| BUSINESSWEEK ONLINE : DECEMBER 27, 1999 ISSUE | ||||||||
| ||||||||
 | ||||||||
| WHERE TO INVEST -- STRATEGIES FOR STOCKS
Who Will Survive the Internet Wars? How to tell which companies have what it takes Running out to buy a new lipstick? It's only a click away at iBeauty.com or gloss.com. Or how about beautyjungle.com? With dozens of sites selling the same $5.99 lipstick or $12.99 toy, the biggest problem for consumers is deciding which site to choose. For e-tailers, the biggest problem is luring customers to their sites. That's why marketing costs are soaring, and why the success or failure of e-tailers will depend on their ability to finance an advertising campaign that pays off in new customers. Online sales are expected to double from $7 billion last year to $14 billion in 1999--and then double again in 2000. But the marketing costs for getting those sales are rocketing, too. Since almost all e-tailers are losing bales of money, the strength to engage in the marketing wars depends critically on their financial heft. Who has the ability to survive the price wars as competition intensifies? One critical yardstick is the gross margin: E-tailers with high gross margins are likely to survive the cyberwars, while low gross margins could be a sign of danger. Gross margin is the portion of each dollar of revenue that remains after subtracting production costs. It does not include advertising costs. The larger the gross margin, the more money that's left over from every dollar of sales, which can be used to strengthen the online company's brand. ''This year, the Super Bowl will be dominated by dot.com TV ads; e-tailers determined to become household names. But if these companies don't have the gross margins to support their spending, they won't be around for the summer Olympics,'' says Paschal Levensohn, president of Levensohn Capital Management LLC in San Francisco, value investors in public and private technology companies. That could be bad news if the public markets tire of funding e-commerce sites. Cash from operations will then become the major source for funding the growing cost of acquiring new customers. The most successful e-tailers, such as eBay Inc. (EBAY) and America Online Inc. (AOL), have some of the highest gross margins, and their stocks are, of course, big winners. ''If gross margins are 40% to 50%, the company has a shot of surviving....Margin is the king in this, it really is,'' says Chip Adams, a partner with Rosewood Capital, a San Francisco venture-capital fund specializing in Internet brands. PROFIT PICTURES. Of course, high gross margins are just one indicator of success. That model still doesn't predict when a company might actually turn a profit. For that, Rosewood goes to the next step: a gauge of how revenues must increase to generate a modest operating profit of 5%. Operating profits are profits that remain after subtracting marketing costs, but before taxes and interest. A 5% operating profit is a realistic expectation for e-tailers, say experts, given their multibillion-dollar market capitalizations. Rosewood selected eight e-commerce Internet companies at random and calculated how much revenue was needed above and beyond their average annual operating costs to produce a 5% operating profit. Projected marketing and sales costs were based on Robertson Stephens estimates. Says Abe Mastbaum, chief financial officer at American Securities in New York: ''This model conservatively projects profitability for e-commerce participants.'' Rosewood also projected how much revenues companies needed just to break even. ValueAmerica (VUSA), which sells office products online, needs revenues to jump 982% to break even, while Internet bookstore Fatbrain needs 566% and direct marketer MyPoints must rack up a 945% increase (table). An obvious best-of-show benchmark for the e-tailers is the auction site eBay Inc., one of the few profitable online companies, with gross margins of 75% or more. Because eBay has the advantage of being a clear market leader, the company also has the luxury of spending far less on marketing than other companies that have fewer sales. eBay, with its $219 million in projected revenues this year, will spend just an estimated $97 million on marketing in 1999, according to Robertson Stephens. Compare that with eToys Inc. (ETYS), which analysts estimate will spend approximately the same amount as eBay on marketing in 1999. But eToys has only half the revenues of eBay. Despite fundamental differences in the types of goods eBay and eToys sell, they cater to the same end user. Not surprisingly, eToy's gross margins are a quarter of eBay's at 19%. But it had better spend wisely because it needs to increase revenues by 1,025% to make a 5% profit, and 792% just to break even. CLOSING THE GAP. Like eToys, Homestore.com Inc. (HOMS), a national real estate listing site, is not yet profitable. But that's where the comparisons end. Homestore has the advantage of extremely high gross margins, at 64%. That's because it has locked up exclusive relationships with the largest real estate and homebuilders associations. They in turn encourage agents to use the Homestore Web site, which saves the company expensive marketing costs. Homestore is in the enviable position of closing in on making a profit. While estimates show Homestore's 2002 revenues at $275 million, Homestore actually only needs $235 million to make a 5% operating profit. At the opposite end of the spectrum is a company like Value America Inc, the online office-supply company. This category is swamped with countless competitors. With price wars breaking out in this category daily, it's no surprise that Value America has gross margins of just 5.3%. What's unusual, though, is that even its beleaguered brick-and-mortar competitor Office Depot (ODP), whose stock price has fallen from $26 a share to just over $10 a share in the past year, has better margins at 29%. But wait, there's even more bad news. According to Rosewood's estimates, Value America has to increase its revenues by 2,451% to achieve a 5% operating profit. Doesn't seem like much value here. ''A BIG BET.'' And how does Garden.com Inc. (GDEN) grow? A Web provider of gardening-related content, analysts estimate that the company must increase its revenues by a fabulous 1,086% by 2002, to $152 million. But look at its gross margins: only 16%. Even granting the Street's phenomenal top-line projections, the company had better tend to its own garden. Garden.com still needs to boost 1999 revenues by 1,900% for a 5% operating profit. The reason: Marketing costs are high, and its margins are thin. With dozens of competitors vying for the same e-commerce dollar, and spending gargantuan sums to get it, some predict a massive shakeout. Homestore.com Chief Executive Officer Stuart H. Wolff thinks that business models that don't ''have sustainability or the type of robust margins you need in order to have a successful long-term company'' will not survive. That's why Adams at Rosewood is keeping an eye on whether e-tailing marketing expenditures will ultimately produce sales. ''As an investor, your bet is whether these companies can increase sales by $5 to $10 for every dollar spent,'' says Rosewood. ''That's a big bet. Is everybody going to get there? Some will, but most won't.'' The bottom line? It's not too early to pay attention to gross margins and to expect operating profits as well. ''It's time for investors to get back to fundamentals'' says Paschal Levensohn of Levensohn Capital Management. ''Investors hoping for the speculative wave to continue to bail out lousy e-commerce business models will be in serious trouble.'' Models, after all, only go so far. By DEBRA SPARKS _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
|  |
 | |
RELATED ITEMS Who Will Survive the Internet Wars? TABLE: Rushing for Revenues... Best Bet: Strong Sites INTERACT E-Mail to Business Week Online | |||
