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Fool On The Hill

Wednesday, February 17, 1999

FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan

Onsale and the Future of E-Commerce

I suggested last week that it might not be so crazy to open a website that sold a dollar for 90 cents. Yes, you lose money on every transaction, but with enough alternative revenue streams -- particularly advertising -- you perhaps could make up the difference on volume. That's the extreme case, and we're a long way from it. Still, my thinking about the future of online retailing has undergone a sea change in the last few weeks, and, to be honest, I'm surprised by my conclusions.

I now think it's likely that companies like Amazon.com (Nasdaq: AMZN) really are at the center of a tectonic shift in the nature of retailing to consumers, a shift that the market hasn't fully discounted. Initially, this shift will pressure every retailer of commodity-like hard goods, but it should ultimately extend into other areas, like financial services, which are already being transformed by the Web. Perhaps most important, it's a shift that should ultimately lead to less competition at the retailer-intermediary stage, not more. That's because only a few companies will be able to survive the bruising price wars that are coming, and these companies will emerge as absolute giants. Getting from here to there, though, could be incredibly painful for investors who aren't watching the road ahead.

Anyone who wants to understand the future of e-commerce must think hard about what's happening at Onsale (Nasdaq: ONSL). Until recently, Onsale was known mainly for AtAuction, a leading e-commerce site that auctions closeout and refurbished computer items, sporting goods, consumer electronics products, and even some vacation packages. FY98 sales were $208 million ($234 million, including items sold on a commission basis) compared to $610 million for Amazon. Over the last two years, though, Onsale's CEO Jerry Kaplan has been running a kind of ongoing experiment in what works (and doesn't work) when it comes to e-commerce. Kaplan is a smart guy who has shown a willingness to tweak Onsale's business model as needed. Given that Onsale has drawn a million registered bidders and now attracts 150,000 unique visitors a day, Kaplan has a lot of empirical evidence to help him figure out what will work. His conclusion: Everyday low prices, or, as he calls it, "verifiable fair pricing."

Onsale found it was getting only 5% to 10% of its customers' capital expenditures, partly because the company's auction model frequently left it supply constrained since it didn't have access to newly introduced products. Onsale was doing a great job of attracting customers to its site, and at a very low cost thanks to the sophisticated way it tracks leads from advertising (down to the penny, Kaplan says). Yet, Onsale wasn't getting anywhere near maximum value out of these customers. Second, Kaplan found that one thing standing in the way of an online customer's purchase decision is the feeling that there might be a slightly better deal just a click away. As Kaplan said in last week's illuminating conference call (from which the following quotes are pulled), a customer's "confidence in getting a good deal is a critical element in the purchase decision."

Kaplan and his team examined these data in light of the fact that distributors "are now willing to support electronic retailers by sourcing, handling, and shipping the goods on their behalf while giving them very favorable prices on the goods themselves." From these inputs, Kaplan said, "We developed a new viewpoint as to where electronic retailing was likely to head." Here's his explanation.

"By linking up with full line distributors, we now have the opportunity to offer our customers a broad supply of products while eliminating any inventory risks, eliminating the capital requirements to buy the goods, and eliminating all the logistics and operating costs associated with handling those goods. So the logical implication of this, to us, is that electronic commerce is going to evolve into more of a service business rather than a product business. By this, I mean that Internet merchants can essentially become marketing, order-taking, customer service enterprises, while delegating purchasing and the inventory and operations to those other partners.

"We believe that the opportunity now exists to do for electronic commerce what the discount online brokerage houses have done for stock trading. They charge a small, limited fixed fee for the service, rather than taking a significant percentage of the sales. We can change the normal retail model -- of buying goods, marking them up and selling them at a profit -- into a fee-for-service retailing model on the Internet. And that's the way we think things are going to go.

"Now, the economics for this new online retail model are very different and quite compelling. Because of the incredibly small incremental cost to process and order online, the whole thing really becomes a volume game. You don't have any capital expenditures required to scale this up. So it's simply a matter of attracting as many customers as possible and in earning a fee each time one of them places an order."

While this model has been entertained in whole or in part by other companies, Onsale may be the first major etailer to approach it straight on after trying other models. The result is AtCost. This site was launched January 19 and is initially selling a broad line of 31,000 new computer products through a partnership with Tech Data (Nasdaq: TECD), a distributor with $11.5 billion in annual sales. Onsale is also talking to other distributors, with consumer electronics being a likely area for expansion. The way AtCost works is that customers pay Onsale a product's wholesale cost plus some charges:
-- a transaction fee (minimum of $5 per order; maximum of $10 per item ordered)
-- a credit card payment processing fee of 2.4% of the purchase price
-- shipping charges
-- taxes, if applicable

Kaplan said that a survey conducted by the Washington Post found that on a basket of items, AtCost charged 12% to 17% less than a local CompUSA (NYSE: CPU) store. He said another study by Montgomery Securities found AtCost beat a local Best Buy (NYSE: BBY) on price by 8% to 10%. While some online retailers already undercut AtCost on certain items, Onsale now seems to be at or near the top on price comparison lists. And customers apparently love the discounts. After just three weeks, AtCost accounted for 22% of Onsale's overall revenues. Despite some expected cannibalization of its AtAuction business, AtCost's ticket prices are averaging more than 50% higher than Onsale's traditional orders.

The AtCost model reshapes the income statement. For instance, stuff that would normally appear on the expense line (logistics, handling, and purchasing) has been moved up into the gross margin line. Those expenses are built into the wholesale price because the distributor is now performing those tasks. Also, Onsale should benefit from more co-opt or market development funds from vendors paying Onsale for product placement or special promotions. This revenue offsets marketing expenses, so it will show up in a benefit to selling, general, and administrative expenses.

While the transaction fee will be a major source of profits, Onsale also stands to make some money from the shipping charges, thanks to volume-related discounts, and from suppliers, due to volume-related rebates. There also should be substantial growth in the "commissions and other income" line since ad revenues should increase as Onsale becomes even more of a destination for online shopping. Already, only 12% of Onsale's business comes from links to other sites, which jibes with the fact that 77% of sales come from repeat customers. Kaplan claimed that Onsale is already getting a solid $20 per CPM for banner ads and that "there's been real demand from several tens of advertisers at this point and many renewals."

He also spoke eloquently about how AtCost will change the nature of retailing by "aligning the interests of the customer and the retailer because it's in our interest to negotiate the lowest possible prices for the goods on behalf of our customers in order to drive the transaction volume." Ultimately, he hopes to offer such a compelling value proposition that Onsale becomes "a kind of Costco (Nasdaq: COST) on the Web," where customers pay a membership fee to buy items nearly at cost. Taken "as a whole," Onsale's pricing package for AtAuction should be "equivalent to high single-digit gross margins," Kaplan said. That reportedly means about 9% gross margins, or as Kaplan said on CNBC when AtCost first launched, "somewhere in the 3% or 4% range for an operating net."

Tomorrow, I'll elaborate on what I think AtAuction means for the future of e-commerce, and specifically, what it means for Amazon. But here are some raw numbers to think about.

Gross margins (%)
Borders (trailing 12 months) 27.07%
Amazon (FY98) 21.94%
CDNow (FY98) 19.76%
Best Buy (trailing 12 months) 17.61%
CompUSA (FY98) 14.10%
CDW Computers (trailing 12 months) 12.82%
Creative Computers (FY98, excluding charge) 11.25%
Onsale (FY98) 10.59%

Related articles:
-- Stock Talk Interview with Onsale CEO Jerry Kaplan 02/11/99
-- $1 for 90 Cents. Sounds Great! Fool on the Hill, 02/10/99

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