Why own e-commerce stocks?

It is quite obvious from the amount of negative press during the past six months and the performance of the Internet e-tailing index that the enthusiasm for the consumer e-commerce and e-tailing sectors has waned significantly from the levels of just a year ago. Given the level of negative sentiment, I thought it might be refreshing to remind readers why consumer e-commerce or e-tailing stocks can be attractive investment vehicles. But first I want to be clear about my position on the sector.

I continue to be a bull for quality leadership companies within each vertical segment. I am often asked how I can be so positive when so many companies will likely fail and the sentiment is so negative. My response is the same today as it was when I wrote our outlook for 2000 research piece in December 1999: I am only positive on the leaders in each vertical space that compare well to our list of critical success factors.

My list of leaders contains only 10 names, implying that the other 35 companies on the list will struggle to continue as standalone businesses. We arrived at 10 names by picking one or two companies within each vertical segment of the consumer and e-tailing markets that compared well against our success factors.

The distinction of vertical segments is key because the success of a company in the children's market is independent of the success of a company in the drugstore market. The reason for the independence is that consumers have different demands and needs for different products. In fact, consumer demand as opposed to other sectors of the gross domestic product is relatively predictable. This predictability is a good segue to the main topic: why investors should own consumer e-commerce stock.

Consumer e-commerce stocks are attractive because they can provide both superior earnings power--measured by return on invested capital (ROIC)--and low volatility or consistency of earnings growth. Other securities typically have only one of these two characteristics, but rarely both.

For example, technology companies typically have high earnings power (ROIC greater than 70 percent) but high volatility because of lower consistency of earnings. Traditional retailers or consumer products companies, however, provide consistent or little volatility in earnings growth but low earnings power (ROIC less than 35 percent).

To support my assertion, it's important to understand why consumer e-commerce companies have greater predictability in earnings and how consumer e-commerce companies can achieve levels of earnings power that their land-based brethren have long envied.

Consistency and predictability of earnings
Historically, consumer businesses have had greater consistency of earnings because the drivers of growth are more stable and predictable. At the macro level, growth is driven by the number of consumers and how much they spend.

The first variable, the growth in the number of consumers, has become quite stable and is highly correlated with the growth of the population. The second variable, the amount consumers spend, has greater variability, but the changes are not sudden and are driven by slow-changing indicators such as wage growth, debt capacity and consumer confidence.

Therefore, the consumer sector is relatively more predictable than most technology sectors, where earnings growth is driven by less predictable and much faster-changing variables.

For example, a new, more advanced software application can deplete the sales of the incumbent leader in less than one quarter. The demand side of technology companies can change based on the evolution of business models and the change in a widely accepted platform. In consumer businesses there is less of a risk of a bubble, because consumers are always there, and their behavior changes slowly.

Superior earnings power
Of course, earnings power for consumer e-commerce and e-tailing is still theoretical because these companies have not reached the scale to measure actual ROIC. Thus, we are left with evaluating potential ROIC. Even the potential levels of ROIC are quite believable as we evaluate the conditions required to achieve them.

As we can see from the chart below, I have laid out examples of different types of companies and the two factors that drive ROIC, operating margins and operating assets (the physical assets of the company, plus inventory and networking capital) as a percentage of revenue.

Historically, consumer businesses or retailers have fallen into the bottom left-hand quadrant with low operating margins and high assets as a percent of revenue, as with Wal-Mart (20 to 25 percent ROIC with 5 to 6 percent operating margins and 20 to 25 percent operating assets as percent of revenue). Some technology companies, such as Applied Materials, are characterized by high operating margins (20 percent) but also by high assets as a percent of revenue (25 percent), resulting in strong ROIC of 80 percent.

Consumer e-commerce companies are positioned to fall in the two right-hand quadrants. First let's look at companies such as eBay and Priceline. Both companies are forecast to have operating margins in the 10 to 30 percent range combined with less than 1 percent of operating assets as a percent of revenue. These companies will be very prosperous. They have no need for physical assets and leverage the Internet to maximize on virtual commerce.

Amazon, meanwhile, has the potential to migrate from the bottom right-hand quadrant to the top right-hand quadrant if it achieves operating margins of 10 percent--higher than those of traditional retailers, such as Wal-Mart.

Let's assume that Amazon achieves operating margins of only 5 percent--the same as Wal-Mart. In that case (which is unlikely as Amazon adds high-margin revenue from services and advertising), Amazon is still positioned to have superior earnings power relative to consumer companies with ROIC in the 80 to 100 percent-plus range. Why? Because it will drive its operating income with substantially less operating assets as a percent of revenue at 3 to 9 percent than Wal-Mart at 20 to 25 percent.

So, the logical question to ask is, When can these companies achieve triple-digit ROIC? We believe it's sooner rather than later. eBay and Priceline are poised to be the first two companies to reach triple-digit ROIC. Though both companies will likely do that in 2001, eBay is poised have significant ROIC in 2000 north of 60 percent.

A director and/or employee of Goldman, Sachs & Co. is a director of Wal-Mart Stores Inc. An affiliate of Goldman, Sachs & Co. has acted as dealer in the commercial paper of the following companies and/or affiliates thereof within the past 12 months: Wal-Mart Stores Inc. Goldman, Sachs & Co. or an affiliate has managed or co-managed a public offering of the following companies' securities in the past several years: eBay Inc. and Wal-Mart Stores Inc. Goldman Sachs & Co. or an affiliate makes an over-the-counter market in Applied Materials Inc. common stock; Amazon.com Inc. common stock; eBay Inc. common stock; Priceline.com Inc. common stock. Goldman, Sachs & Co. or an affiliate has rendered significant corporate finance services to the following companies or one of its affiliates within the past 12 months: eBay Inc., Priceline.com Inc. and Wal-Mart Stores Inc. Goldman, Sachs & Co. or an affiliate may deal as principal in any of the securities mentioned.