The Struggle for Profitability

An investment of $1,000 in Amazon.com in May 1997 when the online book retailer went public was worth $39,000 eighteen months later in December 1998. When software retailer Egghead Inc. closed its stores in 1998 and adopted an Internet-only selling strategy, its stock price surged from $5.37 a share to $20.80.

The run-up in the stock prices of Web-based sellers has been one of the most widely reported financial stories of the last year. And the stock of publicly traded Internet retailers, malls, shopping services, auction houses and other business-to-consumer electronic commerce development companies remain among the hottest on Wall Street.

But behind investor fascination with Internet retailing stocks and the ga-ga coverage of stock prices in the news media has always lurked a key question: When will these companies start showing a profit and justifying their stock prices?

The short answer: Not any time soon.

“We lost money last year and we will lose money this year and next year,” says Jeffrey S. Tauber, chairman and CEO of CyberShop International Inc. CyberShop, an online retailer that sells everything from clothes and furniture to fitness equipment and gourmet food, went public in March 1998 at a price of $6.50. Its stock today sells for $7.50, after peaking at $30.

In fact, with the exception of eBay Inc., an Internet auction house, and a few others, most business-to-consumer electronic commerce companies are not profitable and do not expect to be profitable in the near future. Amazon.com lost 22 cents per share last year. Egghead.com lost $5.5 million just in the quarter from April 1 to June 30, 1998.

And according to a 1998 survey by Forrester Research Inc., 69 of 100 Internet retailers—both virtual retailers and traditional retailers that started Web sites—are losing money. “There aren’t many pure virtual retailers that are profitable,” says Robert L. Smith Jr., executive director of Shop.org, a trade association for online retailers.

That has some analysts questioning the long-term viability of e-commerce investments and the motivations of their investors. “The buyers of e-commerce stocks make the tulip investors of the seventeenth century look like value investors,” says Richard Berry, director of equity research, J.P. Turner & Co., a broker/dealer based in Atlanta. “People are not trading on profitability; they are trading on avarice. It’s the biggest speculative bubble we’ll see in our lifetime and it will burst.” Based on sales revenue and his market experience, Berry believes the value of e-commerce stocks will decline 50-90% in the next 12 months.

Huge sales

While current profitability has little impact on stock pricing, one of the factors that is driving the price of e-commerce stocks skyward is the enormous growth in sales that these new companies have been posting. In all of 1997, Amazon.com had sales of $147 million. In the third quarter of 1998 alone, its sales hit $153.7 million. Adding fuel to the fire were preliminary 1998 holiday sales figures which were up 275% for Internet retailers as a whole, and as much as 500% for some individual Internet retailers, stronger than even the most optimistic estimates, says Elaine K. Rubin, president of ekrubin Inc., an online commerce consulting company based in Woodbury, N.Y.

In all, Internet retailing had a stellar year—in sales. But just how stellar is in question: Boston Consulting Group estimates that online sales in 1998 exceeded $13 billion; PricewaterhouseCoopers LLP says $8 billion.

And this is just the start. Boston Consulting estimates the top-10 publicly traded online retailers experienced year-over-year revenue growth in excess of 160%. Forrester Research Inc. estimates Web sales to consumers will surpass $108 billion in 2003, growing 69% annually.

Seeing red

What is driving the stock prices of e-commerce companies, say analysts, is the anticipation that the explosive growth in sales revenues of these companies will continue. Wall Street analyst, Henry Blodget, executive director, CIBC Oppenheimer & Co., New York, predicts that Amazon.com will reach the $400 mark (unadjusted for stock splits) by December, although the subsequent meteoric rise in the company’s stock price may mean that Amazon.com’s stock may reach that benchmark even sooner. Blodget set the $400 price because he believes it will ultimately be a major global retailer. “They didn’t exist three years ago, and next year they’ll probably do $1 billion in sales,” he says.

But even with this huge surge in sales revenues, e-commerce companies are still posting losses, and are likely to continue doing so for several years. While past sales growth would indicate that e-retailers would be out of the red by now, industry insiders say the wild speculation by investors in future growth has allowed these companies to invest enormous amounts of capital back into the business instead of posting profits for shareholders.

Most Internet retailers are not profitable, says Karl R. Haller, principal consultant, PricewaterhouseCoopers, because, unlike most other publicly traded companies, they are not forced to be profitable. In other words, they are not punished, in terms of lower stock prices for not showing profits the way most other companies are. “Profitability,” says Haller, “has not been a key driver of stock prices.”

In fact, some Internet retailers say their investors don’t even expect the companies to be profitable. “It’s not really about profits,” says CyberShop’s Tauber, who expects to create a $100 million company. “Our investors are looking for us to build a multimillion dollar business.”

Furthermore, says Haller, many Internet retailers could be profitable today if they wanted to. What keeps them from profitability is that they are spending large amounts drumming up sales. “The money they spend on advertising and marketing is significant in comparison to traditional retailers,” says Haller.

Getting consumers’ trust

The Boston Consulting Group report shows that online retailers spent $26 on marketing and advertising per order generated compared with $2.50 for traditional stores. Amazon.com spends 25% to 30% of sales on marketing and advertising whereas typical retailers spend around 5% and many spend even less. “If you adjust Amazon’s marketing expense to a 5% level,” says Haller, “they would have been profitable last year in terms of operating income as well as this year.” But last year Amazon.com had a negative operating income of $29 million and this year it’s projected to be negative $60 million. The rationale behind spending huge amounts on marketing and advertising, says Haller, is that by spending money to build and grow a brand, the company will generate bigger profits in the future. “And if the stock market is used as a gauge,” says Haller, “investors are agreeing.”

Guide to E-Commerce Technology

“We are investing in marketing, there’s no question,” says Egghead.com CEO George P. Orban. “If we didn’t invest in marketing, in the long term, we wouldn’t have a business.”

In fact, advertising is crucial to Internet stores as a way to drive traffic and develop credibility among potential customers. “The name of the game is who the customer trusts and wants to buy from,” says Rubin.

Smith likens the large amounts spent on marketing and advertising to America Online’s approach in its early years. Blodget agrees: “AOL lost money for years, a lot more than Amazon. But people bet on their long-term leadership. Now it looks like they were brilliant to invest the money and take the losses.”

In addition to spending large amounts on marketing and advertising, Amazon.com has also spent significant capital making numerous acquisitions to expand the business. In the past year, Amazon.com has bought Internet booksellers in the United Kingdom and Germany and an Internet movie database. The company also invested in human resources, more than doubling its workforce in 1998.

Blodget believes that the expenditures Amazon.com is making today are smart, and far from being penalized with lower stock prices for posting losses, he believes the company should be penalized if it did show profits. “They should be investing in the business,” he says. “It’s a smart management decision to do so now because in three years the barriers to entry will be too high.”

No worries

The retailers themselves do not seem to be worried about achieving profitability. “We have never forecast a date at which we will be profitable,” says a spokesperson for Amazon.com. “We are making decisions based on long-term business goals.” But Blodget believes that, based on current projections of sales growth and expense growth, Amazon.com will show profits by 2001.

Building the top line is of greater importance to most cyber merchants than having a positive bottom line. Says Kate Vick, chief financial officer at Cyberian Outpost Inc. in Kent, Conn., a seller of computer hardware, software and peripherals: “We’re investing money in the company right now, that’s what our shareholders are investing with us to do.”

In the future, says Haller, Amazon.com will continue to spend heavily, but as sales grow those expenses will be leveraged over a broader sales base, and the company will begin to post profits.

A grace period

Companies that transpire business just on the Internet have an advantage over companies that also conduct more traditional retailing, says Haller. “Investors in traditional retailers are not as willing to accept on-going losses of a new business venture in the name of developing brand awareness of the Web site as are investors in virtual retailers,” says Haller. But traditional retailers do not need to spend as much money to develop and grow their customer bases, Shop.org’s Smith argues. “Eddie Bauer,” he says, “is already ahead in the game, they already have a brand name, customer base, and infrastructure.”

Creating an e-commerce site is an added value function for established retailers says Smith. According to the Boston Consulting Group, multi-channel retailers such as Dell, Eddie Bauer and Lands’ End already account for 59% of online revenues and have better conversion and loyalty than purely virtual retailers where only 5% of unique visitors become customers, and only 1.6% of visits result in purchases.

However, some still question when e-retailers will become profitable. Some believe if investors demanded it, the companies would show profits. “Profitability,” says Haller, “is largely under the control of the company itself. If Amazon.com were being punished for not being profitable, in terms of their stock not doing well, then they would strive to be profitable sooner.”

Rubin believes virtual retailers that don’t stray from their original business model will become profitable in three to five years. Companies such as Amazon.com that changed their original concept to become a broader retailer—more like an Internet department store—will take longer, she says. “It’s clear that given the current growth that these companies are experiencing they will achieve profitability,” says Smith.

The downside

But even if they do begin to post profits some question whether the across-the-board run-up in e-commerce stocks is justified. “There’ll be a few successes and lots of failures,” says Blodget. But, he says, the successes will be huge with many new large companies created. “Given the potential of the Internet to change retailing, this will have as big an impact on retailing as Wal-Mart did. Investors are recognizing that there’s an enormous opportunity here,” he says.

But while the stock run-up has many people starry eyed, it may have created greater problems for Internet retailers. “The volatility created by people speculating in these stocks has made the business more difficult to manage,” says Orban.

For one thing, Orban says, high stock prices make it difficult for the company to find capitalization, because financial institutions believe the company is overvalued. And high stock prices make recruiting difficult. Stock options are a valuable compensation tool and they aren’t as appealing if recruits feel they are overvalued.

In the end, some say, the stock price will never depend on whether an Internet retailer becomes profitable. “Nobody is buying these stocks based on profits,” says Analyst Berry. The stocks are so wildly overvalued right now that even if they did begin to post profits they would still be wildly overvalued. “There are not enough consumers on earth to justify the valuations,” he says. Trading, says Berry, is based on people thinking that stock prices will continue to rise forever. “Search engines reached their peak, and e-commerce will sometime soon,” he says. •