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First round of a long fight

With the start of the new year, it's time to forecast what 2000 will bring for e-tailers and the Internet business-to-consumer sector.

With the start of the new year, it's time to forecast what 2000 will bring for e-tailers and the Internet business-to-consumer (B2C) sector.

The millennium began with as much uncertainty for e-tailers as the rest of the world had for the Y2K bug. And uncertainty persists regarding who the winners and losers will be in an inevitable shakeout from the excessive capitalization of the B2C sector in 1999. In addition, it remains to be seen whether the sector will be ignored because of the new wave of the Internet business-to-business (B2B) sector.

I agree with the majority that not all B2C companies will survive in 2000, but I also believe that investors should expect the leading B2C companies to outperform the Standard & Poor's 500 this year. Therefore, it is important to identify who the likely leaders will be and from this group to build a portfolio of holdings based on the outlook, catalysts and estimated value of each company.

What follows is a "compass" for navigating through the uncertainty and speculation as we begin the new millennium: a view on the key stock price drivers, the issues and risks, and a framework of critical success factors that we used to segment the e-tailers into three tiers.

Key stock drivers for 2000
I recommend overweighing the e-tailing sector with the belief that it will outperform the S&P 500 in 2000 given the numerous catalysts for the leading companies in the sector. The sector should continue to benefit from increased adoption rates in online shopping, improved technologies, and access to capital to fund the growth opportunity.

Growth and stock price appreciation will likely be driven by the following catalysts: mergers and acquisitions (from the likely shakeout), new category and international expansion, acceleration of adoption of online shopping by consumers, strategic alliances, and progress toward profitability.

Mergers and acquisitions likely to result from shakeout
E-tailers have the opportunity to strengthen leadership, accelerate growth, and increase the rate of achieving profitability through mergers and acquisitions. The results of the 1999 holiday season will be a defining moment for more mature online categories such as books, videos, music, toys, computer hardware and software, and consumer electronics.

Products in these categories have been sold online for several years, in contrast to emerging online e-tailing categories such as home furnishings, pets, auto parts and so on. Thus, we believe there will be tangible results that can be used to separate the leaders from the rest of the pack. Ultimately, three to four companies should stand out in most e-tailing categories (depending on the size of the category), with the leading companies consisting of a mix of pure e-tailers and click-and-mortar retailers.

The leaders in each sector will continue to see increased profits and valuations, and the remaining companies could experience declining profits and valuations. This sort of division would result in acquisition and consolidation opportunities.

Leading e-tailers will look to acquire companies that provide a wider range of skills and services, new customers, new industry categories, or increased depth in existing product categories. Such acquisitions would strengthen leadership positions, accelerate growth, and speed time to profitability. Traditional retailers could become prominent acquirers of e-tailers as they contemplate buy-vs.-build decisions.

Product category and international expansion
Similar to entering new product categories, increased geographic presence in international markets results in larger addressable markets and an increase in potential business size for a company. As companies expand their markets, it is logical to expect an associated increase in value. Amazon.com (Germany and the United Kingdom) and eToys (United Kingdom) are the two e-tailers with the most prominent international presence. Other leading players will expand outside the United States in 2000, and Amazon and eToys may expand within Europe and enter Asia or Latin America.

Accelerated consumer online shopping adoption rates
Online shopping adoption rates should accelerate relative to previous estimates, resulting in a larger percentage of land-based sales moving online. Both an increase in online users and an increase in the percentage of people who shop online will benefit the industry as a whole.

According to Forrester Research, online shopping in the United States will increase to an estimated $184.4 billion by 2004 from $20.0 billion in 1999. B2C commerce estimates in general are conservative given that 1999 holiday season sales will likely be higher than expected, and given the likely effect from new strategic alliances such as Wal-Mart/AOL and Kmart/Yahoo to drive new users online.

The largest number of new online users probably will come from households with less than $50,000 in annual household income. Previously, I believed that approximately 3.5 million new households from this demographic would move online in 2000. The recently announced initiatives by Wal-Mart/AOL and Kmart/Yahoo will likely drive significantly more users with less than $50,000 in annual household income online because the customer base of both these retailers consists of this buyer group. The efforts of Wal-Mart and Kmart, in conjunction with the leading Internet companies, will help these potential online buyers overcome the financial barriers and comfort levels associated with shopping online.