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<DAILY TROUBLE>
Friday, July 23, 1999


eToys.com
(Nasdaq: ETYS)
Phone: 310-664-8100
Website: www.etoys.com
Price (7/22/99): $36 3/4

HOW DID IT FIND TROUBLE?

"Luke, this is your father.

"Yes, I was once a cute little boy with a passion for pod racing. The Force percolated in my blood, driving me to do impossible, crazy stunts years before I proved vainglorious enough to be seduced by the Emperor. But never would I have thought of paying over 300 times sales for an unprofitable Internet retailer!"

OK, so Darth Vader didn't really say that. But investors who picked up shares of eToys after it started trading on May 20 have confronted the Dark Side of Internet IPOs. Though it rocketed to $85 from an initial offering price of just $20, it quickly fell back to Tatooine with the thud of the cocky Sebulba crashing his pod.

Sure, eToys had a good story to tell. With smart venture capital funding from the Internet incubator company idealab!, Intel (Nasdaq: INTC), Highland Capital, and Sequoia Capital, the pedigree was right.

Better yet, eToys had been a hit during Christmas '98, attracting 3.4 million visitors during the holidays, or three times as many as the Toys R Us (NYSE: TOY) website. The fact that eToys had been featured in Visa's credit card ads surely helped lend credibility to this startup.

Before it went public, eToys had also managed to wrestle BabyCenter.com away from Amazon.com (Nasdaq: AMZN), indicating it was already diversifying its offerings to include a broad line of products for kids and their parents.

Moreover, eToys picked a particularly auspicious time to go public. The building excitement over the May 17 premier of the Star Wars prequel pushed up shares of toy maker Hasbro (NYSE: HAS) and sparked investor interest in out-of-favor toy retailers.

In addition, Toys R Us had announced in April that it would spin off its Web operations, partly so ToysRUs.com would be able to compete aggressively against eToys. Investors read that as a sign that this upstart was already the market leader.

Still, investors needed to consider the uncomfortable fact that on May 20, Toys R Us sported $11 billion in annual sales but an enterprise value of just $6.5 billion while, at its high, eToys carried an $11.4 billion price tag despite recording just $30 million in FY99 toy sales. Such a disparity suggested that traders were granting eToys a completely unjustifiable premium.

BUSINESS DESCRIPTION

Based in Santa Monica, California, eToys is a leading Internet retailer for children's products. It sells a broad selection of toys, software, books, videos, music, video games, and baby-oriented products.

On July 1, eToys completed the acquisition of BabyCenter, which operates BabyCenter.com, a website that offers content, community, and products for expectant mothers and new parents. eToys plans to run this business as a separate subsidiary.

On July 22, it signed a marketing deal with America Online (NYSE: AOL), which will feature BabyCenter on its health, family, and shopping channels. eToys already has its own marketing deal with AOL.

After the IPO, insiders owned 39.4% of eToys, including a 7.4% stake held by CEO and founder Toby Link. idealab! and other venture backers controlled another 53% of the stock. These figures have since been diluted by the 18.7 million shares issued or reserved for BabyCenter shareowners.

FINANCIAL FACTS

Income Statement*
12-month sales: $34.7 million
12-month income: ($73.1 million)
12-month EPS: ($0.74)
Profit Margin: N/A
Market Cap: $4,976.0 million
(*Pro forma, includes BabyCenter acquisition. Market cap based on 135.4 million fully diluted shares, including about 16.9 million shares related to exercisable options. Loss includes $5.8 million in non-cash compensation charges and $36.5 million in goodwill amortization.)

Balance Sheet*
Cash: $20.2 million
Current Assets: $26.8 million
Current Liabilities: $5.0 million
Long-term Leases: $0.5 million
(*As of March 31, before Baby Center acquisition -- which added about $9 million in cash and $0.5 million in lease obligations -- and IPO, which raised net proceeds of $155.2 million.)

Ratios
Price-to-earnings: N/A
Price-to-sales: 143.4

HOW COULD YOU HAVE SEEN IT COMING?

Although the valuation comparison to Toys R Us made the news stories on May 21, the more apt comparison might have been to Amazon.com, which then had trailing revenues of $816 million and traded for $20.5 billion, or a comparatively modest 25x sales.

Amazon had sold a limited selection of toys last Christmas, but it clearly had plans to open a toy store sometime this year. That launch came on July 13.

WHERE TO FROM HERE?

There's no question that toys represent a huge market. Recent stats offered by Amazon CEO Jeff Bezos put the domestic toy market at $28 billion and the worldwide market at $70 billion.

Moreover, buying toys at Toys R Us, Wal-Mart (NYSE: WMT), Kmart (NYSE: KM), or Consolidated Stores' (NYSE: CNS) K-B Toys just isn't a lot of fun for many adults. An acquaintance recently described Toys R Us as the "house of pain" because some child always seems to be crying. The Web, then, offers a relatively attractive way to buy toys and related children's products.

Though Bezos recently claimed that Amazon has already taken the lead in the sales of children's products on the Web, eToys appears to be doing a super job. During the 1998 Christmas season, over 98% of eToys' orders were shipped within 24 hours, and 95% during the December crunch time. That's darn good.

I also recently compared eToys with Amazon and ToysRUs.com, searching for six items: an Arthur's Computer Adventure video, the Star Wars Landspeeder by Lego, Anakin's Pod Racer by Lego, the Star Wars Racer PC game by Lucas Arts, the Queen Amidala paper dolls, and the Wrebbit (of Puzz 3D) puzzle of Florence's Il Duomo cathedral.

Frankly, I was shocked by the way eToys blew away these other sites. I found all six items at eToys with no problem. Yet, just three of the items turned up at ToysRUs.com and only two at Amazon. For the matched items, prices were comparable.

But eToys' site was much easier to navigate and offered a stellar selection, including 32 Puzz 3D puzzles versus just 5 titles on the rough ToysRUs site and, depending on my search terms, either 9, 20, or 27 titles from Amazon (but still no Duomo).

eToys is also preparing distribution capacity for the holiday season. It's signed a deal with Federated Department Stores' (NYSE: FD) Fingerhut unit to use that firm's million square foot Provo, Utah, facility starting this fall. It has also leased over 400,000 square feet of space in Danville, Virginia, for use as an East Coast fulfillment center. Former L.L. Bean exec Lou Zambello runs the operations.

The company has also done a good job of rolling out new products. In the last month, eToys has added a children's bookstore with 80,000 titles and its Baby Store with 3,000 items, such as car seats, clothes, bottles, and nursery decor.

Still, eToys' very name carves out a large but still limited niche in line with its ambition to be the leading Internet provider of children's products. That could prove a misguided approach in a marketplace where the capacious Amazon is racing to add customers and multiple product lines under the theory that scale matters, both for maintaining gross margins and for reducing operating expenses as a percent of sales.

Although eToys is a legit e-commerce contender, it's likely doomed to operate deep in the shadow of Amazon, which should quickly improve its own online toy store. ToysRUs.com may eventually get its act together, too.

I like the eToys site, but the company's $5 billion price tag still seems awfully rich given the other pods it faces in this race. With 2.3 million shares shorted (roughly a fourth of the float), there appear to be plenty of other skeptics.

-- Louis Corrigan
(TMFSeymor@aol.com)
--------

Dueling Fools on Priceline.com


(c) Copyright 1999, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

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