Will Your E-Business Leave You Quick or Dead? Digitizing can boost shareholder value, but only for well-prepped companies. Where do you stand? Take the test.
(FORTUNE Magazine) – Is the Internet your friend or foe? Making it your friend may be your most important leadership challenge over the next 18 months. And heaven knows, you need a friend right now: The economy is still dragging, and the stock market's not just weak but merciless. Bad enough that if you miss this quarter's earnings your stock will get murdered; now you may be joining the many companies finally admitting they can't even guess their earnings two or three quarters out.
Yet a few winning companies, such as General Electric, Enron, and Southwest Airlines, are using the Net to stave off earnings misses, build profits for the future, and support their share prices. GE has promised Wall Street its e-business plans will create an extra $1.6 billion of earnings before interest and taxes this year--that's net of Internet investments. Enron has used Enron Online, the world's largest e-commerce site, to expand its commodity trading business vastly while cutting per-trade costs 75%. Both uses of the Internet are less than two years old. If the Net could help get you similar performance improvements, you'd love it.
Trouble is, other companies' Net initiatives have exploded, wrecking earnings and share price. Indeed, the Internet can be a devastating enemy: Nike announced recently it would miss forecast earnings by $100 million because a huge Net-related supply-chain project didn't work. And for every Nike there are countless companies that haven't gone public with how they've been burned--megaprojects that took ages, cost zillions, and didn't deliver. So why not just ignore the Net? That can kill you as well, letting a competitor or new entrant rip down competitive barriers you've been building for years.
Here's a way to think about the high-stakes question of whether the Net is friend or foe. It begins with the idea that the Internet is not a business and certainly not a strategy but a set of tools--among the most powerful tools for building shareholder wealth that business has been given in a century. The key to using them wisely is to realize that they work like a turbocharger on an engine: If the engine is well tuned, the turbocharger will juice its performance enormously; but if the engine is struggling, the turbocharger, far from helping, will actually make matters worse. Don't like engines? Think of the Net as steroids--they make a strong person stronger but may cause a heart attack in a user who's flabby.
So will your Net investment strengthen your stock or blow up in your face? We've observed that the most successful Net-savvy companies share seven key strengths. If your company has all seven, your Internet efforts will probably turbocharge your performance, yielding extraordinary increases in shareholder value. If you have none of them, the Net holds only peril for you, and shareholders should run the minute top management says the word "digitize." Most companies, falling between the extremes, need to know that progress in these seven areas is critical to creating shareholder value with the Net.
TAKE THE TEST
To help you gauge the prospects for your company, we've created a simple test. Read each imperative, and score yourself a 0 to 10 based on how much your company resembles each statement. We'll explain the scores on the last page.
1 Your company targets its P/E multiple relative to the market, knows what drives its multiple, and ties the P/E to a strategic plan. SCORE____
Winning companies worry about their multiple. In understanding how to turbocharge share price via the Net, focusing on the P/E multiple rather than just the share price holds a number of advantages. After adjusting for accounting noise in earnings, it lets managers look past the rise and fall of the markets to a somewhat steadier measure. More important, it highlights factors in the share price that aren't apparent in earnings alone.
For digitizing superstars like GE, Enron, and Dell, with P/E multiples that consistently beat the market by 50% or more, that premium comes from four key factors. First is a company's ability to earn returns on invested capital far greater than the company's capital cost. Dell's Net-fueled, built-to-order model generates returns over 200%. Second is keeping capital costs low, generally by keeping earnings growth steady. Earnings at Delta, American, Northwest, and other airlines have been volatile, but Southwest Airlines has consistently earned much greater returns. And investors expect it to keep doing so; Southwest's multiple is more than three times that of its peers. The third factor is giving investors reason to think the company will sustain its superior returns for many years to come. This factor is a key reason that GE trades at a multiple of 36 while many of its competitors, such as Emerson, are at less than 20. Fourth is gaining investors' confidence that the company will keep finding high-return new investments to ensure long-term growth. That expectation is a major reason Wall Street gives Enron a P/E multiple more than twice the market's.
Those factors--return on capital, capital costs, durability of superior returns, and high-return future projects--are always the foundation of a premium P/E multiple. The Net can turbocharge all four--for you or your competitors. Internet tools can do so much, and it all sounds so tempting, that companies waste money and time if they can't concentrate efforts where they'll do the most good for the stock.
2 You regularly track the operational measures that propel share price, you base planning on them, and employees act on them. SCORE____
At GE they call this "driving it to the ledger"--identifying the levers that control the most important financial measures, then giving employees the information they need to move those levers. Companies that can do this are poised to boost their performance with the Net because they have already put the most important information in the hands of their workers. Now imagine the power of putting this information online, in real time, worldwide. Nondigitized competitors are left in the dust, trying to figure out why you changed your product offer, altered pricing, or switched distribution channels.
Example: Through its direct sales model, Dell continually receives valuable data from customers. A few years ago the company noticed a sudden uptick in customers ordering two-gigabyte hard drives instead of one-gig drives. Dell immediately called its supplier and shifted its order to two-gig drives. No problem, said the supplier--which then called a Dell competitor and offered a big discount on one-gig drives. That competitor, looking at six-week-old demand charts, grabbed the offer. When the one-gig PCs hit the channel 12 weeks later, the market for them was dead. The competitor (who confirms the story but asked not to be named) lost market share and took a huge write-off.
Driving to the ledger works when the hard job of prioritizing information and teaching employees how to use it has been done. The Net can spit out tons of data every second. Without a clear view of which information is critical to running the business, the Net becomes a liability rather than a hugely valuable asset. The poor Neanderthal who hasn't even figured out the right metrics to track, let alone managed to put them online, is about to go the way of all Neanderthals.
Note that this is partly about culture. Companies with cultural barriers to distributing valuable operating information widely--and there are many--will miss one of the Net's great opportunities.
3 At least 80% of your company's target customers would say your value proposition is superior to that of competitors. SCORE____
A superior value proposition simply means that small to moderate price cuts by a competitor won't cause a customer to leave you. That's why companies with robust value propositions typically earn high returns on invested capital and get premium P/E multiples.
For most companies, the Net will not yield a new killer value proposition but rather will refine and enrich an existing one. Consider a certain airline we hate to fly. Given our experience of canceled flights, rude staff, and inability to use frequent-flier miles except on flights at 6 A.M. on Christmas day, could this airline do anything online to create a winning value proposition? This is important: We have yet to see an example of an incompetent incumbent company with a far inferior value proposition using the Net, by itself, to turn that offering into a superior one. We have, however, seen many examples of companies with winning propositions using the Net to extend their lead.
Example: The company run by Herb Kelleher, who is featured in this issue. If you still think of Southwest Airlines as a quirky short-haul carrier serving the Sunbelt, take another look; it has by far the highest market capitalization of any airline on earth. The Net was made for Southwest; for years travel agents wouldn't sell its tickets since it paid no commission (though it now does), so many customers were already in the habit of booking directly. But that fact wouldn't have helped much if customers didn't love Southwest's unusual value proposition: limited services, low fares, caring (and funny) employees who try to create an enjoyable experience. Despite being a low cost, no-frills carrier, Southwest has received the fewest customer complaints in the industry for nine straight years.
Southwest has hit a home run on the Net. It now books 35% of passenger revenue online, through a simple Website that gives customers lots of information and control. Building on its lead, the company has added an online tool that lets corporate travel managers track employees' business travel on Southwest, stimulating that source of revenue. By avoiding travel agents and the company's own phone agents, online booking will save Southwest more than $100 million this year. The airline's cost per booking online is about $1, vs. about $10 through a travel agent. That's a huge advantage; no other airline books anywhere near as large a proportion of business online.
Key to a winning value proposition is having more knowledge of your customers than anyone else--and using it. Consider TWA, which started flying an unusual new route from Los Angeles to San Juan, Puerto Rico. It couldn't target potential passengers very precisely. But Travelocity, the Net's largest travel site, had vast data on its own 25 million customers and could identify everyone in L.A. who had looked at San Juan as a potential destination in the previous six months. Travelocity sent prospects e-mails and took them to a private Web page with special offers. "It booked like crazy," says Travelocity CEO Terry Jones.
One of the Net's greatest gifts is the opportunity to learn far more than you ever knew about your customers' experiences, and to use that information to refine your value proposition and better allocate your own resources. Example: GE's plastics business sells polymer pellets to a wide range of customers, who store them in silos. For many of those customers GE has installed sensors that signal GE via the Net when a silo is running low, triggering a reorder. The value proposition is clear: The customer need never worry about running out of stock, since GE guarantees it will refill the silo in time.
GE benefits in several ways. The customer is more likely to keep doing business with GE, since it's easier than ever, and thus GE has probably extended the period over which it can earn its already superior returns with that customer. At least as important, GE now has better information about customers' use of polymers, enabling GE to schedule its own production more efficiently, tying up less capital. This information, which competitors don't have, also helps GE structure future offerings to customers in ways that will better meet customers' needs, thus likely extending even further its period of earning superior returns.
Nicholas Heymann, an analyst at Prudential who follows GE, says efforts like this across the company often reveal customer concerns other than price: "The company can offer convenience, simplicity, precision fulfillment--different means of adding value and thereby getting more of a customer's business."
These are two examples among many of the Net's cruel accelerator effects. In both cases, the companies that were most successful offline became most successful online. There was a time--now long past--when almost any company could whisper "Internet" and watch its stock take off. It's now obvious that the Net can't turn a bad value proposition into a good one, but it can help make a good one better.
4 The activities your company performs to deliver its value proposition are very difficult for competitors--current and potential--to imitate. SCORE____
This is one of the keys to creating shareholder wealth in any company: If competitors can easily copy what you do to earn excellent returns on capital, they'll do so and quickly compete those returns down to the cost of capital. Then no one makes any economic profit, the only kind that increases share price. One of the things we've learned from the dot-coms' demise is that the Net by itself rarely enables a company to create new, inimitable activities that produce sustained large returns on capital and a premium P/E multiple. On the contrary, most of what happens on the Net is potentially easier to imitate than most other business activities. Much of it is available for the whole world, including competitors, to see. Most of the software that makes it happen is sold by firms that will happily sell it to your competitors as well as to you. Even Net initiatives cooked up and executed entirely in-house are usually easy for a sharp competitor to copy, given a few months.
That's why it's vital for a company to develop hard-to-copy advantages before going online. Such advantages often involve culture, habits, and sunk costs. For example, in the brutally tough business of personal computers, why doesn't every company copy Dell's direct business model, which is clearly superior? Countless articles have described it, and Michael Dell has even written a book about it. Dell's activities are hardly a secret, yet most competitors find copying them almost impossible. That's because those competitors are burdened by longstanding relationships with suppliers and distributors, and by a culture built around a different business model.
This is an important reason for Dell becoming and remaining the lead PC maker online. Competitors have copied its Website with stunning precision, but they face far greater difficulty copying the back-end activities--purchasing, scheduling, logistics--that Dell has built around its direct model over the past two decades.
Another example: Enron Online is one of the most successful Net projects anywhere, making markets in more than 1,400 products connected with oil, gas, electricity, steel, credit, and many other commodities. As is now well known, the venture began as a skunkworks operation in London under Louise Kitchen, a visionary trader who saw a clear opportunity for reinventing the traditional phone-based trading system. The venture is valuable not only because it's technologically innovative but, more important, because it boosts Enron's already unique trading operations.
When a Mexican steel manufacturer needs extra electricity for a mill, it could buy it from anyone. Enron offers to sell it power at a price that fluctuates with the price of steel, letting the manufacturer lock in its margins. Even before Enron Online, Enron had the unusual risk-management and trading abilities to sell electricity on that basis and earn highly attractive profits. Enron Online lets it do the deal in days rather than weeks, and with better price data that greatly reduces Enron's risk.
5 Your company has rigorously analyzed all its business processes, achieving large improvements in costs, inventory, and market share. SCORE____
It's easy to bash quality programs right now: The U.S. pioneers, Motorola and Xerox, have performed dismally. But done right, these programs can yield enormous benefits--analyst Heymann estimates GE's Six Sigma program added $6 billion to earnings after training and other expenses in the past five years--and can greatly improve your digitizing odds. Before giving yourself a 10, ask if you've had GE-like tangible returns.
Many of the big companies that have been most successful with the Net report that moving highly efficient, well-understood processes online is actually quite easy and hugely valuable. GE's Jack Welch says that one of his company's most productive uses of the Net is simply showing customers where their orders are. Years ago a customer wanting that information would call a GE sales rep, who would call someone he knew in shipping, who would call someone in manufacturing, and, as Welch says, "everyone would tell a little lie--it's on the truck, it just left, it's almost ready." Now that information goes online automatically. Customers get real information, and employees who used to track it can do more productive jobs.
But it wouldn't have worked if GE hadn't already launched a Six Sigma program to increase on-time deliveries. The company understood how production and delivery got off schedule and committed itself to fixing those problems. Combining Six Sigma and digitizing produces precision fulfillment--meeting the customer's preferred delivery date with almost no variation.
We estimate that trying to reengineer a company's processes while simultaneously digitizing probably doubles the likelihood of failure. Not giving the job to business people who "own" the process probably doubles the failure rate again.
6 Your CIO partners in strategy and performance reviews, your business managers get the Net, and your techies understand your business. SCORE____
The CIO's role is critical. If he or she doesn't deeply understand the company's needs, they won't be addressed effectively. Net initiatives are not just technology issues and can't be handed off to an expert technologist. The experience of all the successful companies we've observed is that business leaders in the company must own Net projects.
Many companies accept that assertion but still make the major mistake of viewing digitizing as a strategic initiative. Joe Liemandt, CEO of Trilogy, a leading player in enterprise software, recommends a different course: "'Strategic' is just a code word for 'doesn't make money'--because if it made money it wouldn't be a strategic initiative; it would be a profitable project." Net initiatives succeed, he says, when they're conceived as profitable projects aimed at specific, quantifiable business goals that increase revenues, reduce costs, or reduce capital.
A caveat: Almost nobody gets technology projects right the first time, so if a Net project is your initial major foray into infotech, the odds are not good. Experience is the best teacher, but we've observed a recurring pattern. Time and again the successes are not the expensive big-bang projects but rather a collection of medium-sized efforts run by business people and encouraged by the CEO and CIO.
7 Your company's leaders believe in the six previous imperatives and constantly teach the underlying principles to all employees. SCORE____
If your company has a culture of accountability, sharing best practices, sharing information, and has values that support the six traits above, then digitizing will be relatively easy for you. That culture is in the hands of the CEO and top team. If they aren't aligned with these six imperatives, then digitizing--no matter how overwhelming the case for it may seem--is likely to fail. In the companies that have used Net tools most effectively, the leaders have built the right culture over years, then have personally and relentlessly driven the case for using the Internet.
Can a company hope to change on these dimensions? Overhauling a culture is extremely hard, but changing a company's stance on using Net tools can be done quickly. Just 2 1/2 years ago, Jack Welch wouldn't touch a PC. He didn't look at e-mail and was skeptical of the Net's usefulness. Now he has converted himself into "e-Jack," driving GE to become the world leader in digitizing.
Many managers don't understand infotech and maybe hate it. They're tempted to minimize its importance or delegate it down several levels. No wonder e-business projects are so badly misaligned with operations in most companies. Those are the companies in which employees, customers, and, for sure, shareholders will suffer.
The overriding message of this analysis--that Internet tools will make the strong stronger while beguiling the weak into falling further behind--may seem discouraging, at least if your score is below 50. It shouldn't be. These tools are so powerful that the rewards of effectively using them may be unprecedented. The turbocharging metaphor is apt: Because of the way Net tools can power up shareholder value, the payoff from improving along the seven dimensions described is now even greater than before.
It is also more urgent. The competitive advantages these tools create will precipitate a shakeout in most industries. Jack Welch says using the tools well is like crossing a widening crevasse in a glacier. The first company across has the easiest time. For the second, it's harder. The third may never make it.
That crevasse is a friend to the first company. For the third, it's an enemy.
Which is it for you?
IS DIGITIZING FOR YOU?
We suggested you award your company a score of 0 to 10 on each of these seven imperatives. Now add them up. Here's how we interpret your total:
50-70 Yes. Do it fast, ahead of competitors. Digitizing your business will turbocharge your performance.
26-49 Maybe, but it's by no means a sure bet. Still, you've got a shot at success. Key for your company will be improving the lowest scores soon.
0-25 No. Don't even think about digitizing. Because your company is failing on the basics, moving to the Net will waste money and time, making matters worse.
LARRY SELDEN is professor of finance at Columbia University business school, where his new course covers much of the material in this article. GEOFFREY COLVIN is FORTUNE's editorial director.