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Beware of the "doom loop" this summer

There are several factors that create an unfavorable environment for consumer e-commerce companies throughout the summer, which could limit broad upward revenue revisions post second-quarter earnings season and could result in some downward revisions.

There are several factors that create an unfavorable environment for consumer e-commerce companies throughout the summer, which could limit broad upward revenue revisions in the post second-quarter earnings season and could result in some downward revisions.

Factors include the "doom loop" effect of revenue softness because of reduced marketing, the general media environment, fewer aggregate industry marketing dollars as a result of fewer companies, and slower consumer spending.

Many e-commerce companies are in the unenviable position of having to reduce marketing spending based on the need to balance growth with available cash in the current capital-constrained environment. The significant reduction in available capital for e-commerce companies to build a brand and drive brand awareness, customer traffic and trial purchases has resulted in many companies altering their marketing programs, which should result in slower revenue growth.

What will be the effect to revenue growth given the reduced marketing spending?

The limited operating histories of many e-commerce companies, in our opinion, limits their ability to accurately project the subsequent reduction in revenue growth driven by lower marketing spending. To avoid the dreaded doom loop effect, companies must either make significant downward revisions in revenue as they reduce marketing to avoid revenue shortfalls that could lead to additional spending reductions or drive significant increased marketing efficiencies.

Potential doom loop effect of reduced spending on revenue growth
A company's reduction in marketing spending required to conserve cash to get to profitability in a capital-constrained environment could result in slower revenue growth than expected. The potential revenue weakness expected during the second quarter for some e-commerce companies would likely force a more conservative budget for third- and fourth-quarter marketing spending to manage current cash-burn rates.

Given the low level of brand awareness, small customer bases and significant dependence on new customer revenue for most e-commerce companies, it is our belief that the lower marketing spending will have a continued negative effect on revenue leading to a doom loop effect. When a company is forced to cut marketing, the resulting reduction in revenue growth is often difficult to predict and sometimes still results in a revenue shortfall compared with a revised budget.

The additional revenue shortfall drives a need for additional marketing cuts to meet operating income estimates, resulting in additional topline softness, which in turn drives additional spending cuts. This doom loop effect is difficult to reverse in a tight spending environment.

Young e-commerce companies' limited brand awareness and limited access to capital make growth challenging. These companies face the challenge of gaining scale and brand awareness, which requires significant marketing spending. However, companies do not have the capital to fund the required marketing spending, leading to a catch-22 of slower revenue growth that could potentially be more pronounced than originally anticipated.

In addition to the potential doom loop there is significantly less free media. The general media environment is vastly different today than it was a year ago, and we see this trend continuing throughout the summer months. In general, a year ago, companies benefited from a significant level of positive press to consumers centered around the enthusiasm for IPOs and e-commerce in general. The free incremental impressions helped to drive awareness and traffic above and beyond the companies' efforts.

Today's environment is extremely different and has been characterized by six months of negative press to consumers ranging from poor customer service and security issues to companies going out of business. In addition, there is less marketing spending in aggregate from the aggregate universe of e-commerce companies (both public and private), which reflects both lower spending as a percentage of sales for individual companies and fewer companies that can spend given the ongoing shake-up. Ultimately, the lower aggregate noise generated by e-commerce companies results in less of a synergistic effect that would have lifted the tide benefiting the category in general.

Finally, we believe that companies that have achieved significant scale and those that sell price-sensitive products (such as high-ticket luxury goods) might be somewhat vulnerable to a slower consumer-spending environment. We do not think this would be a concern for many companies in the absence of the three aforementioned factors, but given the presence of these conditions, slower consumer spending could have more of an effect.

The growth of young e-commerce companies is driven more by increased penetration than by the incremental year over year purchases of existing customers. Therefore, a slower consumer-spending environment should theoretically have little effect on young e-commerce companies as long as their new customer growth remains robust.

We believe that large e-commerce companies and cash-strapped e-commerce companies will find it more difficult to maintain robust customer growth to completely offset slower consumer spending. Large e-commerce companies face the challenge of having a larger percentage of their sales coming from existing customers as opposed to new customers, whereas small e-commerce companies that are cash-strapped have to reduce marketing spending resulting in fewer new customers.

We continue to believe that companies with lower levels of revenue scale/customer bases and significant cash balances are insulated from a slower consumer-spending environment because they are positioned to drive increased penetration to offset declining buying rates of existing customers.

Not all doom and gloom
We do think that companies that have lower levels of scale and that have aggressively and effectively entered new growth areas such as new geographies and new product lines compared with a year ago can continue to beat and revise revenue upward.

Companies that have either achieved strong brand awareness, have highly differentiated business models, or have very strong cash positions should continue to achieve strong revenue growth targets. They could also gain online market share given the lower visibility with consumers of cash-starved companies that can no longer afford to build a competing brand.