The Day Ahead: eToys collapse

If you missed out on the eToys IPO here's your chance to get an allegedly better deal than the institutional guys got back in May
Written by Larry Dignan, Contributor

EToys is trading at a 52-week low and is more than $3 (£1.86) shy of its May 20 IPO price.

Hard to believe that eToys, which went public at $20 and shot to a high of $86 closed Thursday down 20 percent to 16 7/8. That price is significant because eToys hovered around its IPO price and fell below it a few times, but never slumped below $19.

EToys' woes signal the official end of Wall Street's love affair with business-to-consumer e-tailing. However, we shouldn't get too carried away with bashing eToys, which will arguably be one of the survivors -- or at least a nice acquisition target.

EToys, which was tossed out like an old toy, looks great compared to some of those e-tailers that spent $2 in advertising for every $1 in revenue. Those soon-to-be-roadkill companies will be reporting earnings soon.

Here's the catalyst that had investors dumping eToys shares -- eToys reported strong sales but missed the "whisper numbers" for its fiscal third quarter. EToys lost 52 cents a share in the quarter on sales of $107m.

Shares were also hammered because eToys said it would take control of its fulfillment, which was very good but not perfect. EToys delivered goods to customers on time about 96 percent of the time with the success rate hitting 99 percent at the holiday peak. With the new facilities, there will be new expenses.

Officials, however, couldn't give guidance to how the bottom line would change. You'll have to wait a few more weeks for that info.

The response on Wall Street was predictable -- toss out eToys.

That reaction could be overdone, but does show how little patience Wall Street has with e-tailers these days.

EToys was slammed and it's one of the stronger e-tailers. For starters, eToys raked in big sales without discounting heavily or offering a lot of coupons. Discounting and free shipping was commonplace among e-tailers in the toy category and beyond.

EToys' competitor KBKids.com filed for an IPO on Thursday with all of $1.04m in sales through September 30. The company, which didn't give December figures in regulatory filings, said discounting and coupons led to it selling goods for less than it paid for them. Cyberian Outpost used free shipping as its marketing pitch and Amazon.com and CDNow among others handed out coupons like candy.

But eToys managed to stay above the fray. EToys CEO Toby Lenk said on a conference call that the company held the line on free shipping and coupons because those practices don't make long-term sense.

Lenk was trying to push a new metric -- quality sales, which would account for advertising spending, discounting and sales. Lenk boasted that the company spent $36m on advertising to drive $107m in revenue. That ratio could be considerably better than others this quarter.

"Spending a dollar on advertising for less than a dollar of revenue isn't sustainable," said Lenk. "There will be winners and losers."

Lenk's argument is partially on target, but analysts said the advertising-to-sales ratio should be measured annually not quarterly. Profits would be nice too. EToys' sales are expected to go from more than $100m in the December quarter to a little more than $20m in the March quarter. Lenk's advertising-to-sales ratio for eToys will change a bit for the worse.

But Lenk's point is clear: eToys will be one of the survivors in a crowded space that includes Amazon, Wal-Mart.com, Toysrus.com, Smarterkids.com and KBkids.com, a joint venture between Consolidated Stores and BrainPlay.com.

"I thought the report was positive," said Lauren Cooks Levitan, an analyst with Robertson Stephens, which was an underwriter for the eToys IPO. "EToys came out the leader and did so without succumbing to discounting."

So what's the problem?

Levitan said the unknowns about infrastructure costs are worrying Wall Street. If there's infrastructure spending, there will be larger losses ahead. "Long-term the infrastructure build-out is the right move," she said. "For long-term investors eToys is attractive, but for short-term investors it's too early."

Levitan said investors shouldn't have to wait until the December quarter of 2000 to see some eToys upside. Once the company details spending on its new facilities, clouds will clear and the stock should head north a bit. In a few more months, however, investors may abandon e-tailers totally.

The e-tailing shakeout is coming and the sooner it arrives the better eToys looks. Lenk said the shakeout will occur as soon as the equity markets stop financing big ad budgets for new .coms. When competitors implode, eToys argues it won't have to spend as much on marketing and will have the economies of scale and execution to thrive.

Levitan said Wall Street may eventually grow tired of funding upcoming e-tailers, but it's not clear when the big spending will end. "That's the wild-card," she said.

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