Investors Have ‘Dot-Qualms’ on Ad Spending

At a time when “dot-coms” are thumping their chests over the size of their advertising budgets, savvy investors are looking past Madison Avenue to a less-glamorous set of numbers--how much dot-coms spend to acquire online customers.

“I think that question has moved to the top of the list,” said Tod Francis, a general partner with Trinity Ventures, a Menlo Park-based venture capital firm. “During the fourth quarter we saw the greatest windfall in the advertising industry’s history. But . . . if you don’t have the gross margins to cover customer-acquisition costs, you don’t have a business.”

Dot-com spending for advertising topped $3 billion in 1999 and shows no sign of slowing as retailers, brokerages and health-care Web sites struggle to build brand awareness. Investors also are being asked to fund free delivery and complimentary gift wrapping, while companies such as Buy.com sell merchandise at or below cost and More.com lures customers with the promise of lifetime price guarantees on health products.

“Right now, these companies want a living, breathing, consuming human being on the other end of the transaction,” regardless of costs, said Alan Alper, an online industry analyst with Gomez Advisors, a Lincoln, Mass.-based market research firm.

Investors rely on such tried-and-true measures as sales-per-square-foot to compare brick-and-mortar retailers, and catalog operators know they can’t make money if customer-acquisition costs outstrip what a customer is going to spend. Now, online investors are searching for accounting tools to take the measure of massive advertising and marketing budgets.

The search for customers is being clouded by the online world’s Gold Rush mentality. Companies are spending freely in an online land grab that’s designed to establish brand awareness.

“There are great advantages to getting [established online] first,” said Shane Ankeney, director media strategy for the Santa Monica office of TBWA/Chiat/Day, an advertising agency with more than $300 million in annual dot-com billings. “But the ultimate goal is to generate qualified visitors who sign up for memberships, who purchase things and who are willing to come back and purchase again.”

Massive advertising and marketing campaigns are being justified by the conventional wisdom that being first-to-market creates the momentum needed to survive an inevitable consolidation. But as venture capitalists make second- and third-round investments, “acquisition costs are becoming particularly important,” said Laurie MacMurray, an account director with Asher & Partners, a Los Angeles-based advertising agency. “Accountability is now being demanded.”

On first blush, it seems easy enough to divide quarterly advertising and marketing budgets by the number of newly acquired customers. But there’s surprisingly little agreement online as to what constitutes customer-acquisition costs.

Some online start-ups maintain that a hefty percentage of their advertising is really long-term brand-building. Others say every advertising dollar spent is, in reality, funding customer acquisition.

Marketers disagree on whether the cost of buying space on such portals as Yahoo or America Online should be counted. One company may include the cost of free delivery and gift wrapping as a cost of acquiring customers--but a rival may not.

The plot thickens when investors look at advertising and marketing budgets for companies such as Buy.com. The Aliso Viejo-based online retailer paid $6.4 million to sponsor the PGA Tour--but investors also must remember that the deal included 1.125 million shares of Buy.com stock that was turned over to become title sponsor of the tour.

Dot-com executives agree they need to spend money to make money--leading to a joke in accounting circles that online, the EBITDA calculation has become EBITDAM--earnings before interest, taxes, depreciation, amortization and marketing.

Nervous investors eventually will force companies to report customer-acquisition costs in a uniform manner. “During the next 12 to 18 months, there will be a big shakeout,” said Jonathan Morris, executive vice president of New York-based Bluefly.com, which offers low-cost fashionable apparel. Venture capitalists “will lose patience, the public markets will lose patience and businesses will have to act more responsibly.”

Privately held dot-coms zealously guard acquisition costs because they can tip off competitors about a company’s financial health. Some publicly traded companies include customer-acquisition costs in financial news releases--but the numbers sometimes can be misleading.

Amazon.com, for example, said its average customer-acquisition cost was $19 during the busy fourth quarter. Santa Monica-based EToys described its customer-acquisition cost as “an efficient $33 per customer.” EarthLink, the Pasadena-based Internet Service Provider, said its customer-acquisition cost runs $200 to $250.

Is EarthLink spending extravagantly for customers? Is Amazon.com, by comparison, thrifty? Not necessarily.

To start, the companies use different formulas to calculate acquisition costs. EarthLink, for example, includes the cost of free digital cameras used as a sales incentive. Amazon.com didn’t include $11 million in gift certificates handed out during the fourth quarter.

Direct marketers also caution that customer-acquisition costs are not meaningful unless they’re compared with what a customer will spend. No matter how the accounting shakes out, long-time marketers say free-spending online companies eventually must learn to live with the same rules that govern the brick-and-mortar world.

“I think some of these [Internet] companies are ignoring Finance 101,” said Todd Simon, a senior vice president with Omaha Steaks, a family-owned meat products company that began selling beef online in 1991. “If you want to make money, you can’t spend more to acquire a customer than the profits that customer will generate over his lifetime.”

The costly advertising war being funded by cash-rich dot-coms also is ignoring that some customers will never be worth their cost of acquisition. Catalog operators know that some customers--those who call every day to check orders, bounce checks and return merchandise--are more expensive than others.

Online retailers know that to survive, they eventually must learn to keep acquisition costs well below what a customer is likely to spend. As more online competitors shift their search from warm bodies to profitable customers, dot-coms will be forced to rethink their advertising and marketing budgets.

Bob Chatham, an industry analyst with Forrester Research Inc., says investors won’t continue to sit idly by as start-ups spend furiously to build their businesses. “The color of their bottom-line will test . . . [that] strategy,” Chatham said. “Wall Street will punish those firms that tolerate large blocks of unprofitable customers. This is a rat hole that you can disappear down.”