Cashing in on the e-commerce frenzy

With public catalog companies trading at 12-25 times after-tax earnings while e-commerce companies such as trade at 12-25 times sales, smart mailers are looking for ways to cash in on the high Web valuation frenzy.

Catalogers have several options to try to benefit from high e-commerce valuations. For starters, catalog companies can announce Internet initiatives. This strategy has sent the stock prices of a few companies, such as menswear cataloger/retailer Jos. A. Banks and wine merchant Geerlings & Wade, closer to Internet valuation territory – but only temporarily. Investors tend to overreact in both directions, first driving up the price of stock at the mere mention of the Web, and then backing away from the stock too soon. Until the investing public really understands that catalogs arewell positioned to benefit from e-commerce because they already have the back-end in place, Internet initiatives won’t result in sustained share price increases.

Another strategy for catalogers is to spin off their e-commerce business. Teen apparel cataloger Delia’s, for one, sold 25% of its iTurf e-commerce subsidiary in a public offering in early April. Initially priced at $22, the shares peaked at $66 in the next day’s trading, momentarily valuing iTurf at more than $1 billion, or 250 times its revenue in the previous fiscal year. The spin-off enabled the company to raise more than $90 million to build its e-commerce business, more than it would have generated by selling additional shares of the parent company, which is valued at far lower multiples.

Some direct marketers have tried going public as e-commerce companies. Floral marketers 1-800-Flowers and (the former FTD) are both in registration for initial public offerings (IPOs), with both leaning heavily on e-commerce as part of their pitch. Yet both still receive the majority of their revenue from telephone sales rather than the Web. Catalogers should keep a close eye on how Wall Street receives these firms. If they achieve valuations significantly higher than those of traditional mailers, it could bode well for catalogers with fledgling e-commerce businesses looking to board the Internet IPO bandwagon.

Catalogers could also consider selling their catalog business to an Internet company. Many recent mergers and acquisitions by and of e-commerce companies have taken place at extremely high valuations. But only a few of these deals have resulted in any meaningful amount of cash to the sellers. Instead, most have involved stock exchanges, and sellers who receive stock are typically restricted from selling those shares anytime soon – shares that may have been wildly overvalued at the time they received them. As a result, these sellers haven’t really sold in the true sense of the word; they have merely exchanged one risky and nonliquid asset (shares in their company) for another (shares in the buyer’s company).

The other problem with this strategy is that many e-commerce companies have focused on acquiring other Internet companies rather than teaming up with traditional catalog businesses. Web-only marketers have not yet realized how valuable the acquisition of a catalog would be in helping them learn how to generate orders and fulfill them properly.

Putting a price on it

What accounts for these incredible e-commerce valuations? A good analogy is how biotechnology companies captured the imagination of Wall Street and institutional equity investors in the late ’80s and early ’90s. There was a circular logic at work: Very high public valuations for money-losing companies enabled the initial private investors to exit at high multiples, which in turn spawned new startups, more venture investment, and eventually, a glut of IPOs.

Investors backed away from biotech once they realized the time and money required to bring a drug to the clinical trial stage, and once they learned that most new drugs fail to get approved. As a result, few biotech IPOs have been issued since 1996, and public biotech companies’ share prices have lagged considerably behind Nasdaq since early 1997.

Until recently, e-commerce companies have been trading largely on promise, not on results – just like the early days of biotechnology stocks. Money has poured into the sector despite the lack of many proven, profitable Web retailers.

Moreover, underwriters have become ever more aggressive in pricing e-commerce IPOs. Toys marketer eToys was originally expected to be priced at $10-$12 per share, but was upped to $18-$20 shortly before the offering this past May. The stock finally opened at $20. Similarly, book seller’s expected price range was raised from $11-$13 per share to $16-$18 shortly before its IPO in May; it opened at $18. A recent Wall Street Journal column interpreted this trend toward drastic, 11th-hour price increases as “a clear indication of the lack of expertise in this field” of valuing Internet stocks.

Take eToys as an example: The company sold more than 8.3 million shares at $20 in its IPO on May 21, giving it an initial market capitalization – in other words, a total valuation – of more than $2 billion. Note that Forrester Research projects online toy sales at $1.5 billion by 2003. That means eToys was initially valued at 133% of projected sales of the total industry four years from now. When eToys’ share price peaked at $85 later that day, its market capitalization was $7.6 billion. Meanwhile, for the fiscal year ended March 31, eToys had revenue of $30 million and a net loss of $28.6 million.

At the same time, retail toy giant Toys ‘R’ Us had a market capitalization of $5.8 billion – $1.8 billion less than that of eToys, despite annual revenue of $11.2 billion.

Why should eToys be valued at nearly 70 times revenue while Toys ‘R’ Us trades at 50% of sales? Because when pricing an IPO in this environment, underwriters are more concerned with what the market will bear than with a company’s intrinsic value.

But these inflated e-commerce valuations will not be sustained forever. Thanks to a string of high-flying IPOs and never-ending coverage in the press, investors have become more knowledgeable about this emerging industry. No longer satisfied with revenue growth alone, investors have also begun to seek companies that have a defensible selling proposition and a business model that will deliver profits within a reasonable time frame.

For example, the stock price of online computer marketer/auction house Onsale reached a peak of $108 in November ’98, driven by optimism about Web holiday sales. Investors have since begun to wonder if Onsale’s wholesale pricing model can ever generate meaningful profits and if it can continue to attract new customers, given the number of other Websites now also selling on price. By May, Onsale’s shares were trading below $20, despite the fact that first-quarter revenue was up 69%.

In today’s environment, where every credible e-commerce company offers its customers convenience, massive selection, and entertaining content, what will be the new basis for competition? The answer seems to be all of the above – plus the lowest prices. When said it would lower its prices on New York Times best-sellers to 50% off the cover prices, it was matched by identical price cuts at three competitors. Whether Web companies can offer all of these benefits to consumers at rock-bottom prices and still deliver a profit is yet to be proved.

E-commerce companies are now engaged in an expensive war for market share, spending whatever it takes to generate traffic today in the hope that this will translate into profit tomorrow. But as catalogers know, acquiring customers at a loss is a gamble. Especially in the Web world of easy comparison shopping, e-consumers will base their buying decision on a site’s current offering – not on how or from whom they have shopped before.

The recent volatility of e-commerce stocks reflects that the supply now more closely matches demand, and that buyers can afford to be more selective. There is no doubt that the Internet has the power to revolutionize retailing; it’s just that we don’t yet know how.

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