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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 Inc. (AMZN) can't extract a profit from its $2.8 billion in sales, leading some to predict it will run out of money. And on Mar. 7, one of the few profitable Web companies, portal Yahoo! Inc. (YHOO), 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. On Mar. 9, network equipment maker Cisco Systems Inc. (CSCO) 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 Inc. (SUNW), 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 (chart). Since the beginning of the year, the Standard & Poor's 500-stock index is down 12%, and the U.S. 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 Internet 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 Internet 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. And 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. That means 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 (table). But it's there. Says Gary E. Rieschel, executive managing director at Softbank Venture Capital, one of the biggest backers of Internet ventures: "The Internet is about communications, and people have never at any time in history stopped wanting to communicate."

That means the Internet can dramatically reduce the cost of both consumer and business transactions. It also can 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, it's a tremendous tool to help you get closer to your customer, it's a tremendous tool for what used to be called Old Economy companies to apply to our current processes," says Brian P. Kelley, vice-president of global consumer services at Ford Motor Co. 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. Says Massachusetts Institute of Technology economist Erik Brynjolfsson: "Most of [the Net's benefits] will come in changes to business practices and organization. What really matters is when companies and markets reorganize."

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. "We're looking at an improvement in income per person of roughly $1,500 in 2010," says Robert E. Litan, director of economic studies at Brookings, who led the study, along with Alice M. Rivlin, former vice-chairman of the Federal Reserve. 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. With more information available, new ideas will get noticed and put into practice faster. "The Internet is the friend of companies making products that are truly unique and different," says Gary Hamel, chairman of the San Francisco office of consulting firm Strategos. "That means the premium for real innovation will go up."

TRUE GRIT. But the very strengths of the Internet 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. "We have cherry-picked some of the easy projects," says Andrew McAfee, a Harvard Business School professor who has studied how businesses use the Internet.

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 P. 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. On one hand, Internet usage continues to rise, and consumer e-commerce sales are up by 67% over a year earlier, according to the Census Bureau. "Our research doesn't show any downturn in consumer behavior," says Mary Modahl, vice-president of marketing at Forrester Research.

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. Another group, led by Michael Tchong, CEO of technology consultant Iconocast Inc., has launched a Back the Net campaign to urge people to buy something online or 10 shares in a Net company on Apr. 3.

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 & Co. analyst Henry M. 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 C. Koenig, head of the technology banking practice at Goldman, Sachs & Co., which underwrote many of the hottest Net initial public offerings, 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 Softbank's Rieschel, 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. "The Internet only solved 10% of the process, the front-end purchase process," says Rieschel. "What we really needed to do was fund the back end."

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 T. 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. "Now, retail once again looks like a brutal, low-margin business," says Goolsbee.

The Internet was also supposed to transform markets by wiping out the middlemen. Real estate agents, for example, were expected to dwindle away as buyers located homes on the Web while paying lower commissions. But the reverse turned out to be true, since the number of real estate agents has grown rather than fallen. "Studies have shown that people who use the Internet use Realtors more than those who don't," says Stuart Wolff, CEO of Homestore.com Inc., the largest home and real estate related site.

Perhaps the biggest surprise is the comparatively limited impact that the Internet 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 Internet 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 Co., 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 understand how this limits the impact of the Internet in manufacturing, look at the example of Cisco, the communications equipment maker that is 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. This speeds 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 Internet, that would cut an impressive $150 billion from annual manufacturing costs. But these figures need to be put in perspective. A 7% reduction in costs is nothing to sneeze at, but it is not the radical reduction in costs that would signal a revolution.

SLOW AS MOLASSES. And 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 R. Burns, chief materials officer for contract manufacturer Solectron Corp. (SLR), whose big customers include Cisco and IBM (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.

And while the unprecedented communications capabilities of the Web should enable corporations and markets to be organized in new ways, it's going to take longer than proponents expected. "At the marketplace level, I haven't seen radical changes brought on by the Internet," says McAfee. "It's going to be a much more gradual process."

While the obstacles don't disappear, it's easier to see the far-reaching potential of the Internet in those industries that are primarily about moving information rather than truckloads of goods. Take financial services. In many ways, financial products are ideally suited to the Internet, since they deal only with information. Indeed, 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 Inc. (EGRP) have completely changed how the retail brokerage business worked. And Internet services are now offered by nearly every U.S. bank and credit union. Bank of America (BAC) says it's signing up 130,000 online customers a month, giving it more than 3 million Internet customers. Citigroup (C) has 2.2 million, Wells Fargo & Co. (WFC) more than 2.5 million. FleetBoston Financial Corp. (FBF), the nation's seventh-largest bank, combined its online banking services with its online brokerage business, Quick & Reilly, and its online customer base jumped 50%, to more than 1 million customers, which is 35% of the total customer base.

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 Merck-Medco Managed Care, the nation's leading provider of prescription drug care, it costs a matter of cents to handle a prescription order on the Internet, as opposed to more than $1 through other methods, notes Stephen J. Gold, senior vice-president.

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 (HLTH) 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. SBC Communications Inc. (SBC) recently raised the price of its residential high-speed Internet service by 25%, or $10 per month, which is likely to slow its adoption. "Until the foundation of Internet infrastructure gets built out, we're not going to see any consumer Net companies emerging," says Michael Parekh, managing director of Internet research at Goldman Sachs.

In the end, the Internet seems likely to revolutionize mainly communications-intensive industries and activities. 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 Internet deserves to be put in such august company. By Michael J. Mandel and Robert D. Hof

With Linda Himelstein in Silicon Valley, Dean Foust in Atlanta, Joann Muller in Detroit, and bureau reports


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