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Is the worst yet to come for Internet shops?

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Once upon a time, executives at interactive agencies used to tell anyone who would listen that the world was now conducting business on Internet time. They probably had no idea that the swift collapse of their industry would happen on Internet time as well.

A year ago, even for a few months after the Nasdaq’s April 2000 crash, business walked in the door not only from dot-coms, but also from brick-and-mortar companies that were terrified of the dot-com threat. It was easy to post quarter-to-quarter revenue gains in the double digits.

Sure, there were occasional murmurs that the business would slow down at some point. But no one envisioned a "slowdown" that would slash valuations by more than 90%, cause numerous rounds of layoffs and result in several bankruptcies.

No one thought that within one quarter there would be questions about the project-based business model upon which most interactive agencies—or i-shops—are based. Now that model has been replaced by an emphasis on long-term clients.

More bad news on the horizon?

But the worst may be yet to come. By year-end, the number of i-shops may be halved, or worse, analysts say. Bankruptcy has already claimed MarchFirst Inc.

As for the rest of the industry, the lucky ones will likely be acquired by suitors ranging from consultancies to tech companies, such as IBM Corp., to ad agency groups.

"Yes, companies are going to go bankrupt. Yes, companies are going to get bought," said Steven Birer, a managing director at investment bank Robertson Stephens Inc. who follows i-shop stocks. "The pyramid on which this whole thing had been built—the constant inflow of funds—dried up."

The headlines tell the tale. While the MarchFirst bankruptcy has made the most news, other companies have slashed staff and seen their stocks plummet.

Ad agencies that invested in i-shops are trying to figure out how to recast their once sterling investments. True North Communications Inc., prior to announcing its intention to be acquired by The Interpublic Group of Cos. Inc. in March, said it wanted to shed its 44.6% stake in Modem Media Inc. In April, Omnicom Group Inc. shifted its minority stakes in Agency.com Ltd., Organic Inc. and Razorfish Inc. into a new e-services holding company to be co-managed with a venture capital unit of Pegasus Capital Advisors L.P.

The move was seen by some as a way for Omnicom to get struggling stocks off its books. Others speculated that the new company might be a consolidation play in which Omnicom and Pegasus would acquire other i-shops.

But if the potential consolidators are waiting for the business to hit bottom, it hasn’t happened yet. The first quarter proved brutal to many public i-shops. Even Digitas Inc., which as recently as three months ago was predicting growth, revised its projections for 2001 down from 20% to 25% revenue growth to 0% to 6%.

Agency.com’s 2000 annual report details industry perils: "We may be unable to adjust our cost structure quickly enough to offset unexpected revenue shortfalls due to the fact that many of our costs are fixed or are associated with commitments which cannot be immediately terminated, which could cause our operating results to suffer."

Just 18% of Agency.com’s 2000 revenue came from retainer relationships; the remainder was based on time and materials or fixed-fee contracts. Many other i-shops have operated on similar ratios. Compounding the problem was that most i-shops didn’t maintain sales forces when business was good. When business slowed, they had no process for replacing revenue.

"One manager [at an i-shop] said, ‘Why do I need a direct sales force when business is knocking down the door?’" said Rich Young, an analyst with The Yankee Group. "That’s why the business model is failing."

Agency.com Chairman-CEO Chan Suh agrees with that assessment: "We’ve had to emphasize certain areas more than we have before. Sales and business development is one."

Can all this rush to reorganize enable the industry to survive? No one is saying that it will go away, just as no one is saying the Internet will go away. Still, as the carnage continues, there’s little agreement as to which agencies will emerge as the winners.

Many observers think the traditional consulting firms will come on strong, taking business that used to go to the i-shops or, alternatively, buy the shops themselves. But the management consultants aren’t immune to the market downturn.

PricewaterhouseCoopers L.L.P., for example, last month laid off 6% to 8% of its staff, citing client cutbacks in tech spending. And the only concrete evidence that consultants have interest in the industry is the consortium announced in January that combined traditional shop Citron Haligman Bedecarré with Washington-based Magnet Interactive, London i-shop AKQA Inc. and Asian new media shop The AdInc. The new company has financing from Accenture.

Suh takes exception to the potential encroachment of consulting firms on his business. "It’s easy to say Ernst & Young is going to crush Agency and Sapient and all those people," he said. "That’s not true."

But the events of the last year show that the future lies with those that have solid client relationships. "In the short term, the demand for e-consultancy services has completely dried up," said Carla Hendra, president of WPP Group plc’s OgilvyOne North America, parent of OgilvyInteractive. "What that’s done is ... send clients back to people that they know and trust." Namely, their ad agencies.

Ogilvy Interactive grew its revenue to more than 60% last year; Grey Global Group’s Grey New Technologies more than doubled its revenue last year.

Boston-based Digitas doesn’t have big agency backing. Yet, as a descendant of direct marketing shop Bronner Slosberg Humphrey, it has had success serving Fortune 100 clients, just as it did as a direct marketing shop.

David Kenny, Digitas’ chairman-CEO, admits, however, that the shop has been affected by the downturn: "We grew at a slower rate, but we’re not declining at the rate that these other people are." Digitas’ forecast that its revenue might be flat in 2001 would spell trouble in other industries.

But in this market, flat is good.

Survival of the specialist

One scenario might be for some weaker companies to merge, but experts downplay the idea. "Merging two disasters equals one bigger disaster," said Seth Alpert, managing director of AdMedia Partners Inc.

Alpert is hard-pressed to come up with a list of i-shops that he thinks will be successful. Of 20 companies on his watch list, only Sapient Corp., DiamondCluster and Proxicom Inc. seem strong, he said. All are technology-focused.

By and large, analysts feel that ad agencies are more likely to hire away displaced workers than they are to buy a company outright, but some, including OgilvyOne and Tribal DDB Worldwide, are shopping. "What we look for are companies that would give us additional markets to participate in," Hendra said.

Other potential buyers could come from the tech sector. There’s been speculation that Hewlett-Packard Co. would acquire struggling Scient, though that’s strongly denied by both sides.

One key to staying alive may be to specialize. Companies that once offered everything are now rethinking that approach. "You had this huge ‘We can do anything for you anytime, anybody’ mentality," said Kate Everett-Thorp, CEO of Lot21 Inc., San Francisco. Her company’s focus on providing online advertising services enabled Lot21 to remain relatively healthy, she said.

"The market’s asking you to specialize, which is fine," said Jonathan Nelson, chairman of Organic. Nelson said that as the firm focuses on its core expertise, it is "being a little more explicit" about potentially partnering with others who have more specialized services. Organic is currently in alliance talks with Omnicom sibling BBDO.

"A lot of firms had expertise in interactive marketing and really had no idea how to tie into the [client’s] back-end," said Yankee’s Young. "That’s why you’re now seeing [i-shops say], ‘We’re focused on this industry or that industry.’"

Despite i-shops’ hunt for stability, it will take a while to see who survives. It’s something only the passage of time can resolve.

Debra Aho Williamson is a contributing editor at BtoB sister publication Advertising Age.

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