Dueling Fools
August 11, 1999
eToys Will be eToys
Bear Argument
By
Jeff Fischer (TMF Jeff)
eToys has done many things correctly from the beginning, with the notable exception of choosing an attractive business in which to operate.
With due respect, when an Internet think-tank dreamed up eToys, it didn't climb out on a limb. The company sells toys -- online. Aside from the three main components of the site's personalization offerings (a Wish List, a Gift Registry, and a Birthday Reminder service), eToys doesn't utilize the Internet's many potential advantages very well. It sells toys -- online.
This Duel's three bearish arguments focus on:
- The toy business
- The company's valuation
- The competitive landscape and the pure-play business model
If you like to invest in the low-margin, seasonal, toy retailing business, perhaps this online version will entice you. However, if toys are not your favorite investment "plaything," then eToys should not be a rattle in your portfolio's crib. You might buy toys from the company, and you might watch its business unfold from the sidelines -- because it is interesting to watch the impact of eToys on Toys "R" Us -- but you may not want to buy your stake in this tiny company, with $37 million in trailing sales, for the going rate of $4.1 billion (last week).
The business dynamics of the toy retailing industry are less than ideal. It presents difficult inventory management, a lack of constant rejuvenation via new products (unlike books, music and video, which have significant new releases weekly, if not daily), seasonal sales trends, and traditionally low returns on investment.
Toys "R" Us trades at 0.3 times $11.3 billion in revenue for a reason: toys are not the most attractive business in the galaxy. Typically, two-thirds of toy sales occur in the fourth quarter and profit margins are low. Inventory space (and therefore costs) can be a considerable issue and shipping costs, particularly when operating online, become more significant when mailing bulky toys, such as a doll house, a toy chest, or a Shooting Giant Windup Robot if you need it before next week.
Toys. If you weren't interested in off-line toy retailing pure-plays, an online version shouldn't make you jump up and down for joy either. Although, considering eToys' valuation, it has excited many investors.
eToys is valued at nearly $4.1 billion. Toys "R" Us is valued slightly lower, at $4.06 billion. However, I won't use the Wise comparison argument that goes, "These valuations are crazy!" After all, perhaps these valuations make sense. Toys "R" Us has $11.3 billion in sales and a market value of $4 billion. It has been profitable in the past and it is beginning an aggressive online initiative with an $80 million investment. eToys has $37 million in sales (0.33% of Toys "R" Us sales), is years away from potential profit, and it has a similar $4 billion market value.
What do the similar valuations mean?
They mean that investors see most of the estimated $39 billion in annual toy and baby sales moving online in the coming five to ten years, and they believe that eToys is in a position to capture much of the market. I won't argue with this. I don't need to argue. Instead, I merely need to point out that enough upside is already built into the stock of eToys to make it unattractive to the average investor.
Assume that eToys can capture 30% of the annual toy and baby market in the next decade, or $11.7 billion in annual sales (about what Toys "R" Us achieves now), and assume that its market valuation is granted a premium over traditional toy leaders. This being the case, what might be a fair price for the stock seven years from now? $8 billion? That's less than twice the current share price even before considering further share dilution. The S&P 500 doubles every seven years, on average, at much lower risk.
eToys will continue to leverage its customer base by entering more markets (as it has been), but the company is committed, for better or for worse, to the child market. Its corporate name doesn't allow much room for a broadening scope anyway. The "eToys" name wouldn't market grown-up books very well, for example, and although "eToys" could be used to market toys for grown-ups, management states that children will be its only focus. eToys will be a safe, excellent site for children. It already is. That is commendable, but I don't want to be a shareholder in a strictly toy business given the industry dynamics. Not even the leading online toy vendor entices me, and that Number One crown is up for grabs anyway.
eToys was the first mover and is the pure-play in toys. However -- counter to what we often read -- being the first mover isn't most important. Being the first to scale is what matters. First mover status does frequently mean that a company will be first to scale, too (thereby placing importance and the odds on the first mover), but this is far from always the outcome. The first mover often isn't the first to scale or the eventual winner.
eToys had 467,000 registered customers as of June 30, 1999, up 28% from the prior quarter. Amazon had over 10 million customers. The moment that Amazon added toys to its offerings this summer, it reached a customer base more than 20 times the size of the eToys customer base. In what is already a famous quote, after just one day of selling toys on its site, Amazon's CEO Jeff Bezos stated that he believed Amazon was the number one toy seller on the Web.
How can it be so powerful? Amazon was the first mover and the first to scale in popularizing online commerce. So, its eventual niche might prove just that large -- online commerce of all kinds.
Amazon took the lead in online music in a matter of weeks, and it conquered video even more quickly. Amazon sent music competitor CDnow <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CDNW)") else Response.Write("(Nasdaq: CDNW)") end if %> back to the boardroom. CDnow decided to merge with Columbia House, which is owned by Sony <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SNE)") else Response.Write("(NYSE: SNE)") end if %> and Time Warner <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TWX)") else Response.Write("(NYSE: TWX)") end if %>, largely, it is believed, because it couldn't compete with Amazon. CDnow was a pure-play in music, the way that eToys is a pure-play in toys. Bulls argued for CDnow by stating: "It is the pure play!" That argument proved powerless.
I don't believe that being a pure-play will always (or even often) prove beneficial in the online retailing world -- unless the "pure-play" is commerce as a whole. The Internet is about convenience. Convenience means one-stop shopping. One click. One bill. One company to deal with. And the Internet is highly personalized, meaning that you don't need to visit a pure-play retailer to feel that you're receiving close attention to your specific needs.
A one-stop retailer, which Amazon is becoming, can be personalized enough to meet your needs in any one of its departments just as well as a pure-play retailer can meet your needs in just one area. What does that mean? You don't need to visit the pure play. It will be much easier this December to buy all gifts (books, music, toys, electronics) from Amazon, rather than go to Amazon for books, CDnow for music, eToys for toys, and so forth.
eToys has excellent customer service and an easy-to-use Website. Amazon also has that and it offers much more convenience by allowing users to buy many other items beyond toys at the same time. It also has 20 times the shoppers and it added 2.3 million users last quarter compared to 102,000 at eToys. (And most new users at Amazon will naturally see Amazon as a place to buy toys, too.) I could mention that Wal-Mart is moving online with toys as well, but I don't respect Wal-Mart's potential online the way that I do Amazon. Wal-Mart is late and slow. Why would I want to shop there when Amazon has proven itself time and again?
The Bear argument comes down to the fact that eToys is in a less than ideal business, it trades at a price that arguably removes great upside but allows for substantial downside, and it vows to be a pure-play in a medium that I believe will prove to be about converging product offerings in order to provide the most convenience -- thereby making eToys an out-of-the-way destination for many shoppers.
Next: The Bull Responds