufacturing costs. And yet it is

not the radical reduction in costs that would signal a revolution.

Slow as molasses

While supply chains linked over the Net are more responsive than their

predecessors, they have their limits, too. "The flexibility now being

demanded by customers exceeds the physics of what the supply chain can actually

deliver," says Kevin Burns, chief materials officer for contract

manufacturer Solectron, whose big customers include Cisco and IBM. Now that

companies have switched to web-based models, he notes, they expect to be able to

ramp up or halt production of a product within weeks. But it still takes at

least three months to get a specially designed chip made in a Taiwanese foundry

and around 40 weeks to order an LCD screen.

Obstacles don’t disappear, but it’s easier to see the far-reaching

potential of the Net in industries that are primarily about moving information

rather than goods. Take financial services. In many ways, financial products are

ideally suited to the Internet, since they deal only with information. A recent

Goldman Sachs survey reported that 63% of financial companies had sold their

products through an e-marketplace or a web site, the highest of any industry.

The Internet is already well on its way to transforming financial services.

Online brokers such as E*Trade Group have completely changed how the retail

brokerage business worked. And Net services are now offered by nearly every US

bank and credit union. Bank of America says it’s signing up 130,000 online

customers a month, giving it more than 3 million Net customers. Citigroup has

2.2 million, Wells Fargo, more than 2.5 million.

But as in the case of entertainment, technological and institutional barriers

are slowing down the eventual gains. Consider online bill-paying, widely

anticipated to be the "sticky app" that drives traffic. The benefits

of paying bills on the Net, for both consumers and businesses, could be

enormous. But the technology has proven exceptionally complicated, and it has

hit a wall trying to penetrate the banking industry. Among the problems: Banks

and billers have been unable to agree on how bills should actually appear

online. Still, Bank of America plans to launch a big ad campaign later this year

to promote its bill-paying service.

And then there’s health care. Despite the tangible nature of many medical

services, health care has a very large information component that makes it a

natural for Internet applications. Just shifting claims- processing to the web

could save $20 billion a year, according to the Brookings economists. At a

leading provider of prescription drug care in the US, it costs a matter of cents

to handle a prescription order on the Internet, as opposed to more than $1

through other methods.

Broadband’s promise

But there are enormous institutional barriers. For one, privacy

considerations may slow down the full shift of health-care records to the web.

Moreover, health-insurance companies, doctors, and hospitals are unwilling to

give up control of patient records and insurance payments to a third party. This

reluctance helped frustrate WebMD and Healtheon, which expected to lead a

restructuring of health care by moving many claims, payment, and related

processing services to the Net. WebMD’s efforts to provide real-time payment

capabilities were shunned by insurers and HMOs, who prefer the current

cumbersome process that lets them hold onto the money longer.

There’s also the technology factor. In the long run, realizing the promise

of the Net will depend on the widespread introduction of advanced technologies

such as broadband to the home and high-speed wireless. With broadband

connections over telephone or cable-television lines, consumers will be able to

watch TV-quality video clips of the NCAA basketball tournament or download

crystal-clear music files faster than ever before. What’s more, they’re more

likely to use the Net because they’ll always be connected and won’t have to

spend minutes dialing into the Net each time they want to visit a site.

The problem is that getting the new technologies in place may take longer

than expected. Financially stressed telecom companies are slowing down the roll

out of broadband. The failure of small telecom providers means that subscriber

growth may slow down in second- or third-tier markets. And the prices for

high-speed Internet access may rise.

In the end, the Internet seems likely to revolutionize mainly

communications-intensive industries. If that seems too



limited, remember that almost every breakthrough technology over the last 200
years affected some areas of the economy more than others. The automobile

transformed personal transportation and patterns of housing while little

affecting manufacturing. Electricity radically altered manufacturing practices

and any industry that was power-intensive, while not having an enormous effect

on health care. The Net deserves to be put in such august company.

By Michael J Mandel and Robert D Hof with inputs from Linda Himelstein in

Silicon Valley, Dean Foust in Atlanta, Joann Muller in Detroit, and bureau

reports in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc