Analysts Toll Bell for Some Online Retailers, See Future for 'Click-and-Mortars'

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After last week's volatility in high-tech stocks, leading securities analysts have all but given up hope for most Internet-only retailers.


Most retail stocks, from big names like Amazon.com to smaller entities like Value America, are down 30 percent to 95 percent from their 52-week highs.


"The next two quarters, you're going to see the vast majority of online retailers actually going out of business," said Tom Wyman, San Francisco-based analyst at J.P. Morgan Co. "By Christmastime, most of these retailers that aren't in a leadership position are gone because they have run out of cash and they can't get refinanced."


In question are weak business models plagued by failing management, low cash reserves, half-baked brands and no proprietary technology.


Warning signs are in: Companies like online grocer Peapod.com, music retailer CDnow.com, software seller Beyond.com and Value America, plus online stores in the health care, pet supplies and consumer products categories are now under merciless scrutiny.


Auditors have become nervous; senior management is resigning, and telephone calls are often not returned -- all indications that dot-coms that simply transplant the traditional business model online are failing.


"We focus on companies that we think are changing value chains of industries, companies like eBay, Priceline, Travelocity, Expedia and Digital River," said Mark Rowen, New York-based senior analyst at Prudential Securities. "In our view, those companies are clearly not going under. They are very viable businesses."


That opinion is echoed by Harry Wells, managing director of Boston-based securities firm Adams, Harkness & Hill. Though he adds Amazon to that list, Wells still has concerns about the Internet's retailing poster-child.


"Amazon, with their first-mover advantage, will make it," Wells admits. "I don't think it's as good a format as eBay or Priceline fundamentally. The problem you face with Amazon is that somebody can always come along and try to sell cheaper.


"The value in eBay or Priceline is the system itself, and with each additional user, the system becomes more valuable."


Wells is an enthusiastic proponent of "viral" marketing, a cheaper alternative to advertising and essentially the way eBay and Priceline grow their brands. Most online retailers have to spend anywhere from 30 percent to 60 percent of their annual budget on marketing.


And yet, it is often not the marketing that matters so much as the product for sale.


"There are certain product categories that, in my view, will never work online," said Dalton Chandler, vice president at New York-based Needham & Company. "What's the value of the product vs. the cost to store and ship it? Which means that small things that have high price tags work pretty well. Big things with small price tags don't."


Chandler points to online grocers and pet stores as weak candidates. He is also highly skeptical of online retailers that foray into print catalogs or magazines to bolster the bottom line.


"They figured out they're really a catalog company," Chandler said, "which is what most of these companies are. They're just online, rather than sending out chunks of paper.


"What's going to happen in the longer term is that a lot of these companies are going to run out of money and then they're either going to get merged or consolidated or they're going to go out of business."


Not all are that optimistic about buyouts, however. J.P. Morgan's Wyman firmly believes that only the No. 1 and No. 2 pure-play retailers will survive when the game's over by the end of the year. He advises haste.


"Get acquired quickly," Wyman suggests, "if, in fact, you have something of value to be acquired. That's what's so ugly about this, is that there's no merger and acquisition at the end of the day to save most of these initiatives."


"Because these are born-on-the-Web brands that never got built, management teams that never made any money, no proprietary technology," he said, "there's nothing to buy."


And that is not even taking into account the steady crop of traditional retailers going online. These established brands have taken their time to graduate to the Internet, recruiting the pertinent management and developing a different distribution strategy.


"Those dot-coms, we think, will survive in every case," Wyman said, "because they can drive traffic right from their physical stores and customers like the idea that they can return products to the physical stores. They're big national brands, and they've got huge pricing advantages."


J.P. Morgan research shows the industry growing at an annual clip of 50 percent to 70 percent; although, the trend is toward retailers that have created powerful brands, are multi-channel or are across multiple product categories like Amazon.


"In fact, one of the things you might see happen are some traditional retailers that haven't really done much online, when their online counterparts reach a certain level of distress, it would make sense for them to acquire those companies to get a jumpstart on their own online strategies," Needham's Chandler said.


"In the long run, it's the click-and-mortar that will win. There will be very few pure-play Internet retailers that will be successful," he predicted.


For the moment, Internet-only retailers are advised to reassess their strategies and curb their free-spending ways.


"They need to conserve cash," Adams, Harkness' Wells said. "The real trick to online retailing is can you generate more gross profit per customer -- which is the equivalent of same-store sales -- and can you attract the Net-new customer at even lower costs? Because if you can't, inevitably you're going out of business."
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