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Growing e-tailers may trip on own feet

E-commerce giants and eBay are seeing their margins decline while they expand at a breakneck pace.

Are e-commerce companies getting too big for their britches?

Investors and analysts are wondering just that, with e-commerce giants such as and eBay seeing their margins decline while they expand at a breakneck pace. As a result, Wall Street has been punishing both companies' stocks.

In the wake of this week's financial reports, both companies were downgraded by a host of analysts. At least five brokerages lowered Amazon from their top ratings, while two others downgraded eBay.

Merrill Lynch, for instance, moved Amazon down a notch on its ratings. Despite the company's increased number of customers and lower customer acquisition costs, Merrill Lynch cited the company's continuing losses as a reason for a change in the outlook.

"We continue to be discouraged by...a steady increase in our loss estimates without a correspondingly large increase in revenue or profitability estimates," Merrill Lynch analyst Henry Blodget wrote in a report on Amazon.

"Bottom line, it continues to cost Amazon more than we ever imagined to generate revenue," Blodget added. "Although management has now committed to demonstrating that the basic business model works, we are simply exhausted by the endless postponement of financial gratification."

Following the downgrades, Amazon's stock dropped 6.5 percent today, closing down 4.94 to 71. Meanwhile, after dropping 13.31 points or nearly 9 percent yesterday, eBay lost 1.8 percent of its value today, falling 2.5 to close at 136.19.

The problems both companies face: As they expand their businesses, the costs of running the enterprise goes up--and the higher cost is starting to show up in their gross margins. Gross margin measures the difference between a company's revenue and the cost of generating that revenue.

Amazon's gross margins declined from 21.5 percent in the second quarter of this year to 19.8 percent in the third quarter. Amazon attributed the drop

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to bulking up on inventory to prepare for the holiday season, lower revenue from shipping, and the company's move into new--and less profitable--product areas, such as toys and electronics.

Amazon has faced this problem all along. When the company branched out last year into music and videos, it predicted a similar drop in margins because those businesses were less profitable than its core book business.

Amazon chief executive Jeff Bezos defended the company's expansion in a conference call with investors yesterday, saying that Amazon was trying to take advantage of its opportunities.

"Since scale drives increasing returns, profitability, and return on investment capital, getting to scale as quickly as possible in every business drives our decision making," Bezos said. "We believe that the best way to get to scale fast is to do more for our customers in terms of breadth and service level than anyone else."

But Jeff Matthews, general partner with Ram Partners, identifies a disturbing trend with Amazon. Although the company's sales increased $40 million during the past quarter, Amazon's gross margins only increased $3 million. Matthews said that means that as Amazon expands its business, the company is facing decreasing returns.

And Amazon admitted as much, at least in the near term in its earnings release. The company told investors that it expects its margins to decline again in the fourth quarter even as revenue jumps with holiday sales.

"They've hit a wall," Matthews said. "It's a broken model that's never going to work."

But Amazon says that its original business--books--will be profitable next quarter, and many analysts expect that Amazon's other businesses will soon follow.

Derek Brown of Volpe Brown Whelan, who reiterated his "strong buy" rating on Amazon today, said that the company will save money on inventory costs as it gains experience and learns to manage its toys and electronics inventories. Meanwhile, Brown said the money the company has devoted to expanding its distribution system will eventually pay off.

"They're putting the capacity in place to handle massive consumer demand on a global basis," Brown said. "I believe that we are on the verge of a watershed period in e-commerce, and Amazon is in the best position to capitalize on that opportunity."

Meanwhile, eBay's gross margins dropped from 78 percent in the second quarter to 71 percent in the third quarter. The leading online auction company attributed the decline to bulking up its computer network and technical staff.

The company suffered a plague of outages earlier in the year, as more auction users placed increasing demands on its computer systems. Those outages depressed last quarter's earnings as well, as the company refunded fees to sellers whose auctions were affected by the outages.

eBay chief executive Meg Whitman said the company is trying to guarantee its customers "utility-like" reliability of its systems. Despite the investments the company has already made, Whitman said eBay is three to four months away from achieving its desired stability with its computer systems.

"We are building the technical infrastructure for the next millennium," Whitman said in a statement. "It's a journey. You don't wake up one morning and it's done."