February 28, 2001, 12:00 AM

Missing the Mark

(Page 2 of 3)

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.

“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.”

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