Traditional retailers have made money by tacking a marginal amount onto the cost of every product they sell. But some Internet retailers are shrinking their profit margins to zero. One Internet retailer, Buy.com, is so committed to low prices, it will even sell an item below the product's cost. Cyberretailers hope to find their profits elsewhere -- from advertising, services, subscriptions, and a few high-margin goods.

"Products are content!" exclaims "Surreal" J. Neil Weintraut, the excitable venture capitalist of 21st Century Internet Venture Partners. "Companies use products to attract a critical mass of customers and make profits through a smorgasbord of collateral revenue streams!"

It sounds insane. How did it happen? In part, it is the result of something inherent to the medium: on the Internet, competing retailers are just a click away, which encourages customers to shop on price. But it's also the result of the Internet's very newness. Because online retailers are convinced that customers will never again be so cheap to acquire, and because Internet companies have so much capital they can temporarily afford to ignore profits, they are willing to try anything to attract buyers.

E-commerce analysts doubt the future of the zero-margin model.Onsale launched atCost to capture price-conscious computer buyers.Supply-chain issues could change everything in e-commerce.

MORE'S LAWWhat has made less-than-zero margins possible is the elevation by Internet investors of revenues over profits.

Online retailing projections from market research firms like Jupiter Communications and Forrester Research -- which in their first years far overshot the eventual totals -- were met and surpassed for the first time in 1998, at the same time that attendance at traditional retailing outlets decreased significantly from previous years. Countless articles have been written about how, with the 1998 holiday shopping season, "e-tailing" has finally fulfilled its promise.

Investors have responded in kind. Internet stocks have continued their sprint upward, as investors have catapulted unprofitable Internet companies to multibillion-dollar valuations. Armed with an abundance of private and public equity, cyberretailers have been given a reprieve from the economics that apply to physical-world merchants. Exactly how these online companies will make money and which ones will survive have yet to be determined. But as long as the money keeps pouring in, online retailing margins will continue to plummet -- most likely to zero and, in some cases, even below. To be sure, the impact on the overall traditional retailing industry will be profound.

E-TAILING FOR DUMMIESHow does selling goods at less than cost work, exactly? Regardless of the product category, the recipe for building an Internet retailing business has become fairly formulaic: Raise millions in venture capital. Build a well-organized and sturdy Web site replete with community-inspiring elements -- like informative content, chat rooms, and free email -- to attract customers. Offer a wide array of products within your chosen category at deeply discounted prices, to attract an audience if not a direct profit. Reinvest all revenues in expanding your technical infrastructure and your marketing campaigns. Demonstrate extraordinary revenue growth. Go public. Branch out into other retailing categories.

Eventually, you will be able to reap profit from your audience, if not from your sales of goods. Nobody seems to be sure exactly how, but advertising revenues are one possibility. Also, because you have been investing in bleeding-edge data-gathering technology and closely monitoring your customers' buying habits, you might be able to sell higher-margin merchandise to the most active and loyal of your existing customers. You might sell them this more profitable stuff as a service, by subscription even. There could be other services you could sell them, too. If you were to become desperate enough to risk customer backlash, you could always auction your extensive database of incredibly detailed customer information to the highest bidder.

But don't worry! The patience of your investors -- whether they're in the private or public equity markets -- is unlimited. You're not going to be desperate anytime soon. "Internet commerce is not just about selling books, music, and videos online," argues Amazon.com CEO Jeff Bezos. "This is simply the first step in the ongoing migration of the $4 trillion global economy onto the Internet. Given that context, investors consider a few hundred million dollars a small price to pay."

PROFIT LIMBOIf, as Mr. Weintraut says, products for sale on the Internet are no more useful than content as a means of attracting an audience, if retailers' primary short-term goal is to attract an audience, and if deep-pocketed venture capital and Wall Street investors remain patient, there is every reason to believe that in the increasingly competitive online landscape, retailers will turn to selling products at, or even below, zero gross margin. (Gross margin, in contrast to net margin, takes into account the cost of the item but not ancillary costs like packaging, shipping, Web site production, and marketing.) Admittedly, there are a number of these ifs, but none is particularly far-fetched.

In fact, Buy.com, the latest iteration of Internet retailing (which we wrote about last month; see February 1999's New Mediator), takes this zero-margin migration a step further. Buy.com was founded by CEO Scott Blum in 1996 as Buycomp.com, and the company's roots are in online computer hardware sales. (Mr. Blum's previous venture was Pinnacle Micro, a CD storage system company that he cofounded in 1987. He resigned from the company in 1996 under a cloud of Securities and Exchange Commission charges, since settled, that the company had engaged in improper accounting practices.) But last November, armed with $60 million in funding, Mr. Blum acquired SpeedServe, an online retailer of books and videos, from Ingram Entertainment and quickly began to expand his company's offerings. Just before the 1998 holiday season, the company changed its name to Buy.com and grabbed a lot of attention by guaranteeing the Web's lowest prices on everything sold by its family of Web sites, which now offer software, games, music, and other merchandise as well.

The company says its proprietary search technology uses intelligent agents to scan the Web on a daily basis for prices on the same goods that Buy.com offers (the technology's stealth nature, Buy.com claims, ensures that it cannot be locked out of competitors' Web sites); the intelligent agents then return to Buy.com's site and automatically trim Buy.com's price below the lowest competitive price -- even if that means selling the item at or below cost. The company supplements its product revenues with exclusive Web site advertising agreements.

Success, as measured in cyberretailing, has come quickly. At our press time Buy.com estimated that its 1998 revenues would surpass the $111 million record for first-year Internet retail sales held by Compaq Computer. Buy.com estimates sales of $19 million for December alone -- the month that, after just over a year of operation, began Buy.com's quiet period before going public. (Muzzled by its lawyers and investment bankers, Buy.com's management was unavailable for interview.)

Buy.com's meteoric rise is the most recent, and extreme, example of a company exploiting Internet retailing's advantages. By attracting enormous amounts of capital, developing bleeding-edge technologies, maximizing the efficiencies inherent to the Internet, and relentlessly marketing itself, Buy.com has built what it views as the natural evolution of the Internet business model. Now, by tapping the public markets, it is readying itself to make use of even greater sums of capital. "Buy.com may not be profitable for a while," says Kate Delhagen, an online retail analyst for Forrester Research. "But I expect it will do lots of business for a long time to come."

Despite Buy.com's ostensible success, skeptics abound. It's easy to doubt a company whose revenue growth, however extraordinary, has been bought with potentially negative gross margins. Unsurprisingly, traditional retailers cite Buy.com as the latest proof that Internet retailing is a mad and unsustainable business model. Even many online retailers think that companies like Buy.com have gone too far. "The bottom line is, you end up getting what you pay for -- even on the Internet," says Toby Lenk, CEO of eToys. "We'll see how long some of these bargain-basement Web sites last."

DARWINNERSIn the midst of this zero-margin phenomenon, identifying the definitive winners -- consumers -- is far simpler than sorting out those most at risk. "There has never been a better buyer's market on the Internet," says Ms. Delhagen. "And consumers are smart. It won't be long before real-world retailers will eventually have to match these low prices."

As a result of this competitive environment, every supplier of retail goods stands to lose at some level, physical-world retailers most of all. "It's very difficult for these companies to think of spending an inordinate amount of money on a cyberstrategy that will ultimately reduce their margins," argues Jerry Kaplan, CEO of the online auction company Onsale. Forced to choose between doing nothing while some Internet entrepreneur eats their lunch and committing hundreds of millions of dollars to online retailing with little anticipated return, traditional retailers face some difficult decisions.

As for the Internet retailers, they will have "no choice but to provide more value for the consumer while making less money doing it," according to Credit Suisse First Boston analyst Lise Buyer. The result will be price wars, attrition, and consolidation. Even Internet retailing success stories have had to reinvent themselves in the face of increased competition: CDNow and N2K, two online music vendors that graduated into the public markets (Nasdaq: CDNW, NTKI), have announced that they will merge to take on Amazon.com's new music business.

But as long as the private and public equity keeps flowing, Internet retailers will continue to slash margins, consumers will be rewarded with unprecedented bargains, and traditional retailers will eventually suffer the consequences. The new low-margin Internet companies aren't going anywhere: Buy.com -- with minimal operating expenses, $60 million in the bank, and what will no doubt be a stratospheric IPO -- can give away merchandise for a long, long time. Ms. Delhagen sums it up best. "This is a land-grab opportunity," she says. "The priority is not making money, but building brand and a huge customer database. Internet retailers will continue to practice extraordinary price gouging."

Internet entrepreneurs were bound to try selling goods at less than cost. Though we don't know yet whether this will prove to be the cornerstone of a viable business model, the capitalizations that these high-revenue online companies enjoy mean that they will be able to sustain their strategy for a long while yet -- and that will drive down margins everywere.