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Why May Not Be a Buy

Wall Street can be so fickle toward e-tailers. Take (AMZN). Even though the online store enjoys fat, 25% margins, analysts are cool on the shares because they've once again become expensive while sales growth (25% in the first nine months of 2005) is no longer white hot. In contrast, (OSTK) is growing 80% or more a year, but analysts carp that its 15% gross margins are too narrow.

The Street wants both: wide margins and rapid growth. When consumer-electronics retailer goes public in a deal expected to price Dec. 14, however, the market isn't going to get either one. The Aliso Viejo (Calif.)-based e-tailer epitomizes the Internet's boom and bust. Of all the crazy, early stage Internet business models,'s was one of the oddest: The company set out to sell stuff for less than wholesale and make up the difference in advertising.

The notion bit the dust long ago -- even before went public the first time, just before the bubble burst in 2000. The company went private in 2001, and public shareholders lost nearly all of their money (see BW Online, 1/26/05, "Back to the Future at").

SECOND TIME AROUND. So is any more attractive a deal this time around? Locked into the hot competition of the consumer-electronics market, tries to get by with only 10% gross margins. While is likely to turn profitable in the fourth quarter, the recipe doesn't look ripe to deliver fast profit growth. That's especially true since's sales grew only about 15% in the first nine months of 2005 -- well below the roughly 25% clip of all U.S. e-commerce. appears to combine what Wall Street likes least about Overstock and Amazon while lacking either company's redeeming qualities. "Compared to when they went public five years ago, they have higher gross margins, so their business model looks better," says Linda Killian, portfolio manager at the IPO Plus Aftermarket Fund in Greenwich, Conn. "But it's still an unprofitable company."

Citing legal concerns about commenting before a stock offering, representatives declined to be interviewed.

TOUGH LOSSES. Indeed,'s penchant for razor-thin margins still has the company in the red. In the first three quarters of this year, the company lost $8.4 million on $233 million in sales. The loss narrowed from $12.5 million in the same period in 2004, so Killian believes the company will probably eke out a fourth-quarter profit (it lost less than $1 million in the fourth quarter of 2004). But the improvement has come from lower noncash expenses such as reducing costs associated with the declining value of assets. Cash losses are actually getting larger.

Worse, nothing on the horizon suggests the improvement will be more than modest. Despite periodic attempts to diversify, is still concentrated in consumer electronics, where it gets 89% of sales. That's up from 87% last year. And with competitors including Best Buy (BBUY), Amazon, and Overstock, it's a tough place to make a buck. Online electronics customers are devotees of price-comparison sites such as and Shopzilla, which keeps pressure on prices and margins.

GETTING SOCIAL. is making an effort to jumpstart growth. The company highlights top sellers, newest arrivals, and limited items in a given category (see BW Online, 11/18/05, "Boosting E-Tailers’ Holiday Best"). It also set up a social-networking site, (yes, that's Buy spelled backward), aimed at getting consumers to use Buy for other purchases.

Yub surfers get discounts at other stores, giving them an incentive to go to Yub to check out products and ask other Yub members' opinions before buying. But initiatives including Yub haven't delivered much yet, so it's hard to say whether they'll have the desired effect.

In addition,'s plans for the $45 million it will raise from the offering are modest. The e-tailer expects to spend $25 million on a marketing campaign, according to a filing with the Securities & Exchange Commission. That's a nice bump from the $13.4 million spent on marketing in the first nine months, but nothing that looks like a game changer. At 10% gross margins, the campaign would have to generate at least another $120 million in annual sales to pay off. That's a 50% sales gain -- a lot to bet on.

UPS AND DOWNS. So if isn't an Amazon or even an Overstock, what is it? Signs suggest that Killian's projection on profitability is correct -- that will be profitable in the foreseeable future. No analogy is precise, but the closest fit among public e-tailers may be RedEnvelope (REDE), another small online store that has bounced just below the break-even mark, losing $5.2 million in the first six months of its current fiscal year on $38.1 million in sales. Its most recent forecast calls for sales growth of at least 20% for the full year.

Even before RedEnvelope went public, other small e-tailers were saying privately that the company wasn't growing fast enough to deliver gains for public shareholders. And they were right: The stock has bounced down, and lately up, since going public in 2003 at $14 a share. Today it trades at $11.12. looks like that kind of a stock.'s outlook could certainly be bleaker, but it's not an especially promising investment either, with so many Web companies doing much better. If you find shares of in your stocking this Christmas, you're not getting a lump of coal. But in an analogy shoppers will surely understand, it's not exactly a new iPod.

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