Web Retail's Higher-Fliers
Stores' Shopping Advantages Are Adding Up in the Market

By Catherine Rampell
Washington Post Staff Writer
Sunday, October 28, 2007

Amazon.com stock closed Friday at $90 a share, up 135 percent over a year ago. As buyers snap up everything from "Harry Potter" books to motor oil at the granddaddy of online retailers, its stock's nightmarish plunge from $106 to less than $6 a share after the tech bubble burst seems a distant memory.

And it's not just Amazon. Over the past year, shares of Blue Nile, a jeweler, have increased 103 percent; 1-800-Flowers.com, 124 percent; and GSI Commerce, a company that manages Web sites for retail companies, 45 percent.

Internet retail has been the bright spot in the sector for investors this year. People are more secure shopping online these days, according to analysts. Security breaches may still be a concern for some shoppers, though those can happen even at brick-and-mortar stores, said Patti Freeman Evans, an analyst at Jupiter Research, recalling the hacking of databases at TJX, which owns T.J. Maxx and Marshalls.

There are other reasons Internet shopping is up: It gives consumers more choice and is convenient. It saves on expensive gasoline. Broadband has gotten cheaper, and more households have Internet access: about 75 percent and growing rapidly, according to research firm Sanford C. Bernstein.

If the companies can get customers to their Web sites, it's often easier to make a profit that way. Operating costs are lower than traditional retail because of lower rent, inventory and personnel expenses. The customers are the kind retailers crave: Half of all online retail sales come from people with household incomes of more than $75,000, according to Jupiter Research.

Still, online shopping has a long way to go to compete with the real-world version. Although Internet sales are growing rapidly, up 20 to 35 percent each of the past five years, that growth has been from a small base. Only about 5.2 percent of U.S. consumer goods are purchased online, according to Jupiter Research.

During the first nine months of 2007, online retail spending totaled $84 billion, with the biggest growth coming in video games and consumer electronics, according to ComScore.

And cybershoppers can be a fickle lot, as the history of online retail has shown. This year's standouts show that if investors are going to put money on Internet retailers, they have to understand the retailer's competitive advantage and know whether it can last.

Not every Web-retail stock has fared well.

RedEnvelope and uBid.com survived the bursting of the dotcom bubble but have dropped about 44 and 68 percent, respectively, over the past year. Neither of those businesses was the first to market in its category, and neither has been able to distinguish itself from rivals, analysts say.

"If you don't have a viable winning strategy early on and don't get the formula very quickly, you get left behind, and it's hard to make up the ground," said Jeffrey Lindsay, an analyst at Sanford. "If you don't get onto that elevator at the ground floor, it's difficult to get on further up."

Amazon, founded more than a decade ago as an online bookseller, is an example of an early company that boomed, busted and clawed its way back to profitability.

The Seattle company was one of the first e-commerce sites, and its longtime leader Jeff Bezos is still at the helm. It initially turned a profit in late 2001, then started losing money because it continued to invest heavily in research and development.

Last year, it had a profit of $424 million on revenue of about $1 billion. The company's growth strategy is to focus on getting more repeat customers and to sell a greater variety of goods, including internationally. It is also cutting costs.

Amazon was "investing a huge amount into technology and content, which really crippled their margins over the last couple years," said Michael Souers, a specialty retail analyst at Standard & Poor's. "Now they're cutting back on pretty much everything."

Six years ago, the company spent 4.4 percent of its revenue on marketing, according to its financial reports. Now, it spends about 2 percent on advertising. Highly targeted search ads and e-mail marketing allow companies such as Amazon to invest more efficiently in marketing, according to Kristine M. Koerber, analyst at JMP Securities in San Francisco.

Amazon has cut back on some of its technology research and development, including abandoning a mapping feature last year on A9, its internal search engine. The mapping feature wasn't focused on Amazon's core mission of selling goods.

"A few years ago, the bulk of their investment was in the nuts and bolts. They were just trying to figure out how they can get a customer's order fulfilled," said Malindi Davies, an analyst with CIBC Markets. "Now, they're focused more on 'How do we make the customer happy?' "

Making the customer happy is not a simple formula. In some cases, it required Amazon to take risks that, at least initially, were unpopular on Wall Street.

In 2005, when its stock was trading at about $43, it started offering Amazon Prime, which allows unlimited two-day shipping and discounted overnight shipping for a flat fee of $79 a year. High gas prices and narrower margins made this an unpopular move with investors, and the stock dropped steadily for weeks after the announcement. Analysts say the stock's recent increase is partly attributable to the customer loyalty it won because of such initiatives.

The philosophy of having to lose some in order to win some has worked for Amazon in other respects, also.

Amazon has expanded outside its core business. The company made a big push to grow beyond books, CDs and movies, adding non-perishable groceries in 2006 and other commodities to its site. This year, it is experimenting with delivery of perishable groceries near Seattle.

"There was concern from some investors about whether their platform and brand name would stretch to those categories," said Lindsay. "Would buyers want to buy things like dry groceries online?"

Amazon's stock price fell steadily for a month after the initial grocery announcement. But "in the end, Amazon was proven right," Lindsay said. "Amazon expanded into these areas, and the [company's popular customer review system] worked well, and the revenues have proven it."

By selling more goods, Amazon can cater to changing tastes, another analyst said.

"The beauty of not being specialized in this case is that you can weather the shifts in retail spending and customer desire," said Scott Tilghman, analyst at Soleil Securities.

On the other hand, some highly specialized companies' stocks have also done well.

Blue Nile, started in 1999, has stuck to its plan to primarily sell diamond engagement rings.

The company focused on its narrow luxury niche and targeted its marketing on making consumers comfortable buying big-ticket items online. The company went public in 2004 and last year had a profit of $13 million on $251.6 million in revenue.

One key feature in building a successful online business is constant investment in consumers' trust, said Mark Vadon, Blue Nile founder and chief executive.

"If they understand what they're buying, they're more comfortable and more likely to purchase," Vadon said.

Online auctioneer eBay, whose stock is up 11.8 percent in the past 12 months, allows consumers to talk directly with vendors through Web chats and has encouraged consumers to educate each other. This month, it created eBay Neighborhoods, virtual communities of buyers and sellers who can share knowledge about products.

Now, online retailers say that their futures depend on international growth and that they are continuing to export the lessons they've learned in the United States to emerging markets in Europe, Asia, and Latin America.

Only about 2 percent of goods bought abroad are purchased online, according to CIBC World Markets.

"The product selection abroad is so much lower than that in the U.S., both in terms of breadth of products and the number of categories," said Tilghman.

For investors, international expansion means not only more potential customers, but also spreading the risk around, he said. "There's additional opportunity to mitigate the risk of being exposed to any one country's economy."