My Stoned Thoughts October 17, 1999 Society is the collection of many diverse opinions not the viewpoints of The Problem with drugstore.com

• About one year ago, I decided to retire at age 39, and focus my energies on investing in the internet space. As a rule, I had made the commitment to avoid public equity investments in internet stocks, since none of these stocks have any fundamentals to support their valuations. Instead, I am now focusing on internet startup investments, where valuations are more reasonable, and downside risks are minimized. During my analysis of the internet as a whole, I've found that one company represents everything that's wrong with the internet - Drugstore.com (DSCM).
• Marketing and Branding Costs - First and foremost, DSCM's marketing costs are far out of line. Marketing costs drive two aspects of any business model, revenue and brand awareness. The problem with DSCM is that their marketing costs exceed their revenue. In any normal company, the marketing VP would be fired for this type of shoddy results, and I can certainly imagine that DSCM's internal revenue projections were significantly higher than their actual results.
• But what does all this mean? First, we have to come to the realization that the reason that companies advertise is to drive revenues. Period. There is no other reason. Yes, branding is important, but the reason that you brand is to sell product, sometimes in the longer term as opposed to the short term. No matter what, DSCM's sorry excuse for their performance, the larger question is whether something is more inherently flawed with their business model. DSCM is spending marketing money at a rate that is equivalent of companies over 10X their size.
• The key lesson is that branding alone will not create a web site. And DSCM is living proof. Yes, they have a great and memorable name. But you have to do more. When I analyze internet companies, I first and foremost analyze their marketing costs. Marketing efficiency, in my view, is a very good indicator of future success of the company in the internet space.
• Gross Margins - Hello? DSCM's margins are negative. They are selling products less than cost. Negative margins are nothing, by itself, to get upset about. All companies at some time, must sell things at less than cost, in order to launch a product, or sell slow moving inventory. But to put this together with their marketing costs becomes very scary. Imagine if you are selling cars at less than cost, and then have a huge marketing budget to alert the public of your great prices. How many cars would you sell? You would sell a lot, wouldn't you? Unless there was something wrong with the cars. So why isn't DSCM selling more? After all, we're talking about products that everyone needs, and buys on a regular and recurring basis.
• Branding - One key problem with this absurd escalation of marketing costs, is that everyone is chasing the ever elusive goal of best brand. The power of an internet company's brand will drive their long run success. WRONG! I agree that the power of your brand today, will drive your marketshare today, but that is it. The key reason is that the internet is evolving very quickly, and so are the number of competitors. In the long run, the company that adds the most value to their industry will reap the most gains. This goes back to one of the key slogans inside of my old company - Sales over night, Brand over time.
• Commerce Strategy - Think about this. We're talking about the health sector here. Our nation's largest and fastest growing sector. And also, for the record, our most inefficient sector. The internet is critical to making this sector and also our economy more robust. This is part of the reason that DSCM has such an absurd market capitalization, the promise of what could be. But DSCM is not living up to this promise. Not even close. Managed care is nothing compared to the amount of inefficiency that the internet can stamp out of our nation's healthcare system.
• What is DSCM? They are nothing more than an on line catalog of drug and pharmaceutical products. Yes, customers get the 24X7 convenience, but commerce models such as these will become obsolete quickly. Companies must add more value than just 24X7, particularly in this space. Here in lies DSCM's deepest problem. The fundamental issue underlying DSCM's shoddy financial results, is they are not adding enough value in the market relative to their competition. Imagine what would happen to CVS's revenue line if they started selling at overall negative margins for a quarter.
• Bricks and Mortar - The health space is very different than other internet sectors, because they are not going away. In fact, some of the traditional pharmaceutical chains are having record quarters. Why is that? The main reason is that bricks and mortar are serving a market need in which the web cannot compete. Immediacy. When you get a prescription from your doctor, you want it filled, and then in your system quickly. You don't want to wait a day, and pay overnight shipping charges. The fact is that the internet will never be able to serve this market need, and with that said, this market need is fairly significant.
• Hence, there is really no need for a lot of competition between the internet companies and the bricks and mortar companies in the health space. In fact, long term success will be more determined by the alliances forged between internet companies and bricks and mortar companies.
• Expense control - Last but certainly not least, DSCM's expenses are out of control. I invested in a similar company about a year ago, www.medicinenet.com, and they built their commerce site for $1M. It cost DSCM $19M for the same thing. On top of this, their Q3 results show a line for somewhere around $9M of executive compensation. That's close to 70% of revenue right there. What are they doing over there? Is it a non stop party or something? I bet it must be a lot of fun and not a lot of work at DSCM.
• Conclusions - Internet marketing efficiency is a key measure of a company's future success. Health internet business models will evolve considerably over the next five years, putting less impact on near term brand and share brands, and more emphasis on future business models and alliances. Cost control in any business is still important, even an internet business. DSCM will not last.

Let me know what you think via email at mystonedthoughts@yahoo.com.