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E-tailers play catch-up

To date, the Internet retailing sector has underperformed against other major indexes, with e-tailing stocks down an average 13 percent while the tech-heavy Nasdaq has climbed 20 percent.

It's been an ugly two months in the e-tailing industry.

To date, the sector has underperformed against other major indexes, with e-tailing stocks down an average 13 percent while the tech-heavy Nasdaq has climbed 20 percent.

Like the divergent paths the Nasdaq and Dow Jones industrial average have taken in performance this year, so, too, has the e-tailing sector strayed when compared with the Goldman Sachs Internet index and other Internet segments, such as business-to-business (B2B) stocks.

Although there are numerous issues putting pressure on e-tailing stocks, three main culprits are at work.

Investors' attention has shifted to B2B and Internet infrastructure stocks from business-to-consumer investments. This situation is similar to last year, when sites selling directly to consumers were the stars stealing investor attention away from Internet portals--the hot sector prior to business-to-consumer.

E-tailing stocks also are under pressure as these companies put more shares into the market to fund expansion via secondary and convertible debt offerings. Amazon.com's stock has declined 19 percent since it filed a $600 million euro convertible debt offering, and Drugstore.com shares have declined 25 percent since it filed for a secondary offering.

Given the large number of IPOs in the e-tailing sector last year, many companies have ended or soon will end their lockup periods, allowing more shares to hit the market as insiders, employees and early investors can begin selling their stock.

Finally, the significant number of IPOs funded last year with limited discrimination and a substantial level of capital creates the potential for shakeup and consolidation--creating uncertainty about the sector's winners and losers and keeping momentum investors away.

So what is the outlook for the e-tailing sector in 2000, and what will it take to regain momentum?

As was the case in 1999, I think the leading e-commerce companies, rather than the entire sector, will rebound in 2000. This would be in the same manner that leading portals and search engines rebounded in late 1999 after being out of favor during the summer of 1999.

A few select companies, such as eBay, Priceline.com and Amazon, are likely to outperform without catalysts to drive the business-to-consumer sector. These companies all share the common characteristic of significant scale and leadership positions, strong and established brand names, large customer bases and near-term profitability potential, or actual profits.

Because of these characteristics, they have a larger base of non-momentum or mutual fund investors that allows them to transcend the performance of the broader sector. In fact, during the past four weeks we have seen the start of upward movement in eBay's and Priceline's stock prices.

There also are companies that could experience a significant rise in their share price if they post a strong financial performance or have some other catalyst to drive the stock, in conjunction with a sector catalyst or a rebound in the sector.

And what will it take to regain momentum in the consumer e-commerce market?

There are several sector catalysts that could drive outperformance of selected companies in the e-tailing sector by mid-summer to early fall.

These catalysts include investment in consumer e-commerce stocks by new investor groups beyond momentum and technology investors, a cooling interest in business-to-business stocks, the evolution of the e-tailing business model to new e-commerce strategies, and a slowdown in technology IPOs.

When it comes to new investor groups, I have noticed a significant level of interest from a different investor constituency during the past several weeks. Increasingly, value investors and those seeking stocks with growth at a reasonable price have been inquiring about several of last year's leading stocks that have since suffered more than 50 percent declines from their 52-week highs.

The large declines make many of these securities potential investment opportunities for these two sets of investors based on their investment criteria--companies with greater than a 40 to 50 percent decline from their 52-week highs.

Given that these two investor groups also have found limited opportunities in "old-economy value stocks," these "new-economy value stocks" provide an attractive opportunity because of the relative outperformance of the Internet and technology sectors. If this scenario were to become a reality, many of the leading e-tailers--such as Priceline, Amazon, eBay, Webvan and eToys, which are all down significantly from their 52-week highs--could regain the attention of the broader market. But that's providing a catalyst can be seen on the horizon.

Meanwhile, the issue of a hot sector cooling, like B2B, is déjà vu.

"We have seen this movie before," Michael Parekh, head of the Goldman Sachs Internet Research team, has often said, referring to the repetition of events that occur in the broader Internet sector. Specifically, the cycle that occurred in the consumer e-commerce sector in late 1999 could similarly occur for the business-to-business e-commerce sector in 2000.

The enthusiasm for the business-to-business e-commerce sector in 1998 and early 1999 resulted in 29 IPOs during 1999 and, in many instances, exorbitant valuations driven by limited stock supply, short squeezes and momentum investing. By late fall 1999, an overabundance of IPOs led to investor uncertainty, speculation about likely winners and losers, and a lowering of valuations. All of these concerns weighed on the sector, and investors began to swing back to the older, forgotten sectors of Internet portals and search engines, which had fallen out of favor when consumer e-commerce emerged as the "new, new thing."

Companies such as America Online and Yahoo have recovered and appreciated about 33 percent and 179 percent, respectively, from their 52-week lows in early August, as investors returned to these forgotten sectors and invested in the leaders.

Meanwhile, many e-commerce companies are positioned to transcend their business models from selling just products to selling services and solutions. This type of business model carries higher profit margins and requires no additional fixed assets, such as new buildings or equipment. As a result, consumer e-commerce companies may be able to increase their potential return on invested capital, which should drive higher valuations for those companies. This issue will be delved into further April 3-5, when Goldman Sachs holds its first e-tailing conference in Las Vegas.

Among the four catalysts to pump life into the e-tailing sector, a slowdown in deal flow is the least likely to occur. But should that happen, investors would need to start focusing on new investment opportunities other than IPOs.

Given the need for these catalysts, investors may begin to question: When will the e-tailing sector turn around?

Pinpointing a rebound is extremely difficult, as many of the catalysts I have outlined depend on market sentiment. I think, however, that eBay, Priceline and Amazon can capture gains without near-term sector catalysts because each company has emerged with an e-commerce model that spans multiple Internet sectors, and each has attracted a broad investor base.

In addition, not all stocks will rebound, as the market will begin to recognize and discriminate between winners and losers. That said, I maintain that the tier-one companies measuring very well against our list of critical success factors will remain the leaders within their sectors. These companies include Amazon, Ashford.com, Barnesandnoble.com, Drugstore.com, eBay, eToys, 1-800-Flowers.com, PlanetRx.com, Priceline and Webvan.

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