| Separating
the Winners from the Losers in the Online Retail Industry |
Published: March 10, 2005
In the mid-1960s, the Cold War
was in full swing. The Cuban missile crisis of late 1962 was fresh in
most Americans' minds and the threat of thermonuclear war was very real.
For the U.S. Department of
Defense, one of the biggest concerns was that a nuclear attack would
disable military communications, crippling the nation’s ability to
launch a counter-attack. The government needed a reliable communications
system that wouldn’t be destroyed even if several large U.S. cities
were attacked.
To tackle this problem, the
Defense Department assembled a crack team of scientists and researchers.
The group began a highly secretive project known as ARPAnet -- the
earliest version of that vast computer network we know of today as the
Internet. The first transmission made via this early Internet was
completed successfully in 1969.
At that time, and for nearly
two decades to come, only an elite cadre of scientists used this
network. However, the Internet was finally commercialized in 1995, and
at that point in time the online population exploded. It's hard to
believe that by 2004, less than a decade after the Internet first
reached the mainstream public, about 1 billion people worldwide were
online.
Thanks
to its ability to reach millions of potential customers at a fairly low
cost, it's not surprising that the Internet has become a powerful force
in the world of retailing. And although the technology bust of 2000 led
many to believe that online retailing has faded in importance, nothing
could be further from the truth. The chart to the right shows annual
e-commerce sales data from 2000 through the end of 2004 estimated by the
U.S. Census Bureau. A brief glance at these statistics shows that online
commerce grew rapidly even during the 2001/2002 recession. In fact, the
U.S. e-commerce market is now well over twice the size of what it was
back in 2000.
But as in every industry, the
rising tide of e-commerce hasn’t lifted all boats. Many consumers will
remember the now infamous sock puppet, the "spokesman" for
Pets.com, an online retailer of pet food and supplies. In 1999 and the
first six months of 2000, Pets.com spent about $80 million on
advertising and the puppet appeared on the Today Show as well as Regis
and Kathy Lee. But, over the same period, Pets.com only managed
about $13 million in revenues. Not surprisingly, the company soon went
belly up. Others, such as drKoop.com and eToys.com,
eventually followed suit.
On the upside, there have been
some spectacular winners from the Internet’s growth binge. Amazon.com
revolutionized retail bookselling in 1995 and quickly became a global
sensation; by the end of 2004 the company’s annual sales topped $7
billion. Meanwhile, eBay is yet another tremendous success story.
The company has nearly $4 billion in annual revenues and is projected to
deliver annual earnings growth of nearly +30% over the next five years.
Winners and Losers
What separates the winners in online retailing from the losers? My
staff and I believe the answer to this question is similar to the secret
to successful offline retailing: Inventory management.
The problem with inventories is
that they tie up capital and can be difficult to dispose of. Department
stores offer a perfect example of this problem in the offline world.
Typically, these stores will start buying merchandise for the holiday
season in the late summer and early autumn. If they guess the season’s
trends correctly, then they’ll be able to dispose of all that
merchandise by the end of December. But all too often, these stores get
stuck with piles of unsold inventories in late December. To move it off
the shelves, they’ll often be forced to drastically cut prices -- a
move that hurts profits.
Inventory management, along
with heavy discounts associated with moving unsold goods, is one of the
largest problems faced by online retailers. However, not all retailers
are burdened with inventory-related charges. In fact, some retailers
don't actually hold any inventory at all. Not surprisingly, these
firms tend to not only deliver above-average profits, but their stocks
also tend to outperform those of traditional retailers.
With this in mind, my staff and
I prefer to invest in companies that don’t hold inventories, but
instead simply earn a fee for enabling transactions. A perfect example
of this is eBay. The company does not actually sell anything. Instead,
eBay users sell items to one another using the firm's web-based
technology platform; eBay then collects a fee based on the value of
items sold. Individual users, not the company itself, hold all of the
inventory listed on eBay. This is one of the primary reasons why we’ve
held eBay in our Aggressive Growth Portfolio since October 2001. It's
also the main reason why the stock has delivered a stunning +265% return
over that time period.
And then there's Provide
Commerce. This company is an online seller of flowers, as well as
gourmet and organic foods. Like eBay, Provide has reinvented the
traditional retail supply chain. The company has gathered a network of
hundreds of suppliers all around the U.S.; when a customer places an
order on the company’s website, Provide orders and buys the product
from one of its suppliers, shipping the item directly to the customer.
There are no distributors and no importers involved.
Provide also holds no
inventories; items are sourced only in response to customer orders. This
low-inventory model is a major reason why my staff and decided to add
the stock to our Aggressive Growth Portfolio in November of 2004; since
that time, the stock has gained as much as +65%.
Although both Provide and eBay
remain compelling plays in the online retailing world, this week my
staff and I decided to look for additional companies that fit our
stringent investment criteria. Specifically, we looked for online
retailers with innovative business models, low inventory requirements
and strong growth.
The table below shows some key
players in the online retailing industry, as well as some basic
fundamental data on each stock. In the report that follows, my staff and
I will examine two of the most promising plays from this group.
| Company
(Symbol) |
Market
Cap ($ Mil) |
TTM
Sales ($ Mil) |
P/E
(FY 2005 est) |
LT
Growth |
| Alloy
(ALOY) |
276 |
401 |
N/A |
N/A |
| FTD
Group (FTD) |
378 |
417 |
N/A |
N/A |
| RedEnvelope
(REDE) |
145 |
97 |
59 |
24% |
| Varsity
Gr. (VSTY) |
124 |
37 |
37 |
N/A |
| Stamps.com
(STMP) |
396 |
38 |
39 |
38% |
| Collectors
Univ. (CLCT) |
127 |
31 |
24 |
20% |
| Priceline.com
(PCLN) |
897 |
914 |
16 |
20% |
| InterActive
Corp (IACI) |
15,400 |
6,200 |
18 |
19% |
| Provide
Comm. (PRVD) |
371 |
146 |
28 |
31% |
| eBay
(EBAY) |
56,200 |
3,270 |
41 |
30% |
| Amazon.com
(AMZN) |
14,700 |
6,900 |
27 |
21% |
| Autobytel
(ABTLE) |
256 |
103 |
19 |
20% |
| 1-800
Flowers (FLWS) |
508 |
623 |
28 |
27% |
| Drugstore.com
(DSCM) |
235 |
360 |
N/A |
11% |
| *
All data as of the close of trading on Friday, March 4th, 2005 |
In addition to EBAY and PRVD, our other two favorite picks from the list above are...
Important:
To view the remainder of this article, in which StreetAuthority.com
founder Paul Tracy and his staff provide an in-depth profile of the two most
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