More Retailers Testing Virtual Waters

With profits plunging, Toys R Us recently announced plans to close dozens of stores and lay off thousands of workers. But in the company’s budding online business, it’s a different story.

“We’re hiring,” said Joel Anderson, vice president of Toys R Us Direct. “I sat down with my boss yesterday and he basically said, ‘What do you need?’ The checkbook is there.”

Profits remain a pipe dream across much of online retailing, but the giant chains of the physical world are on a cyberspace building binge. Toys R Us, Borders Books, Tower Records and many others have either rolled out or revamped their virtual superstores in recent months.

For them, it’s part of an effort to seize control of the Internet much the way their superstores have overrun the retail landscape on terra firma over the last decade. But so far, cyberspace is proving to be a tougher market for them to crack.

Online pioneers such as Amazon.com, CDnow and EToys--companies that probably would have been crushed had they opened shop on a street corner--have built substantial electronic-commerce leads and are proving remarkably resilient.

The billion-dollar question on the Net is which of these two business breeds will prevail over time: the virtual companies or their carbon-based counterparts. Both sides claim the clear advantage.

Virtual companies say they alone can focus on e-commerce, unencumbered by giant payrolls, vast real estate empires and the fear that the Internet will erode their in-store sales. The bricks-and-mortar stores, however, boast universally recognized brands, enormous marketing muscle, vast inventories and unmatched buying power.

The stakes are hard to comprehend now, with most online retailers losing money hand over fist. Analysts say that could continue for years as companies spend heavily to build their brands in a business with minuscule margins.

But the payday is coming. Jupiter Communications, a New York-based research firm, estimates that online-shopping revenue will surpass $40 billion by 2002, up from $2.7 billion last year.

“The companies that are able to establish market share and mind share right now,” said Ken Cassar, an analyst at Jupiter, “are the ones that will capitalize when these businesses represent serious dollars.”

The fast-approaching holiday shopping season is shaping up as an early test for the newest retail category to be tested on the Net: toys.

In a cavernous building in Commerce, EToys, a Santa Monica start-up, is converting an old bottling warehouse into a high-tech North Pole. By November, nearly 500 employees working staggered shifts will be picking, packing, wrapping and shipping thousands of toys each day.

Meanwhile, across the country, Anderson and his 30-person team are scrambling to expand the 3-month-old https://www.toysrus.com site, fine-tuning computer systems, revamping a Chicago shipping center and adding hundreds of items to the online selection each week.

The outcome of this battle may hinge on whether the Internet is truly an opportunity for Toys R Us or merely a distraction. Toby Lenk is banking on the latter.

“We know Toys R Us is going to be a very strong company online, and we’re not going to be able to stop that,” said Lenk, co-founder and chief executive of EToys. “But their No. 1 competitive problem is not us and the Internet. It’s that discount chains like Wal-Mart have muscled into the toy space. We think we can be No. 1 online because we’re focused just on the Internet.”

In fact, Toys R Us’ preoccupation with the mounting threats to its physical stores gave EToys its most important break: a nine-month head start. Toys R Us set out to launch its online store last fall, but the project collapsed as department heads turned their attention to problems in the physical stores amid the crunch of the holiday season.

The Paramus, N.J.-based company finally launched the site in June, but only after creating a separate online division and putting Anderson, one of the company’s top regional sales executives, in charge. “Initially, we were just borrowing resources from various departments,” Anderson said. “But now we’ve got a core group of people with some skin in the game.”

But now that the site is up and running, Toys R Us confronts one of the most nettlesome problems traditional retailers have faced online: getting shoppers to go to their virtual stores.

Amazon, for instance, continues to control 90% of the online book market, according to Jupiter, even though it has been under online assault by Barnes & Noble since May 1997.

Similarly, CDnow and Music Boulevard together account for 45% of online music sales and seem to be pulling away from Tower Records and other traditional retailers that sell online, analyst Cassar said. Tower will face even more pressure now that Amazon has also entered the online music market.

This is partly because online shoppers are proving to be surprisingly loyal to the stores they do business with first, analysts said. As easy as it is to move from one digital store to another, consumers are reluctant to leave sites where they’ve developed trust, established an account and built a user profile that yields product recommendations.

But it is also because attracting online shoppers has proved to be remarkably expensive. Ironically, it’s the well-heeled giants of terra firma that tend to blanch at such costs.

Tower, for instance, was recently hammering out a $1-million to $2-million promotional deal with one of the Internet’s most popular search engine sites. Then one of Tower’s online rivals swooped in and offered $6 million.

Tower Continues Its Frugal Ways

Tower, a billion-dollar company, could easily have upped the ante. But the company has built its empire over 20 years through frugal financial management, and executives weren’t prepared to throw that out the window for an online opportunity that still seems very uncertain.

“We don’t want to put millions in the hole,” said Mike Farrace, a vice president at Tower. “What is there to be gained? CDnow has already lost $18 million this year, and [Music Boulevard] has lost as much as $30 million. In our company, that’s just unconscionable.”

That may also explain why many giant physical retailers, including Virgin Megastores, have declined to enter the online race. It also explains why Barnes & Noble announced last week that it hopes to raise as much as $100 million by selling stock in its online subsidiary.

Virtual retailers, with no brick-and-mortar stores to fall back on, can’t afford to hesitate. EToys paid $3.2 million to America Online just six weeks after it launched, then it turned around and paid $500,000 to Yahoo so that when users type in “toys,” an EToys banner ad pops up.

“Have we overpaid? Probably,” said Phil Polishook, vice president of marketing at EToys. “But it’s a scramble for mind share and customers.”

The marketing advantage may be turning, however, as online retailers focus their attention on capturing the next wave of Internet shoppers, most of whom aren’t even on the Internet yet.

To reach these neophytes, Amazon, CDnow, Music Boulevard and others are moving their marketing offline, spending millions on television, radio and print ads.

But the physical chains already have massive marketing budgets and interact with millions of customers every day, generating advantages for their online stores. Toys R Us, for instance, plans to place its online address on shopping bags, in-store banners and all of its upcoming television commercials. By doing so, superstores can reach millions of potential online shoppers with almost no increase in their marketing budgets.

By the superstores’ logic, the first wave of online shoppers may be lost. But subsequent waves will already be familiar with their brands and perhaps even loyal to their physical stores. Now the task is to retain those loyalties as they migrate online.

“As this marketplace moves beyond propeller heads into the mainstream,” said Steve Riggio, vice chairman of Barnes & Noble, “we think we will be the bookseller of choice.”

Price Comparisons Almost Effortless

The economics of online retailing also seem to favor traditional stores, which buy so much product that they can simply cut better deals with suppliers than smaller companies can. This is important because the Net, which makes comparing prices almost effortless, is shaping up as a market of extremely narrow margins.

Barnes & Noble has tried to take advantage of its purchasing power by dropping online prices even lower than its in-store discounts. Jeff Bezos, chief executive of Amazon, acknowledges that it’s not easy to keep pace.

“Barnes & Noble has a large purchasing-power advantage over Amazon.com, as does Borders,” he said. “What we have done is make strategic decisions to fund that purchasing power gap out of our own investment funds so our customers don’t pay for that lack of purchasing power. The trick is to get big fast enough so we can level the playing field.”

It helps to have Wall Street on your side. Amazon, like some other Internet companies, is flush with cash because investors have been clamoring for its stock. Even though Barnes & Noble’s revenue this year will surpass Amazon’s by about $3 billion, Amazon’s stock market value is more than $5 billion, about twice that of Barnes & Noble’s.

The founders of EToys, which is still privately held, are hoping for a similarly spectacular payoff someday. For Toys R Us, which is watching its terrestrial empire shrink, the potential online payoff is no less significant.

“Physical stores aren’t going to go away,” Anderson said. “But we see this as the single biggest growth area in the next decade.”

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Times staff writer Greg Miller can be reached via e-mail at greg.miller@latimes.com.

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Online Outlook

So fat, online retailing has yielded little more than losses and light sales for most companies in cyberspace. But the industry is expected to grow over the next five years.

ONLINE RETAIL MARKET (in billions of dollars)

2002: $40.8 billion

BOOKS AND MUSIC (in billions of dollars)

2002: Books $2.2 billion

2002: Music $1.4 billion

* Note: Dates for 1998-2002 are projections

* Source: Jupiter Communications