When the Reel Runs Out

Let's all say it together: the Internet economy has finally sobered up. You might even say it's hitting the hangover remedies. After three years of spectacular IPOs, endless start-ups, and liquid venture capital, we are now inundated with stories of profitless dot-coms reaching the end of their burn rates and gasping their last. Every sector of the new economy is feeling the pressure to deliver on its promises to investors, but no one has been hit as hard as the merchants of e-commerce. Just nine months ago, brick-and-mortar shopowners were warning that online retailers, powered by the convenience of in-home shopping and unencumbered by sales tax, could mean the death of real-time stores--and with them, the decline of public space. Now the bell is tolling for the online retailers, and it wasn't sales taxes that killed them off; they're going under all by themselves.

According to the San Francisco investment bank Thomas Weisel Partners, every single online retailer that has gone public this year is worth less than it was on the day of its IPO; the same holds true for ninety percent of online retailers that sold stock last year as well. The online tech magazine Upside Today has assembled a "dot-com graveyard" of Internet companies that have folded in the last few months, with e-tailers comprising the biggest losers; witness such celebrated failures as Petstore.com and the online clothier Boo.com. Other vulturine Web sites such as "FuckedCompany.com" have come into being for the sole purpose of marveling at the Internet attrition rate.

Why, with all online retailing's advantages, hasn't it worked? Important clues can be found in the story of Reel.com, the Emeryville, California-based video sales Web site that laid off all but a handful of its staff three weeks ago. Unlike companies such as Boo.com, whose demise can be traced to specific disastrous blunders, Reel.com did an awful lot of things right. The company created a specific vision for its site, found a niche among customers, established a brand with an ambitious marketing scheme, and enjoyed the patronage and expertise of a parent company, Hollywood Entertainment, that regularly invested tens of millions of dollars and had years of business experience at its disposal. If a company with so many advantages can't survive, what can?

Most people are familiar with the remarkable rise of Reel.com. Stuart Skorman, an eccentric New England video store businessman who bounced around the casino circuit as a professional gambler, came to California and, in 1997, established the Reel.com Web site as a means of renting videos online and providing an exhaustive database of obscure titles for film buffs. Within six months, Skorman had opened a single brick-and-mortar store on Shattuck Avenue, but the real worth, investors figured, was in the online component of Reel's "bricks and clicks" model. Skorman threw millions of dollars into the content side of the Web site, assembling an enormous database of film reviews and trivia about the industry. But while the content side was terrific, the retailing part was shaky; for example, there was no way for repeat customers to file away their credit card information, so video buyers had to type in their credit information with each transaction.

Still, such problems seemed insignificant early on, while the company was experiencing astronomical growth. By 1998, Reel was collecting $1 million a month in sales revenue and had assembled more than $10 million in investment capital. When the company embarked on a remarkable promotional campaign later that year, selling just-released copies of the movie Titanic for half the recommended price, Reel netted 300,000 buyers, tens of thousands of new customers, and valuable brand-name recognition overnight.

Of course, selling Titanic videos at six bucks below cost drained enormous amounts of the company's cash. But to Wall Street, Reel looked like gold. In October 1998, the video store giant Hollywood Entertainment bought Reel for almost $100 million in cash and stock, and despite the jaw-dropping price for a company that had lost close to $20 million in the eight months of its existence, Hollywood's stock rose, buoyed by investor expectations that such a visionary enterprise was bound to pay off. So now, unlike other more tenuous dot-coms, Reel was partnered with a brick-and-mortar company that possessed a bigger brand name, an enormous customer database, millions in cash, and the experience that comes with running a company that actually has to pay attention to its bottom line.

Unfortunately, there were still a host of technical and logistical problems afflicting Reel. Some of these were Web site glitches that in retrospect can be seen as cautionary tales of how not to run an online operation. But others seem endemic to the entire online retail industry, and Reel's experience in coping with these problems suggests that they may be both unavoidable and utterly lethal to an e-tailer's profit margin.

According to Johnnie Lieske, who was recently laid off from his job as a program manager at Reel, many of the company's early technical problems were never adequately addressed, and as sales increased and customer traffic grew, what had once been a minor inconvenience soon became expensive and time-consuming. "When we [first] collected customer information, we just had one field to have their first and last name," Fieske says. "When we [later] switched over to our new shopping cart, we kept the old system, but some people would put their last name first, and others would do something different. So when we got a call for customer service, and they gave us a name, it wouldn't always show up on our database. We were so busy setting up an office in Seattle to produce content for the site that we never fixed the basic problems. We never rebuilt from our start-up mode."

Meanwhile, credit card fraud was emerging as a major problem, so Reel was shipping products that couldn't be recovered and, to add insult to injury, having to pay bank penalties for unauthorized transactions. Then, just as Reel was beginning to enjoy the fruits of its merger with Hollywood, the e-commerce giants Amazon.com and Buy.com announced that they too would start selling videos online. As Reel company managers tried to retool the system to accommodate an exponentially growing customer base, the site was forced into a price war with the two biggest e-tailers in the country.

In the end, what may have killed Reel was the logistical nightmare of accommodating so many customers --- the promise that had made Reel such a hot item to begin with. As Reel began processing such huge numbers (according to Hollywood spokesperson Sean Mahoney, Reel had 1.8 million visits in January alone), the problems of warehousing, shipping, and distributing videos began to overwhelm the company. The two images of Reel--as the online source for even the most obscure titles, as well as an outlet that could handle potentially unlimited sales orders from all over the country--colluded to produce obligations the firm couldn't hope to honor without an endless infusion of cash from its parent company.

"Look at our inventory, for example," Lieske says. "The Matrix will have a director's cut, DVD, VHS, a Spanish edition--all these myriad products for one movie, plus keeping track [in the content division] of all the elements to a single movie like the director, the actors, etc. It gets really complicated. And then what happens when somebody buys ten movies, but you only have five in hand? Do you back-order the ones you don't have? Say you ship out what you do have, and then two movies come in two weeks later -- do you ship them and bill the customer, or do you still have permission to use the credit card number? If a back order doesn't come through, you have to send the customer an e-mail to that effect. All these transactions have to happen over a secure line. And how do you pull products from the shelf when you're shipping thousands of copies a day? That's a tricky business; movies might be scattered from one end of the warehouse to the other.

"When we were a start-up, we were surrounded by videos in the office, and people would say excuse me and reach around you to get a video they had to ship out. A smaller company would be able to deal with these issues, but you can see that it becomes a very fat pyramid. It starts out small, but then the business rules get very complicated."

By the end of 1999, Reel had lost $98 million in infrastructure investments, despite racking up sales revenue of $40 million for the year. Last December, Hollywood Entertainment officials banked on investor capital to keep the operation afloat when they filed papers to issue an IPO. But then the NASDAQ went south, and there was nothing between Reel and insolvency. On June 12, company officials announced that they were shutting down Reel's retail operation and laying off all but twenty employees.

Clearly, while the company made some mistakes, many of Reel's challenges confront every online retailer. Many of Reel's expenses were related to the firm's enormous rate of growth, yet the e-tailer imperative is "grow or die." And if Reel's competition with the Amazon.com behemoth helped speed its demise, what does this suggest for the myriad of other e-tailers, most of which are considerably less endowed than Reel and will inevitably compete with the ever-increasing variety of Amazon products?

According to recent reports by investment firms Merrill Lynch and Morgan Stanley Dean Witter, Amazon.com itself has but a year before even this monster runs out of cash. Could we be facing the prospect of massive e-tail bloodletting, as firm after firm dashes itself against Amazon, which will then expire of its own bloat?

"A lot of the dot-coms want to revolutionize business in six months," says Anand Arkalgud, the manager of business development for the Oakland, California-based business software designer TechOne. "'I'm starting a new business, and I have this captive customer base, and I have an interesting thing to sell them.' It's a trap that all too many people fall into, because they think they have this very easy process. But managing services over the Web is very complex. Imagine ordering a pizza. The elements of just ordering a pizza, with all the potential toppings, is very complicated. People set up companies with an idea, and suddenly you start handling this tremendous number of customers with varied content needs. The logistics of handling that can be huge. A lot of new companies haven't set up their back-end structure, and a lot of customers are themselves learning how to use the Web, even as these companies are learning how to conduct a Web-based business. It's a very complex, interactive process."


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