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Are eBay and Amazon swimming naked?
The growth strategies of the two big online retailers may not boost the stocks in the short term.
February 9, 2005: 2:14 PM EST
By Eric Hellweg, CNN/Money contributing columnist

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BOSTON (CNN/Money) - February is proving to be the cruelest month for online retail and e-commerce investors, although January was no peach either. In the past two weeks, sector bellwethers Amazon.com and eBay, as well as erstwhile stellar performer Overstock.com, have taken a drubbing in the market.

The culprits? Slowing growth and increasing competition, which are forcing the companies to boost capital expenditures.

Maturing markets

For this column we'll focus primarily on Amazon (Research) and eBay (Research). (I'll look at Overstock in the near future.) I admit that my first reaction after reading through these companies' most recent earnings reports and listening to their post-earnings conference calls was, "Is this the start of the e-commerce and retail sector morphing out of its growth phase and into a mature market?"

"That's exactly what's going on," says Scott Devitt, an analyst with Legg Mason. "You've had three years of tremendous post-bubble growth. Now the companies have to reinvest."

Other analysts are sounding similar warnings. Jupiter Research's Patti Freeman Evans says, "By 2009, 70 percent of all online users will have made a purchase online, and that's where we're expecting the online buyer penetration to top out."

Freeman Evans explains that the transition from attracting new users to encouraging existing customers to buy more will be tricky -- but imperative. "Independent spending growth [by existing customers] will be a larger driver in five years' time," she says.

Given the volatility in the marketplace and the serious transition these companies are undergoing, investors need to pay attention to the initiatives the companies are announcing to fuel growth in a tighter market.

Consider this contrast: While Google, a leader in the currently boundless paid-search market, saw no resistance to possible price increases for its service, eBay backpedaled from some of its proposed fee increases.

Market maneuvers

But of the two companies -- eBay and Amazon -- eBay seems better positioned to maneuver the constricting market than Amazon. Look at the three initiatives it's announced: focusing on PayPal growth for offline merchants, international growth for its auctions (specifically in China), and international PayPal use.

"Their growth rate internationally is still above 50 percent," Devitt says. "If [eBay is] at 37 times forward earnings and maintaining 30 percent margins, that's a good investment at current valuations." eBay has shed nearly 30 percent of its value since its last earnings announcement.

Amazon, on the other hand, is in a pretty tight spot and has yet to offer up growth strategies that resonate with investors.

"Competition is seriously hurting Amazon and it needs to increase spending just to keep up with the market," writes Safa Rashtchy, an analyst with Piper Jaffray. "The picture is getting worse: more spending, steeper decline in margins."

Recently Amazon has announced extended movie trailers on its site, photo-enhanced location capabilities for its A9 search engine, and Amazon Prime, a membership program offering low, flat-rate shipping costs for an annual fee of $79.

CEO Jeff Bezos calls Amazon Prime "perhaps the most expensive thing we've done since free Super Saver shipping."

The A9 developments are in the local-search category, a growing area, but will photos translate into revenue? "[There's] no clear explanation for increased spending or when we will see the benefits," Rashtchy writes.

Wall Street hates it when companies spend on growth, because it hurts earnings in the short term. Therefore, investors looking longer term should expect volatility during this transition and should base investment decisions in large part on the maps the companies lay out.

It's happened before: Devitt cites how eBay's stock fell in 1999 when it first announced international plans. International revenue now accounts for nearly 50 percent of the company's sales.

The rising-tide effect enjoyed for so long by so many e-commerce and online retail companies may finally be receding. But as the Sage of Omaha, Warren Buffett, says, "It's only when the tide goes out that you learn who's been swimming naked."


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