Net Retail's Grim Reality - Industry Trend or Event

Retail sales have slowed their shift to the Web, which may spell re trouble for e-commerce stocks.

As Amazon.com reported lower second-quarter revenues than analysts had expected, other key indicators are signaling an e-commerce slowdown. So, inflated dot-com valuations -- supported by a vision of continued strong e-commerce growth -- may no longer be valid.

Online retail sales dropped during the second quarter as overall U.S. retail sales grew. The U.S. Department of Commerce estimates that total U.S. retail activity reached $817 billion in the second quarter, up 9.2 percent from first-quarter levels of $748 billion. Though Commerce Department second-quarter e-commerce data will not come out until later this month, e-commerce researcher BizRate.com's data show that online retail activity fell 13.2 percent to $7.1 billion from first-quarter levels near $8.2 billion.

Retail sales are inherently seasonal, with first-quarter results at the lowest level. In the second quarter, retail activity usually jumps and remains near that level throughout the third quarter. Holiday buying then contributes to a dramatic spike in the fourth quarter. In the last few years, e-commerce has defied this growth pattern, as each successive quarter increased regardless of season.

But that may no longer be the case. The appearance of seasonal slumps at this early stage in digital retail's evolution comes as a surprise. Analysts had expected Net retail levels would continue to rise consistently quarter-over-quarter for the next few years as new consumers turned to the Net to purchase goods and more retail sales were driven online.

To date, much e-commerce growth can be attributed to the unprecedented growth in the U.S. economy over the past decade. Retail activity reflects that growth, driven by consumer confidence in the economy and personal financial circumstances. This prosperity, however, has concerned Federal Reserve Board Chairman Alan Greenspan. With growth comes the potential for inflation. To allay inflationary pressures, the Federal Reserve Open Market Committee has raised interest rates six times in its last 10 meetings. Early signs seem to indicate that Fed rate hikes are working. The Federal Reserve notes that growth continued in April and May, but was cooler than the white-hot first quarter.

This slowdown, however, could spell trouble for online retailers. According to BizRate.com, 79 percent of the $8.15 billion in purchases made online during the first quarter of this year flowed to three categories: computer goods, gifts and flowers, and entertainment. Consumer goods took just 9 percent of the total. This indicates that a majority of online purchases are for nonessential items. During an economic slowdown, these purchases would be the first to decline. And of the top three categories, only spending on gifts and flowers rose during the first quarter. The others each sank by around 25 percent.

"It may be that in some sense the thrill is gone," notes Jeff Krell, senior manager of analytics at BizRate.com. "The fall is not being driven by smaller shopping carts, it's being driven by fewer purchases." While the average order size remained nearly the same in the second quarter ($112, VS. $111 in the first quarter), 8 percent fewer orders were made online.

More troubling, the percentage of buyers new to e-commerce has remained nearly flat since the fall of last year. Amazon's quarter corroborates this. The company's percentage of sales coming from new customers dropped to 22 percent from 30 percent a year ago, hinting at Amazon's slowing ability to bring in new customers.

Many companies cut marketing spending last quarter under pressure from investors tired of huge losses. But Amazon's results may show that these reductions hurt a company's ability to draw new customers. In fact, Lehman Brothers analyst Holly Becker partly attributes her recent decision to lower her rating on Amazon's stock to the potential requirement that online firms will have to keep spending massive amounts of money on marketing to entice buyers online. Offline retailers, on the other hand, have storefronts to remind buyers of their presence.

Experts also note that future e-commerce growth may not meet expectations because the most-affluent demographic groups are already online. As the Net population continues to swell, the ranks of online buyers will have less disposable income and are likely to purchase less on average than current buyers.

After this quarter's earnings announcements, it seems Net commerce companies - all of which are still highly valued relative to their offline counterparts - are transitioning from extreme-growth to more moderate-growth revenue scenarios. And if this assumption of hyper-growth is no longer valid, then neither are the current valuations of e-commerce stocks. For instance, Priceline.com's stock fell 22.3 percent on news that second-quarter revenues were not as strong as investors had expected.

Merrill Lynch Internet analyst Henry Blodget noted in a recent release regarding Yahoo's second-quarter earnings report: "E-commerce transaction volume was flat at $1 billion for the quarter, a clear indication of the slowdown in the growth of e-commerce in the U.S. market." Blodget added, "Yahoo appears to have performed well relative to the rest of the industry in commerce, but the flatness suggests that investors should not count on commerce to drive future sequential growth."

Many offline retailers like Gap and Wal-Mart are mobilized to increase the volume of sales generated by the Web. So if e-commerce levels continue to sag, and if more online-only retailers miss targets for growth, the gap between online and offline retail stock prices will be even harder to justify.

Because the Fed's most recent rate hikes have yet to impact the market, economic slowing may be on the horizon. It will take another blockbuster holiday season to revive sales levels at online stores. But that's still two quarters away, so the decline in Net commerce stocks may be far from over.

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