B2C DOT-COMS ARE INVESTMENT TARGETS FOR TRADITIONAL ENTERPRISES.

Softness in dot-com valuations in a tighter capital market will increase investments in dot-coms by traditional businesses that seek to "buy, rather than build" B2C e-commerce infrastructures and online customer bases.

What the Future Holds

On April 14, 2000, Peapod (a "dot-com" grocery business) and Royal Ahold (a growing international "brick-and-mortar" food retailer headquartered in the Netherlands) announced a definitive agreement whereby Royal Ahold will invest $73 million in Peapod and receive 51 percent of Peapod's outstanding shares. On completion of the deal, Royal Ahold'' total stake in Peapod will be 75 percent. In addition, Royal Ahold will offer Peapod a $20 million line of credit.

This is an example of a traditional (i.e., brick-and-mortar) enterprise (Royal Ahold) "buying" e-infrastructure from a distressed dot-com (Peapod). Traditional enterprises such as Wal-Mart (which is building www.wal-mart.com) and Kmart (which is developing www.bluelight.com) will continue their

Internet investments with partners. However, over the next 24 months, we expect enterprises such as these to see the advantages of becoming "white knights," investing in cash-poor business-to-consumer (B2C) ventures that can provide e-commerce platforms and markets.

* Many traditional enterprises do not have a culture or management decision-making process that can support the rapid decision making and technology deployment required to be competitive in e-business.

* With e-business technical and management talent scarce, the slow growth (relative to dot-coms) of the stock price of traditional firms makes it difficult to attract talent using stock options as an incentive. This can be a disincentive for talented people or, at best, can result in greater cash outlays in salaries and bonuses for the right staff.

* Carrying the total infrastructure development cost for e-business is likely to have a more adverse impact on a traditional enterprise's earnings than "piggybacking" on developments already in place in a dot-com.

* Acquiring or partnering with an existing e-business can substantially reduce time-to-market and improve competitive positioning for a traditional enterprise, thus enhancing revenue from the "e" sales and distribution channel.

We expect several megamergers and substantial equity or debt investments over the next year between dot-coms and major traditional enterprises. This means there is a limited window of opportunity to "bargain hunt." As traditional enterprises start funding dot-coms, the competition for investment in the available and viable dot-coms will accelerate. Traditional enterprises will replace investors, but the trend will not be long-lived, and valuations will rise again.

Business Drivers for the Merger Trend

Stocks of Internet-based B2C start-ups have behaved more like "collectibles" than equity investments. After a heady period of "free capital," the equities market in dot-coms will continue correcting over the next six to 12 months. Traditional valuations will rebound as the disparity between dot-com and traditional valuations evaporates.

Venture and mezzanine financing investors and initial public offering (IPO) underwriters for B2C Internet start-ups will require greater earnings performance. Weaker enterprises will not survive intact; they will be forced into mergers and acquisitions with other dot-coms or traditional enterprises. B2C enterprises with strong hybrid, consumer aggregation or partnering strategies, however, will continue to flourish.

"How can I compete against companies that don't have to make a profit?" will cease to be the lament of traditional enterprises, as the market forces profitable business strategies. Instead, traditional enterprises will be asking, "Which firms should I invest in and with which firms should I partner?"

Rationale: Businesses and Investors Will Become More Rational

The value of an enterprise's stock is the net present value of future cash earnings, but the investment community seemed to have ignored this over the past 24 months. For example, compare Amazon.com with Border Group. With $1.6 billion in sales and losses of approximately $700 million, Amazon was valued at approximately $16 billion, while Border (a Michigan-based hybrid-model book and music seller) with profitable sales of nearly $2 billion was valued at only $1.15 billion. Even with a strong online brand, there is little reason to believe Amazon's profits will equal roughly Border's entire revenue stream.

These factors lead to one of two scenarios:

* Over the next five years, dot-com companies will increase profitability far above the historically established level of traditional hybrid or brick-and-mortar enterprises (0.2 probability).

* Dot-com enterprises and traditional enterprises that have moved to hybrid business models with sound markets; brands and business strategies will converge in valuation (0.8 probability).

Given the higher probability of the latter scenario, B2C dot-coms with weaker brands and markets will become adjuncts to or replacements for traditional enterprises' internal B2C e-commerce development initiatives.

An Emerging Business Strategy for Brick-and-Mortar and Hybrid Enterprises

As development talent becomes scarcer and the sophistication of e-commerce sites increases, development costs will continue to rise. Traditional enterprises will look to acquire or take significant equity stakes in those dot-coms that have the following attributes:

* Traffic within the traditional enterprise's market space

* Little or no earnings with a significant "burn rate"

* A compatible e-commerce infrastructure

* Online brands compatible with, but weaker than, the traditional enterprise's brands

* Continuing capital requirements.

These enterprises will be looking to augment or replace traditional enterprises' internal B2C e-commerce development initiatives. Dot-com firms approaching insolvency will become less valuable in the public market, but more valuables to traditional enterprises for their traffic and e-commerce infrastructures. This will drive traditional enterprises to "e-business by investment or acquisition" or the "buy vs. build" scenario. The opportunity for real "deals" for traditional enterprises will be short-lived, as "bargain hunting" among B2C dot-coms causes a rebound in dot-com valuations.

The buy strategy, while requiring approximately the same cash outlay, may result in improved earnings. Buying e-business infrastructure through dot-com investments may allow traditional enterprises to leverage their strengths (brands and physical infrastructure) and the strengths of the dot-coms (e.g., time-to-market, access to online markets and access to scarce talent). The following Strategic Planning Assumptions should be kept in mind:

* There will be a market correction in dot-com valuations over the next six to 12 months, causing hybrid or brick-and-mortar valuations to converge with dot-coms; however, the equities market in B2C dot-coms will stabilize, and increase beyond 12 months, as investments flow in from traditional enterprises (0.7 probability).

* The short-term effect of traditional enterprises investing in dot-coms as a "buy vs. build strategy" will free venture and public market capital for investment in stand-alone dot-coms that have particular value to such hybrid business strategies as marketplaces, auctions, buyer aggregators and Internet malls. These enterprises will become increasingly valuable (0.7 probability).

* Beginning six to 12 months out, acquisition and investment by traditional enterprises will begin to bolster the currently declining B2C dot-com valuations, increasing the cost of investment (0.7 probability).

Dot-Com Investments Could Improve Traditional Enterprises' Earnings

The "buy" strategy for traditional enterprises makes sense as a way of unlocking the value of the dot-com's infrastructure and reducing the total e-business deployment costs. It makes sense from a Wall Street perspective, since there are techniques for dealing with dot-com investments that may increase the traditional enterprise's earnings by shifting the e-commerce development expense, at least in part, into the dot-com investment and removing it from the traditional enterprise's income statement.

Cost Method for Investments: Enterprises that buy equity stakes of less than 20 percent in dot-com enterprises may use the cost method of accounting for equity investments. The investment shows up at cost as an asset on the investor's balance sheet. No losses from the dot-com investment flow to the investor's income statement, moving some or all of the e-business development costs to the partially owned investment. The net effect is that reported earnings for the traditional enterprise go up. The cost method works particularly well with privately held dot-coms. Minority equity investments by traditional enterprises in dot-coms can potentially improve traditional firm earnings (EBITDA), while continuing to propel investment-heavy e-commerce strategies. This will work best with enterprises for which distribution agreements can be arranged. An important consideration is that the investment should be available as general funds to the dot-com and not earmarked for specific development efforts for the traditional enterprise.

If an investment below the 20 percent level does not provide sufficient funding for the dot-com, other financing methods may be employed, including convertible debt, preferred stock or warrants in the dot-com. These financing methods also may allow the investing firm to assume a controlling interest (consolidation) or a significant influence (equity accounting) in the dot-com when business conditions warrant. To keep the investment on the balance sheet, rather than having losses flow through to the income statement, it is important that the status of the investment is not "impaired" by the exertion of undue control or influence over the dot-com's operations. To maintain the cost method, it may be necessary to get preferential rights upon dissolution or to ensure that debt financing is senior to earlier debt. This is especially true when the traditional enterprise makes significant cash infusion into the dot-com.

Equity Method for Investments: It may be necessary to make an equity investment greater than 20 percent (but less than 50.1 percent). In this case, the pro rata portion of earnings or losses of the dot-com will flow through to the investor's income statement (along with goodwill amortization). It is important to note that, when using the equity method for investment, goodwill expenses can be significant, since they may have a much shorter write-off period than the actual consumption of cash or losses from operations. Equity investments at 50 percent or more may trigger the consolidation of financial statements.

Issuing convertible debt - or equity instruments such as preferred stock - as a way to infuse cash into a dot-com may have some risks, especially when the dot-com is publicly traded. The convertible debt will have to be pegged to the market - fluctuations in the dot-com's share price will affect the value of the note, and could result in losses (or gains) in investments if the share price fluctuates - with those earnings fluctuations being posted to the traditional enterprise's income statement. Issuing nonconvertible debt may be a way to avoid fluctuation of the valuation of the note, while maintaining a method of ensuring increasing control or influence in the dot-com as it becomes more profitable, or as its losses drop to the point where the traditional enterprise may be willing to increase the equity stake.

Need for Advice: Although it may make strategic sense to invest in a dot-com with the right profile, this is a rapidly evolving area in accounting. The decision should be based on the strategic value of the partnership, in addition to the impact on earnings. No decision should be made without fully engaging accountants or auditors to assess the impact.

When to Switch to a Majority Interest

When does it make sense to escalate the investment, or convert warrants or convertible debt to a majority equity position?

* When the dot-com achieves profitability.

* Even if the dot-com loses money, but at lower rate than the cost to the traditional enterprise of maintaining its own operating infrastructure for e-commerce.

* When the dot-com's losses are less than the current expense to develop and maintain an e-commerce infrastructure.

The Issue of Maintaining Control

With minority investments, traditional businesses potentially give up significant strategic and day-to-day management control of the entity, building out the e-commerce infrastructure. We recommend that the traditional-enterprise investor negotiate exclusive distribution, franchise or co-branding agreements with the dot-com. A marketing and distribution agreement provides some level of security to the traditional firm by contractually obligating the dot-com to invest in the infrastructure required by the distribution agreement. In addition, it allows the traditional enterprise to have review, oversight or supervisory responsibilities regarding the activities covered by the agreement. This means, however, that the infrastructure requirements must be spelled out explicitly, including service-level agreements. The distribution agreement may also allow oversight over the joint project without exerting undue control over the whole organization (which could trigger a different accounting treatment of the investment). When the equity investment is less than 20 percent, exclusive agreements between the traditional enterprise and the dot-com may trigger equity accounting, since an exclusive distribution agreement can constitute significant influence.

Bottom Line: For Traditional Enterprises: Continue current e-business investments, particularly in internal and supply-chain applications. Maintain investments in e-commerce applications; however, aggressively investigate B2C dot-coms that have desirable infrastructure. Seek to partner with high-traffic e-commerce dot-coms that cater to one's market. Look to establish exclusive e-commerce distribution agreements, franchise arrangements or other alliances that allow control over the e-business development through the operating agreement. Be prepared to invest in dot-com enterprises as they continue to burn cash. View this as a buying opportunity. Some dot-coms will be "bargains" when compared with the cost of building the infrastructure from scratch, or when comparing dot-com losses with operating costs and amortized development costs for self-developed e-commerce initiatives. When dot-com losses are lower than internal operating costs, seek to increase the equity stake.

For Dot-Com Enterprises: B2C e-tailing dot-coms should focus on identifying brick-and-mortar and hybrid business partners. Find enterprises with brand recognition, market penetration and the broad-based physical infrastructure to support distribution, returns and stimulate traffic to the e-commerce site. Seek to negotiate distribution agreements. Investigate methods of leveraging storefronts, call centers and direct sales forces of the traditional enterprises in cross-marketing/cross-promotion programs. Enterprises focusing on vertical communities and consumer aggregation applications should continue with their current strategies.