Blue Christmas

Baldwin Louie — Mon, 01 Jan 2001 17:00:00 -0500

No one needed cheer this holiday season more than online retailers. A slew of high-profile failures throughout the year tarnished the entire field; survivors needed a knockout holiday season to turn around investor sentiment and to help them assemble the funds they desperately need to stay in business.

But the season of hope turned into a season of gloom. With the notable exception of Amazon.com (AMZN), by Dec. 21 most online stores appeared to be falling short of their sales goals. In fact, the growth of online sales slowed even as many retailing giants made increasingly large commitments to the Web. On Dec. 15, the entire sector was stunned by news so dire it put into question the survival of one of e-retailing's brightest stars: Online toy seller eToys reported its holiday sales would be roughly half of what it had expected. The company, which will run out of cash by March 31, hired Goldman Sachs to find a buyer or merger partner.

Online stores are not the only ones suffering. Overall, America's retailers are expected to have one of their worst holiday seasons in a decade. To pick up sagging sales, Kmart (KM), for one, slashed prices and kept its stores open round the clock before Christmas. The economy's growth rate sputtered to 2.2 percent in the third quarter, its slowest pace in four years. And last week, not even Fed Chairman Alan Greenspan could put a stop to a seemingly endless stock market slide [see "The Market That Stole Christmas"] by suggesting that interest rate cuts might be in the offing. With uncertainty about the incoming administration's ability to steer the longest economic expansion in U.S. history toward a soft landing [see "Bush Builds a Team"], consumers are spending less and gravitating toward the myriad bargains lavished on them by anxious retailers.

Yet while traditional retailers have the staying power to weather tough times - as they have done before - that might not be true for much of what is left of the online retail sector.

Without a doubt, eToys (ETYS)' problems are uniquely its own. Once the leading online toy seller, it faced fierce competition this season from the recent and apparently successful partnership between Toys "R" Us and Amazon. Consumers were also frightened away after eToys famously failed to deliver some orders last year by Christmas. To make sure that didn't happen again this year, CEO Toby Lenk spent heavily to build two enormous warehouses to handle inventory and delivery; sales this season simply won't cover the outlay.

But eToys' shortfall is so severe - the company expects holiday sales to total between $120 million and $130 million, rather than the $210 million to $240 million it had forecast - that it calls into question the growth prospects for the entire sector. Already, research firm BizRate.com (dossier) has downgraded its holiday online-sales projections from $6.1 billion to $5.68 billion. Goldman Sachs says that sales growth will be at the low end of its projected range of 50 percent to 100 percent. That's bad news for any online retailer that needs to raise additional capital next year.

That includes companies with sluggish holiday traffic such as Buy.com and Cyberian Outpost (COOL), as well those whose business is not tied to the holidays, such as Webvan and Drugstore.com. "Of the companies that need cash, less than a handful will be able to raise it," says Anthony Noto, an analyst with Goldman Sachs. He adds that Egghead.com (EGGS), PlanetRx and a handful of others will need to raise money in 2001. Those that have managed to slash costs dramatically could survive on what they have; they are likely to reach profitability eventually, but in some cases their business will be so scaled back that they'll be comparatively insignificant.

Indeed, with the eToys flameout and the sluggish growth of the entire online retail sector, one basic assumption underlying the case for e-commerce optimism has been shattered. For Net retailers, dizzying growth was a given, as was the notion that Internet stores would increasingly steal market share from their offline counterparts. Investor skepticism focused on the retailers' ability to parlay that growth into profits.

Certainly retailing continues to grow faster online than offline. But most observers no longer expect Web stores to account for as much of total retailing - some estimates went as high as 20 percent - as they once did, at least not for the foreseeable future. And as of now, online retailing accounts for just 1 percent to 3 percent of all retailing.

Some dot-coms tried to distance themselves from the seasonal gloom, issuing press releases and conducting hastily arranged calls with investors to tout their performance.

In one such release Dec. 18, Drugstore.com said its November traffic was up 40 percent over the previous year, while sales during one recent week actually equaled sales for the entire holiday season last year. Cyberian Outpost said during a call with investors Thursday that its Outpost.com store recorded a 60 percent leap in sales during the first 19 days of December, compared with the same period a year earlier. The company added gross margin dollars had tripled during the same period. And designer apparel retailer Bluefly (BFLY) said its fourth-quarter sales were expected to surge about 90 percent; the growth, while impressive by this year's standards, is based on last season's modest total of $3 million.

Meanwhile, at a recent meeting to discuss the future of e-commerce, the chief executives of Drugstore, travel site Expedia (EXPE) and luxury-goods retailer Blue Nile, insisted that their companies will survive. They all forecast continued growth, pinning their hopes on their strong relationships with existing customers, broadband technologies and overseas expansions. But even roundtable participant John Doerr, a partner at Kleiner Perkins Caufield & Byers (dossier) who remains upbeat about e-commerce, predicted that only one in 20 companies in the sector would survive.

The reasons for the slowdown at online stores are abundant. The economic chill is partly to blame, as is the increased competition from brick-and-mortar stores. Companies such as Best Buy, Target and Wal-Mart, which for the first time this year have credible online efforts, have seen their traffic soar. Still, traffic is not always a good indicator of sales, and final holiday sales figures will not be known until January. In addition, online retailers have been forced to cut back on the lavish advertising and promotions that drove growth in years past.

Many experts also note that online shopping, while no longer a fringe phenomenon, is simply not ready for prime time. According to Kirthi Kalyanam, associate professor and director of e-commerce initiatives at Santa Clara University, an increasingly large number of early adopters is buying online and deepening the scope and size of online purchases. But online shopping needs to become easier before it can reach a truly mass audience. "For the mainstream shopper it is still not there," says Kalyanam.

The shortcomings of online commerce were all too apparent to shoppers who browsed through shelves stocked with Barbies, Play-Doh and stuffed animals at a Toys "R" Us in San Francisco the week before Christmas. For Bob Farese, on a mission to buy gifts for his three sons and two daughters, browsing online is too hard. "The choices are overwhelming," he says. "If you want pants from L.L. Bean (dossier), there are about 10 choices. If you want an action figure, there are about a hundred. It's a lot easier to scan this with your eye," he adds, waving at a wall packed with action models.

In the Westwood Village district of Los Angeles, Jackie Bailes says some of the novelty of online shopping had worn off. Bailes had made numerous Web purchases last year, but didn't expect to make any this holiday season. "I had good experiences, but I have more control if I go to the store," she explains. "I can comparison-shop and ask questions." This was more important now, adds Bailes, since she is trying to watch her spending this Christmas.

These price-worries seem to echo the concerns of many who did shop on the Internet. A survey of 3,200 online shoppers by Robertson Stephens (dossier) showed that more than half abandoned their shopping carts this holiday season because of shipping costs. What's more, 71 percent said they made purchases because of shipping promotions, which were prominent at stores such as Amazon and Best Buy.

"[Online] retailers are not making people happy on pricing," says Lauren Cooks Levitan, the Robertson Stephens analyst who conducted the survey. To compensate, online stores will have to focus on convenience. "That means you might end up with a smaller target market because there are more price shoppers than convenience shoppers," she says.

The most significant exception to all this bleakness seems to be Amazon, which continues to draw customers with its combination of selection, product reviews and reliability. Most analysts agree that Amazon is on track to meet, or even top, its $1 billion forecast for holiday sales. The company's Delight-O-Meter, which counts units sold since Nov. 2, surpassed 31 million last week, as the company continues to hold the top spot for shopping traffic. Its branded Toys "R" Us store alone is the second most-visited online shopping destination. "We certainly see significant growth in this business," says John Barbour, CEO of Toysrus.com, brushing aside any concerns of a slowdown.

Yet even some longtime Amazon bulls note there is reason to worry. Merrill Lynch (MER) analyst Henry Blodget says Amazon grew by nabbing market share from weaker rivals, such as eToys - not because of overall market growth. "What happens in six months to a year when there is no more market share to gain?" Blodget says.

To a large extent, Net retailing is suffering from its unrealized promise. So far, the vast majority of online stores have done little more than put up catalogs on a screen, forgoing features such as intelligent recommendations and personalization, according to Erik Brynjolfsson, a professor at MIT's Sloan School of Management who remains optimistic about the long-term prospects of e-commerce. For the short term, however, Brynjolfsson says he is less sanguine: "We are going to see a little accelerated Darwinism over the next few months."

Jennifer Couzin, Keith Perine and Kevin Roderick contributed to this story.

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