Subject: Redherring.com - Revenge of the Bricks- From the August 2000 issue
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Date: Thu, 4 Jan 2001 15:24:05 -0500

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Revenge of the Bricks
The world's largest corporations are creating the world's newest ones, forming online exchanges as their answer to the Internet. Let's see if they get it right.

By Peter D. Henig
From the August 2000 issue
They're testing the bounds of hyperbole on this one. In the eyes of their stakeholders, the massive new business-to-business exchanges being formed by traditional industries are the single greatest creation since Henry Ford invented the assembly line-consortia-led exchanges, megahubs, industry-sponsored exchanges, and trading marketplaces. They're collectively referred to as NewCos, and they are designed to accomplish three goals: help such industries as aerospace and chemicals use the Internet to squeeze efficiency out of their supply chains; squash dot-com business-to-business startups that have been promising to do the same; and give birth to a new corporate entity that can save costs for its participants, earn profits, and eventually generate billions in an IPO.
It doesn't matter that most of them haven't gotten far beyond the press release stage. Stalwarts as diverse as Sears (Nasdaq: S), Ford Motor (NYSE: F), and International Paper (NYSE: IP) are getting into the act, joining forces with competitors to build these huge online trading hubs, where procurement processes, supply chains, and all other business transactions for an industry can take place under one virtual roof. Increasingly, they are touted as the salvation of the brick-and-mortar world, which is annoyed at being written off so soon, and whose leaders are claiming that, yes, they do have something valuable to offer the Internet. It's called market power, the liquidity no exchange can live without.

They are, perhaps, the only real way of fulfilling the promise of electronic data interchange (EDI), those expensive software packages linking large corporate supply chains to customers and vendors. And megahubs created in the automotive, aerospace, oil and gas, shipping, and utility industries-not to mention countless others-could bring the same corporate efficiencies to the masses, redefining the way buyers and sellers interact, creating streamlined channels with creditors, vendors, distributors, and shippers, providing the deepest window yet into a market's inventory capacity and price discovery process. Purchase orders, invoices, payments, credit approvals, inventory, and an entire range of other business relationships will all happen online.

Or at least that's the plan.

The fact is, it's going to take some major leaps to get from A to B. For one thing, the movement will require traditional companies to do something as fundamentally nontraditional as opening up the gritty details of their businesses. The best articulation of that challenge were the comments of an unnamed supplier who was quoted in a white paper on B2B exchanges written by Morgan Stanley Dean Witter (Nasdaq: MWD) Internet analyst Mary Meeker: "Let's see, you want me to put all my products and prices online so my customers can beat me about the head and shoulders. Then I can commoditize myself even more to take my razor-thin margins down to microscopic levels. Finally, I get to pay transactions fees for this privilege... What am I missing?" In addition, the concept requires such decades-old rivals as General Motors (NYSE: GM) and Ford to embrace-which won't be a pretty sight. Meanwhile, the federal government is keeping an eye on the phenomenon for signs of antitrust violations.

What promises on paper to be a fully neutral exchange with deep windows into efficient pricing methods and available inventory levels may ultimately prove to be too weak and overly ambitious an attempt at answering the call of the Internet. Large corporations may still be too slow, and possibly too stupid, to get it right. Those who succeed could create the dominant business-to-business exchanges across lucrative industry verticals, saving billions in expenses, regardless of whether they ever turn a profit. Those who don't will once again prove that consortia among competitors rarely last. Just because the world's largest corporations have the market power to build the world's newest ones, doesn't mean they'll actually be able to make them work.

SAVINGS RACE

Like the challenges, the potential rewards are huge, even if the future profits may not be. Although business-to-business exchanges are still in their infancy -- with the consortia-led exchanges younger still -- IT consultancy Forrester Research (Nasdaq: FORR) predicts exchanges will ultimately account for 53 percent of all online business-to-business transactions. Yet, even though revenue models of these new independent companies are still being defined, their cost savings are apparent. Keith Melbourne, general manager of trading communities for Hewlett-Packard (NYSE: HWP), estimates that the high-tech industry, which generates $360 billion in direct procurement each year, can shave 40 percent or more off its costs by using his industry's new high-tech exchange. Investment bank Bear Stearns (NYSE: BSC) estimates that full supply-chain integration within an exchange could enable the average company to reduce supply-chain management costs by 25 percent. And Ms. Meeker projects that if the cost of processing a purchase order manually now ranges from $125 to $175 offline, online procurement can drive costs as low as $10 to $15 per order.

On an aggregate basis, the cost savings alone to industry leaders could make revenue gains for the exchange-or IPO returns if it comes to that-seem paltry. "What does Shell or BP (NYSE: BPA) really care about-making an extra $200 million, or shaving 1 to 2 percent off of their total costs?" asks Daniel Aegerter, founder and former CEO of Tradex Technologies, a business-to-business software firm recently sold to Ariba (Nasdaq: ARBA). "It's cost savings, that's where the success will really be."

But while there's nothing slowing the pace of the press releases, smokestack industries are wading into this gingerly, fully aware that exposing their core businesses online is not something to be rushed. Memorandums of understanding have been drafted, but not much more. Few exchanges have reached definitive partnership agreements, and even fewer have actually executed transactions of any significance. In fact, the first phase of consortia-led marketplaces, which call themselves exchanges, are hardly exchanges at all. They are using preliminary tool sets from software firms like Ariba or Freemarkets (Nasdaq: FMKT) to put catalog items online, or run auctions of excess inventory. For the moment at least, it's still a one-to-many model. Large undertakings like Sears's and Carrefour's GlobalNetXchange for the retail industry have made purchases of indirect commodity items like pencils and paper clips. Others, like the HighTechMatrix for the high-tech industry, have sought out resin for printer tops and executed spot purchases of DRAM chips. Most industry-led mega-exchanges are years away from reaching their true promise, where full supply-chain integration will shorten product cycles, radically improve profit margins, and the huge volumes of transactions can generate revenue and profits large enough even to recoup the cost of building these things. Forget IPOs.

Still, companies as diverse as Safeway (NYSE: SWY), Goodyear (NYSE: GT), Chevron (NYSE: CHV), and Campbell Soup (NYSE: CPB) are sold on their benefits. NewCos will, in appearance at least, resemble exchanges built by independent Net market makers like VerticalNet (Nasdaq: VERT) and Ventro (Nasdaq: VNTR), which have already gained acceptance among many industry buyers and sellers. With their hands in multiple vertical markets, including medical supplies, chemicals, and paper products, these companies have proven that the exchange model works, and made them wonder why it's taken large corporations so long to catch on. Some venture-backed pure-plays like ChemConnect and Altra Energy Technologies have been even more successful, gaining true market liquidity for their participants while attracting some of the same industry backing now so eager to compete against them.

Frequently, private companies are far ahead of the consortia. In the paper industry, PaperExchange.com received its first round of funding in spring of 1998 and by year-end had 12 employees and 250 members. Now, following a strategic partnership with VerticalNet, it has more than 3,100 corporate, and over 4,500 individual, members in over 80 countries. This is a far cry from the simple press release issued by Weyerhaeuser (NYSE: WY), Georgia-Pacific, and International Paper stating their launch of an exchange serving the paper and forest products industry sometime in the third quarter of 2000.

THE BEST OF ENEMIES

The fundamental challenge facing new industry-led exchanges is that the equity stakeholders that are forming and funding them -- venture capitalists need not apply for board seats here -- have rarely, if ever, coöperated on anything. Will competitors truly be willing to open their kimonos and reveal pricing, inventory, or design specification information to long-time industry rivals? That's the big unknown. The Big Three auto makers forming the auto parts exchange have been enemies for decades. Retailers, such as the 16 members of the Worldwide Retail Exchange, have long fought each other tooth-and-nail for market share. And the largest suppliers of paper and forest products, like Georgia Pacific and International Paper, remain so uncertain about the viability of their own exchange that International Paper, at least, is also backing PaperExchange.com, its private company counterpart. Not to mention the fact that the federal government often frowns on oligopolies stacked with more than their fair share of market domination. It's understandable, then, that promises of hiring separate management teams and independent boards to run fully independent exchanges, unencumbered by the self-interests of major stakeholders, comes with a certain amount of fear, uncertainty, and doubt.

Despite howls of criticism that longtime foes won't find common ground, the world's largest buyers and sellers remain undeterred in their efforts. The benefits of lowered costs and improved efficiencies, they say, far outweigh the possibility that they won't even agree on the next press release, or that NewCos may never earn them a penny. Reduced customer acquisition and supplier sourcing costs, the avoidance of building multiple extranets to connect buyers with suppliers, and the elimination of pricey internal EDI software are all industry positives, regardless of financial outcome to the exchange. "The savings are so compelling we can't afford to screw this up," says Mr. Melbourne of Hewlett-Packard. "It's going to happen anyway so we have to put our personal agendas aside and all be advocates of NewCos."

But if there's one thing everyone agrees on it's that NewCos can't be run by committee. "If they think they'll run them like the United Nations, they can just forget about it; they'll never get out of the box," says Mr. Aegerter. Minor squabbles have already emerged. Until calmer minds prevailed, the Big Three auto makers were headed down separate lanes to set up their own proprietary exchanges. In fact, Diamond Technology Partners (Nasdaq: DTPI), an investment bank, was called in at the last minute to broker a truce between Ford and GM, which was, in reality, more of a technology compromise between software vendors Commerce One (Nasdaq: CMRC) and Oracle (Nasdaq: ORCL).

Even if NewCos are appropriately formed with separate management teams tasked with business objectives completely independent from the self-interests of their largest stakeholders, the mere fact that they represent independent joint ventures among competitors is still a significant mark against them. As Dave Perry, CEO of Ventro, an independent market maker for B2B exchanges, sees it: "The single biggest problem is that joint ventures are hard, joint ventures with many players are twice as hard, and joint ventures with many players who've been competitors for 80 years are nearly impossible."

Friction has taken root inside and among exchanges. "We were formed for the purpose of creating a standard for the retail industry," says Joe Laughlin, CEO of GlobalNetXchange. "We were disappointed that a second exchange was formed [by 16 of the world's largest retailers]. We had talked with them, but there were differences of opinion in terms of operating structure, how the equity was to be allocated, and the selection process of a technology provider."

The technology partners aren't making things any easier. They often pit one exchange against another. Commerce One bills itself as an open platform for building trading marketplaces and is willing to take equity stakes in its new trading hubs. Ariba sees itself more as a toolkit for exchanges, although it, too, is beginning to consider equity stakes in its new partner companies. Oracle sells itself as an aggressive one-stop shop, something its competitors would argue no single company can deliver. And although IBM (NYSE: IBM) and i2 Technologies (Nasdaq: ITWO) have teamed up to offer themselves as a powerful software and service marketplace vendor, Ariba and Commerce One clearly have the momentum. Meanwhile, some exchange shareholders aren't even willing to give away revenue or equity to their technology providers. "Our exchange is not a Trojan horse set up for the benefit of a third-party vendor," says Mr. Melbourne.

Animosity can become so fierce that even buyers and suppliers -- the entities that need each other the most -- can split apart and form competing exchanges. Dana (NYSE: DCN), Delphi Automotive Systems (Nasdaq: DPH), Eaton, Motorola (NYSE: MOT), TRW (NYSE: TRW), and Valeo of France, the top six suppliers in the automotive industry, are now considering forming their own marketplace after the Big Three auto makers announced their auto parts exchange, Covisint.

The auto parts exchange offers a window into who may ultimately lose in the buildout of megahubs. Suppliers complain that the exchange is just another way of squeezing them while boosting auto makers' profits. It's the same argument posed by suppliers across all industries. Most experts agree there must be value-added propositions for both buyers and suppliers to induce their membership in any specific exchange. "If these exchanges are to succeed, there has to be a superior value opportunity for all sides, and if not, then no side will participate," says Chuck Donchess, executive vice president and chief strategy officer for Commerce One.

EXCHANGE MACHINES

Meanwhile the race is on to become the de facto exchange in any one industry, where buyers and sellers feel the gravitational pull of just one market. Although multiple exchanges are sprouting like weeds -- populating market verticals with several identical exchanges -- realistically only one, or possibly two, will survive. In the utility market, Consolidated Edison (NYSE: ED), Duke Energy (NYSE: DUK), Pacific Gas & Electric (NYSE: PCG), and Edison International (NYSE: EIX) announced their own global utility market shortly after e-commerce applications provider, Bex.com, announced a competing exchange led by Kansas City Power & Light (NYSE: KLT), Ameren (NYSE: AEE), and others. And while aerospace leader Raytheon (NYSE: RTN-B), with its site, EverythingAircraft.com, consolidated its own Web strategy around a single global aerospace trading exchange with Boeing (Nasdaq: BA), Lockheed-Martin (NYSE: LMT), and BAE Systems (OTC: BA)"Roundtable", this didn't stop Honeywell (NYSE: HON) and United Technologies (NYSE: UTX) from moving forward with their own marketplace initiative, MyAircraft.com.

Although multiple markets may ultimately make sense by serving the needs of different geographical regions as well as subspecialty markets, placing the buying power of the world's largest corporations into more than one buyer- or supplier-led network goes against the basic tenet of making any exchange work: liquidity. "The most important thing is to have a volume of transactions with customer involvement," says John Sviokla, vice chairman of technology investment bank Diamond Technology Partners. He also refers to it as "economically viable scale."

Liquidity depends, however, on the basic level of fragmentation underlying each industry from the start. The more fragmented the industry, the greater the possibility of value creation for all parties involved. Ultimately, it will be in the truly fragmented industries, often in which no single buyer or seller controls more than 1 to 2 percent of the market, that true value creation occurs, and where the exchange itself can reap the greatest rewards. Here, independent Net market makers have the greatest chance of surviving against the market power of industry-led consortia. In hospital supplies, for example, the market for specialty health care items, like catheters and heart valves, lends itself nicely to Promedix, a Ventro-backed independent exchange. The market for more everyday hospital supplies, however, is far more consolidated around a few large industry providers, like Johnson & Johnson (NYSE: JNJ), General Electric (NYSE: GE), Medronic, Baxter International (NYSE: BAX), and Abbott Laboratories (NYSE: ABT), which control 70 percent of the supplier market, a situ-ation in which Mr. Perry says "the only barrier to their success will be in them not killing themselves."

To be truly successful, if not transformational, industry-sponsored exchanges will barely be about connecting buyers and sellers. Dwaine Kimmet, vice president for strategic business development for Commerce One, says the best exchanges of the future -- like, in his view, those of the aerospace and defense industry -- must realize they are really about connecting supply chains to supply chains "Forget B2B. Think E2E". It's a place where market participants can make spot purchases, auction off goods, obtain letters of credit, contract for logistics and distribution, monitor daily price and order flow, and even engage in the design and specification process peculiar to specific industry manufacturers. At the same time, they could be synchronizing their operations with the operations of both buyers and sellers. Supply chains could become so efficient, notes Doug Smith, managing director for investing banking firm Chase H & Q (NYSE: HQ), that ultimately we could have build-to-order everything -- not just for personal computers, but for cars, shirts, shoes, and socks. "Ultimately, it's about getting as close to the customer as possible, that's what these corporations still have yet to figure out," he adds.

As a result, to become more efficient, industry-sponsored exchanges and Net market makers of the future may divide their business-to-business exchanges according to their own core competencies and operate more hand in glove with each other, rather than competing intentionally for the same customers. For example, while PetroCosm, a business-to-business industry-led exchange launched by Chevron and Texaco (NYSE: TX), is still in phase one of its launch -- barely trading catalog items online, such as the paper clips and pencil sharpeners needed to run their businesses every day -- such procurement costs represent only 20 percent of their total annual expenditures. The other 80 percent, says Lorne Bain, CEO of WorldOil.com, represents engineered products and services, like specialized well heads and drill bits, for which there are no specific item numbers to catalog into a bare bones exchange.

If WorldOil.com, a startup Internet market maker, can address the narrow vertical for upstream oil drilling and exploration while the consortia-led exchange takes care of the spot purchases of oil and gas commodity goods to keep the doors open and trucks running, then the combination of the two could address both the horizontal and vertical procurement needs of the energy industry, creating an argument for consolidation between new economy business-to-business exchanges and old economy NewCos being formed. In fact, so likely is consolidation among exchanges that, according to estimates by Ventro and investment bank UBS Warburg, the 700 to 800 B2B exchanges in existence as of May will balloon to over 5,000 by the end of 2002, only to collapse down to 10 to 30 players over the next decade. Or, as Ms. Meeker so bluntly puts it, "Many B2B business models will simply fail."

THE THEORY OF EVOLUTION

Of course, consolidation may be just a kind way of saying these newly formed B2B exchanges never had sustainable business models from the start. The truth is there may be nothing fundamentally new about NewCos at all. Corporations have been trying to make their supply chains more efficient since Eli Whitney jiggered up the cotton gin. The newest trading exchanges, theoretically a quantum leap in the ways of doing business, may actually be nothing more than just a further evolution.

And evolutionary concepts do not always make great businesses. If the New York Stock Exchange -- one of the world's most well-defined exchanges -- is any example, NewCos have a long way to go before becoming a cash cow. Even though $7.3 trillion worth of securities and 169 billion shares trade across its market each year, the NYSE barely generated $100 million in revenue for fiscal year 1998. In comparison, the Big Three auto makers estimate it will cost almost twice that to bring their suppliers online enough to participate in Covisint.

Curiously, the world's largest brick-and-mortar companies have finally responded to the Internet by forgetting the single most important thing no startup should live without: a revenue model. "We're still working on that," confirms Mr. Laughlin of GlobalNetXchange. In fact, streamlining supply chains and cutting costs -- rather than generating profits and going public -- may be the most the industry-sponsored exchanges can hope for. That might be good enough. "Some of these consortia may form companies that get no further than cutting costs. But I'd argue that even then, they'd still be successful," offers Commerce One's Mr. Donchess. Others aren't so sure. Internet companies lacking revenue models or paths to profitability have recently been left for dead in the public markets. Consortia-led exchanges might be no different. Or as ChaseH & Q's Mr. Smith puts it: "It's possible these consortia could start believing their own bullshit and get caught up in the euphoria of their exchanges, even though investors have already done a good job of taking the air out of that bubble." Just because the world's largest corporations are building the world's newest ones, doesn't mean they'll fare any better.

Mr. Melbourne and his brethren with significant skin in the game remain convinced that lasting and sustainable revenue models can be built. Even if transaction fees decline, access fees from industry participants that already possess the appropriate exchange software, license revenue from selling them that software, or subscription fees for those who want hosted services could all add up to additional revenue streams. And although generic value-added services, like shipping, logistics, and security, may also decline over time, industry-specific services, like online parts manuals, continuing education courses, and access to the design specification process are further, and potentially high margin, revenue sources. It's possible large corporations need look no further than the consumer e-commerce buildout to learn their lesson. E-tailers provided a great channel to consumers, but none, or very few, have become profitable themselves.

It's a business model the Federal Trade Commission is keeping close watch over, concerned that the oligopolies that are forming industry exchanges will unavoidably, if perhaps unintentionally, abuse their collective market power. Analysts and executives remain unconcerned. NewCos will coöperate with the FTC in every way in order to get their exchanges off the ground. Indeed, they have already hired the best antitrust lawyers, says Ed McCabe, a B2B analyst with Merrill Lynch (NYSE: MER)'s Internet team, adding, "The FTC has got its eye on them." Phil Duke, executive vice president for shared services at Lockheed Martin drills down deeper: "We're not getting together to aggregate our requirements for Aluminum 233, because that would be an abuse of power, and we and the government don't want to go there." Indeed, technology providers themselves are taking every precaution to insure that there's no shared pricing information once transactions are signed and that the deals themselves will still be negotiated and finalized on a one-to-one basis.

Given the sordid history of consortia in general, the FTC may have little to worry about. Ranjay Gulati, associate professor of organization behavior at the Kellogg School of Management at Northwestern University, says one need look no further than the checkered pasts of Sematech, US Memories, or Taligent -- all vain attempts at technology-industry consortia -- to witness the failure of the proposition. Taligent, in particular, was a lesson in how corporate partners, each with different agendas, can waste time and money banding together -- but going nowhere. This consortia between Apple Computer (Nasdaq: AAPL), IBM, and Hewlett-Packard was formed in 1992 to create a competing operating system to smash Microsoft's dominance of the desktop. Three years and $50 million later, Taligent folded.

There will be a good deal of Darwinism taking place among business-to-business exchanges over the next six to nine months -- the few that get them right could indeed generate large returns for their stakeholders while creating new efficiencies in their industries. What brick-and-mortar executives collectively refer to as making business "faster, better, cheaper." But, as Mr. Donchess says, "You don't go public just because you're doing business with your former competitors. You need a very highly technology-focused solution, a five-year business plan, and a highly capable management team who can then take it to the promised land."

Right now, there's much ground to cover from what is, essentially, a large stack of press releases sitting in conference rooms scattered across the world's largest corporations, announcing exchanges that haven't even been built yet. Many of them, realistically, may never even work.

Nico Correa contributed to this story. Write to [email-masked].

Discuss B2B trends in the ongoing B2B Boom discussion forum. Or check out forums, video, and events at the Discussions home page.

©1997-2000 Red Herring Communications. All Rights Reserved.

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