Look beyond the merchants for e-Christmas

Although we have seen many of the Internet-retail stocks perform well over the past couple of months, we have not seen the two- to three-times run-ups we saw last year. Where is Santa? When will he arrive? Who will he treat?

The answer to the ho-hum, not ho-ho, investor sentiment lies with several factors.

Revenue momentum a must
The hallmark of Internet investing during the past couple of years has been top-line momentum, and more importantly, top-line upside. Investors have come to expect 5 to 15 percent revenue upside from the leaders in the group each quarter. In this way, companies like Amazon.com or eToys "grow into" their lofty 15 times to 40 times forward revenue multiples over the course of several quarters.

During the past two quarters we have begun to see leaders like Amazon and eBay hit or miss analysts' top-line estimates. As a result, it has been difficult for analysts to aggressively raise their 2000 top-line expectations the 5 to 10 percent we have seen historically.

Profitability matters
Most Internet businesses are fixed cost in nature; this means their profitability scales with revenue growth. The exception is when gross margins begin to come down, often a result of underlying industry pricing pressure. Without stable gross margins it is difficult to predict the long-term margin structure of a business model. Declining gross margins are a no-no in any industry.

We acknowledge that, like all fixed-cost businesses, Internet companies pass through an investing and scaling phase where they incur losses. But on the way to profitability, companies must show that they can drive sustainable, if not increasing, gross margins, produce operating margins (or losses) that improve in a predictable manner, and break even in line with or ahead of analysts' expectations. So what's wrong?

In each of the past two quarters, we have witnessed less revenue upside (eBay actually missed second-quarter revenue expectations), lower-than-expected gross margins, and limited (if any) long-term profit visibility from most Internet merchants. In fact, Amazon, the category leader, continues to "invest" opportunistically with little regard to delivering on near-term profitability expectations.

With this backdrop, investors are rightly looking beyond Christmas 1999 and into the long-term profit picture. Like it or not, Amazon has become the industry bellwether. After all, if the biggest player in the industry can't drive investor enthusiasm, who can?

Brand clutter--the new Grinch menace
With the massive amount of public and private capital raised by Internet companies during the past couple of years, it comes as no surprise that overspending on advertising is diluting the medium--and certainly the message. The problem we see with the spending is that there is too much competition for limited consumer attention.

It also seems that Wall Street has become saturated with too many ".com" stories. It is no mystery to investors that if consumers can't remember the ticker for a stock, then they can't be expected to remember the URL when it comes time for shopping.

Less is more, and consumers will continue to shop with the big names that they trust both online and offline. This is why with the emerging bricks-to-clicks online launches that many traditional retailers have undergone this year, it becomes even more expensive and more difficult for nascent Internet brands to gain scale.

In practice, we have seen Amazon, eToys and eBay all raise sales and marketing spending guidance in the past quarter. If they are feeling the pain, you can be assured the rest of the industry is as well.

Follow the eyeballs to find e-Christmas dollars
We agree that this year's consumer spending is likely to be up two to three times from last year's levels for most e-merchants. Certainly this is something to get excited about. The real winners may not be the merchants moving the goods, however, but the media networks like America Online, Yahoo and Lycos.

Even the traditional broadcast and outdoor media companies may be a place to look for strong ad revenues this season. After all, the airwaves and driveways are flooded with ".com" advertising this season, not to mention that roughly one-third of all Super Bowl spots are expected to be consumed by ".coms." And advertising rates have never been higher.

From an economic perspective, it makes a lot of sense that the media industry will be the big winner this season and beyond. The top eight Internet media networks (or portals, as they are commonly called) control more consumer usage (time) than the next 70 Web sites combined. Without access to those eyeballs, there is no Christmas for the e-merchant.

Like it or not, consumers are still finding their way to Internet storefronts through the portals. This is why AOL's backlog of advertising commitments has eclipsed $2 billion and Lycos' has topped $400 million. Access to eyeballs is everything.

Where do hard-earned dollars end up?
Looking at it from a margin perspective, we believe it's clear why the best way to play the e-tailing boom is to own the media players. Assume that, on average, the e-merchant captures a 20 percent gross margin. Said another way, twenty cents of every dollar is left to cover expenses after the e-merchant sells a product.

Now consider that e-merchants are spending roughly 50 percent of every revenue dollar on sales and marketing, most of which is going toward advertising on the network sites, television and radio. If we assume that gross margins in the advertising business are in the 90 percent range, it becomes clear that 45 cents of every revenue dollar won by the e-merchant ends up as gross profit for the media industry. This is more than two times the amount captured by the merchant. So if you wonder where your holiday shopping dollars are ending up, look no further than AOL, Yahoo, Lycos or CBS.

The bottom line is that although we remain excited about e-Christmas "the sequel," the competitive playing field has changed dramatically since last year. And, perhaps even more importantly, so have investor expectations. Profits matter, even in the season of good tidings.

The preceding comments should not be considered a recommendation concerning the purchase or sales of any securities mentioned herein.