Missing the Mark

In January 2000, the future of Garden.com seemed as bright as a daisy. The 4-year-old web retailer of plants and garden gear beat pundits’ projections for the quarter and its shares again garnered buy recommendations from several leading securities analysts and investment bankers.

But was Wall Street, still in the throes of its soon-to-fizzle love affair with Internet stocks, looking at Garden.com through rose-colored glasses? Though the top line was recommendations to buy the stock, a close look at details supplied in investment reports reveals thorns poking through a determined optimism. Analysts issuing positive ratings did mention, but sometimes downplayed or ignored, potential problems—problems that moved to center stage only a few months later as the dot-com engine began to run out of steam. Robertson, Stephens, for example, noted a drop-off in traffic figures for December 1999 from the previous month, but dismissed it as “consistent with historical patterns.” The same Robertson, Stephens report questioned Garden.com’s plans for a new offline advertising campaign given the saturation of dot-com ads, but concluded that offline and online content would support the campaign, driving traffic to the site. Thus glossed over were two emerging truths that would define the year for many e-retailers: first, traffic isn’t so much the point as sales, and second, continued spending on brand building isn’t necessarily the best way to get the sales.

In May, Garden.com was still generating buy recommendations—and at some firms, on into the summer. At that point, some analysts talked up concerns about the company’s cash burn rate and options for additional financing. But citing positive indicators such as new orders and web site ad revenues topping projections, some held onto buy recommendations pending the company’s announcement that it would reveal a revamped strategic focus and plans for financing in September.

Others didn’t wait. San Francisco-based W.R. Hambrecht, for example, in August downgraded its recommendation on Garden.com shares, noting doubts about the company’s yet-to-be-announced new strategy and questions about future financing. Still, it stopped short of telling investors to bail out now and instead rated the stock neutral. Three months later, Garden.com was headed for the place where it would end the year: six feet under.

Up in smoke

Garden.com’s story isn’t unique; it’s just one of the most visible. Many web retailers experienced variations on the same theme in 2000, disappearing in startling poufs for reasons that seemed obvious once the smoke had cleared. By the time the year ended, at least 210 Internet companies had shut down, according to a report from Webmergers.com, an online marketplace for buyers and sellers of Internet properties. About half of them—109—were b2c e-commerce sites. The closures put about 15,000 workers out of a job and racked up a collective loss of about $1.5 billion in investment funding.

How does a fledgling industry attract, and lose, that much money that fast? More to the point, why didn’t more web retail analysts call the biggest losses earlier in the year, or indeed at all?

For starters, the industry’s growth has been so fast that the traditional methods of evaluation didn’t seem to apply. Throw in overblown expectations, a dose of in-house investment banking politics and a stock rating system that requires a decoder ring and it’s a perfect recipe for why the big crashes among online retailers weren’t flagged earlier by more analysts. Now, a one-year-older and wiser industry—from investors to consultants to merchants—is well into 2001 with a firmer grip on what factors best predict winners and losers.

Outright sell recommendations from Wall Street analysts are as scarce as—well, let’s say they’ve been as scare as venture capital money for e-retail start-ups was in the second half of 2000. That truth extends across industries. On a five-point scale that rates stocks for investors from one as a strong buy to five as a strong sell recommendation, sell and strong sell recommendations combined constituted about 1% of the 27,000 recommendations issued by analysts for stocks of North American companies last year, according to Thomson Financial’s First Call, a provider of financial information and broker-sourced research.

“About one-third are ones [strong buy], one-third are-twos [buy] and one-third are threes [hold],” says Chuck Hill, First Call’s director of research and a former investment analyst with more than two decades of experience. “Theoretically, you should have as many sells as you do buys.”

So why isn’t that the case? Hill speculates on two reasons. One relates to analysts’ concerns about companies cutting off communication following negative recommendations, which happens rarely. A second factor is that a chunk of many analysts’ compensation today comes from their company’s investment banking business. “If you’re the investment banker or the investment banker wannabe, you want to stay on a company’s good side so hopefully the next time they have to raise money they’ll come to your firm,” Hill says.

In fairness, there are reasons for analysts to be optimistic in their ratings, Hill adds. Overall, the market does tend to go up over time, offering some justification for a positive bias—although that’s a rationalization that doesn’t hold up in the case of Garden.com or Pets.com. There’s also a built-in enthusiasm most analysts feel for the industry they’ve elected to cover.

These points aside, however, there are further complicating factors. Not all analysts use the same terms in issuing recommendations, which makes comparing recommendations difficult. For all of the above reasons, it can take a playbook to figure out what a rating really means—a fact of life understood by experienced market-watchers. “Buy can mean hold; and hold, sell and strong sell could all mean sell,” Hill says. And neutral can mean neutral, or it can mean that the company is in essence on the deck of the Titanic looking at the scenery.

The speed at which investor interest in the Internet retailing marketplace developed added another twist to figuring out who would stay on the upside—or not. “The mistake almost everyone in the sector made was overestimating the speed at which people would change their buying behavior,” says Tim Miller, president of Webmergers.com. “When the Internet adoption rate started showing this hockey stick-like upward curve, people began to extrapolate those growth trends into all areas. If you are expecting a 100% to 200% growth in e-retailing, it’s a reasonable assumption that it’s wise to invest aggressively and capture those positions.”

Hopes vs. history

But the resulting “irrational exuberance” of the Internet stock marketplace—a term coined by Federal Reserve Chairman Alan Greenspan—put hopes at odds with history. Usually, companies have revenues and earnings when they go public. But in the absence of traditional metrics such as cash-flow, EBIDTA (earnings before interest, depreciation, taxes and amortization) and the like, Internet retailers’ stock rose on projections, based on new metrics like traffic and page views.

“A lot of this is based on vision,” says Mark Rowen, an analyst with Prudential Securities who has recently issued sell recommendations on Internet retailer stocks Webvan and Barnesandnoble.com. “How the vision gets executed is sometimes very different from what was laid out. Webvan is a good example. It was a very bold vision, but they haven’t been able to execute on the initial model. It’s difficult to judge from the outset whether a model is going to work—with the Internet in particular, because the valuations weren’t based on fundamentals. Most companies are in business for a certain period of time and are already profitable when they go public, but in the Internet space, that wasn’t the case.”

Don’t get carried away

So where does that leave investors—or more to the point, e-retailers trying to sidestep the potholes that swallowed up so many of their number last year? For investors, Hill contends some of the best advice still comes from Wall Street. “Just don’t get carried away with it. We’ve had bubbles before; it was just a matter of time until this one broke,” he says.

But e-retailers looking to stay afloat need more than financial targets and a viable business model—they need detailed strategies to help them make good on the execution. Private consulting and research firms specializing in Internet businesses have sprung up in that space with their own ratings systems, tied heavily to their research on what consumers buy, when, and what are consumers’ limitations and concerns—all the sorts of non-financial issues that equities analysts don’t focus on.

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“We’re not stock analysts and we don’t make recommendations on stock purchases,” says Paul Ritter, director of e-commerce research at the Boston-based Yankee Group. “We form opinions on whether or not companies are pursuing effective strategies for achieving success with their business model, where some of the flaws in the model are, and some of the things they’re not focusing on but should be.” As such, private research and consulting firms don’t have to go out on a limb and rate companies like analysts do. Yet the outcome of their research is essentially what Wall Street is after, too: a solid idea of a company’s prospects for success or failure.

Firms like Yankee look at the financials but also dig very deeply into the strategies that support those targets. Yankee has drafted a seven-point list of indicators for success in online retailing (see “Winning Metrix for E-Retailers”). To win, Ritter says, companies must perform well on all seven factors simultaneously—five or even six out of seven doesn’t cut it.

“Pets.com is an example,” he says. “They had great visitor traffic, industry-leading conversion rates upwards of 20%. But dig deeper, and you find things like how they were operating for the whole year on substantially negative gross margins before even incorporating operating costs. That’s a difficult model to sustain for months, let alone quarters and years. People got caught up and thought it doesn’t matter if they’re losing money because eventually it will turn around. But how could it possibly turn around if they were doing things as Pets.com was? There was no chance for success in that business model.”

Some argue that private Internet sector research firms can be as beholden to their consulting clients as stock analysts can be to their firm’s investment banking clients, and that they must also tread a fine line when giving opinions publicly.

But consultants’ published research on Internet firms is peppered with predictions for the demise of dot-coms who fail to deliver on one key strategy or another. Forrester Research, for example, last April said Pets.com would fall by the wayside, unable to keep up with multi-channel competition. Merrill Lynch Capital Markets meanwhile, was still rating the stock a buy two months later in June, based in part on high-volume traffic and conversion rates that proved insufficient to bring Pets.com in from the cold.

Not a lot to draw on

“The difficulty of predicting the success of a lot of these businesses was the early stage at which they went public,” says Daniel Good, a Merrill Lynch retail analyst. “There’s not a whole lot of historical information to base forecasts on. What people tried to do was draw a line out five or 10 years and assume that 5% to 10% of total sales for the product category could get done online. Then they looked at the number of players in the space, and made some assumptions on growth. But two things happened. One, certain product categories haven’t taken off as quickly. And two, e-commerce as a whole hasn’t taken off as quickly.”

Consultants say things are changing now. Wild extrapolation has faded as analysts and consultants swap speculation about e-retail companies for actual performance data. “Most people will admit they’re not valuing companies any more based on things like visitor traffic and how many ads they’re seeing,” says one observer who asked not to be identified. “Just because a company gets a lot of exposure on major cable channels doesn’t mean they are a successful firm—or will be.”

There’s a lot to be said for experience—the observation of several industry-watchers who’ve pointed out that experience is something this young industry doesn’t have much of yet. With 30 years of equities research under his belt, Hill has been through the boom and bust cycle before. In the ’60s and ’70s, he saw company stock selling at 100 times earnings. “Computer peripherals companies, computer leasing companies, time share companies—all of these were going to be the new growth area, and most of them did not survive. Most got bought at a fraction of their highs and some went out of business. It’s going to be the same with the Internet,” he says. “Whenever these new waves come along, there’s always a concept phase, when the companies are going to get overvalued before they come back to reality. The ones that survive will grow at a good rate of earnings and be among the better performers.”

mary@verticalwebmedia.com

Winning metrics for e-retail

Handicapping the prospects of Internet-based retailers starts with the same core criterion, whether on Wall Street or in private research and consulting firms: a sound business model with opportunity for adequate margins. But as the dot-com failures of last year demonstrate, success or failure also rides on other factors, sometimes overlooked in a purely financial analysis. Here, Paul Ritter of The Yankee Group highlights seven make-it-or-break-it predictors of e-retail success. Is the web marketer:

— Selling products with sufficient gross margins? “Pets.com was paying for goods at a price at which it couldn’t even afford to sell them. Part of its customer acquisition model was to try to buy customers by offering lower prices and selling at negative gross margins.”

— Providing a tangible value proposition versus competitors and offline channels? “Furniture.com’s value proposition to get people to buy online was that you could speed up the time frame for getting it—maybe six to eight weeks instead of eight to 12 weeks. It turned out to be not that significant to buyers.”

— Pursuing innovative and cost-effective customer acquisition strategies? “EToys was spending upwards of $100 for customer, when its average sale was far less and its average net was $15 per sale (eToys reports a per customer acquisition cost of $40). It would have to have more visitors than Amazon just to reach break-even.”

— Providing an easy and enjoyable web experience for consumers? “You’ve got to make it easy for customers to find the products they’re looking for on your site and all the information they need when they need it in order to maker buying decisions.”

— Striving for high conversion rates as well as significant visitor traffic? “Money can be spent effectively to increase your conversion rates—that’s just as valuable as going from 1 million to 2 million visitors.”

— Providing efficient and effective fulfillment for products purchased online? “A lot of companies spent more time on fulfillment this year. Returns for the holiday season were more than twice the number and twice the rate of last years’.”