Blue Christmas at eToys

A sales warning by eToys wrecks the firm's Christmas and throws its business future into doubt. But was it ever a sustainable business to begin with? Given the currently high cost of capital for the online retailing model, many other e-tailers are facing a similar question going into the new year.

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By Brian Graney (TMF Panic)
December 18, 2000

Thanks to the wonders of modern American consumerism, the weeks before Christmas are routinely the most wonderful time of the year for retailers. Think of bustling malls, shoppers laden down with packages, and frantic buyers elbowing each other out of the way to snatch up the year's "must-have" gifts.

For the toy business especially, it's hard not to smile at the prospect of millions of normally sane Mommies and Daddies scrambling in desperation to turn their children's wish lists into a few moments of plaything euphoria come Christmas morn. There are no givens in business, but selling toys at Christmastime seems about as close to a sure thing as you can get. It should be like selling water in a desert.

Well, so much for that theory.

Late Friday, former e-commerce highflyer eToys (Nasdaq: ETYS) revealed that the 2000 holiday selling season won't be so holly and jolly after all. This December was supposed to be the month that makes or breaks the online toy retailer, and it looks like the month has lived up to its billing. The Los Angeles-based firm said sales for its current fiscal Q3 will come in between $120 million and $140 million, a real downer considering the forecast was for $210 million to $240 million.

Gross margin will also fall short of estimates, and the quarterly loss will be so bad that a per-share forecast wasn't even included in the press release. The company blamed the shortfall on everything from the slowing economy to the ludicrous notion that toy consumers were distracted by the recent presidential election stalemate. Why not just blame Santa Claus himself?

As a result of the weak holiday performance, eToys' business fate is now largely out of its hands. The firm said it has enough cash and borrowings to make it until March 31 or so without a "substantial" capital infusion. An unspecified number of employees will be laid off next month in a last ditch effort to reduce operating costs, but that move will only stave off the inevitable. Given the current investment climate, Frosty the Snowman has a better chance of making it into the summer in his present form than eToys. Goldman Sachs has been hired to shop the company in what may amount to a post-Christmas fire sale.

The ironies of the eToys story run deeper than the obviously strange notion of a toy retailer being done in by the holidays. Over its 18-month history as a publicly traded company, the firm has been widely criticized for spending too much money on advertising and marketing in an attempt to lure the toy buying public to its website. But in the end, it appears the company didn't spend enough.

When push came to shove this holiday season, consumers viewed eToys as just another online retailer. The $175 million that was spent on marketing and sales over the past year-and-a-half may have generated more than $200 million in trailing revenues for the firm, but it did little to provide an identifiable brand-related competitive advantage. Despite the can't-miss url and poignant TV ads, online shoppers simply went wherever their bargain hunting, toy shopping spirits took them for their purchases.

A second irony of the eToys demise relates to the fact that more than any other public e-tailer, eToys went out of its way this year to assure investors that its business was sustainable. CEO Toby Lenk and other executives bragged about the company's "sustainable business model" in a January conference call following the last Q3 performance, when many Internet analysts and investors still took such comments seriously. With scores of e-tailers like eToys and (Nasdaq: AMZN) now falling on hard times, the sustainability of the online retailing business itself is being called into question.

In theory at least, just about any business model is sustainable, even the current e-tailing model so derided by skeptical observers as being little more than selling dollars for 90 cents. Just add more and more capital to the business -- if that is in fact the right characterization -- and almost any operation can be sustained indefinitely. In reality, however, capital is not always in abundant supply. It also comes at a cost, a cost that is directly related to the long-run capital needs of the business. This isn't some kind of New Economy thinking, mind you. The same business realities hold for even the most stodgy businesses imaginable.

Take the case of textile company Pillowtex (OTC BB: PTEXQ), which filed for bankruptcy protection last month. Up to the bitter end, some analysts went on kicking and screaming that Pillowtex's after-tax cost of capital was not much more than 10% or so, since the company was mostly funded by credit facilities and debt instruments that bore interest at annual rates ranging from 6% to 10.21%. However, that conclusion was dead wrong.

Sure, plugging those different interest rates into a traditional weighted average cost of capital equation produces a cost of capital that seems reasonable enough. But such a perfectly theoretical exercise has no grounding at all in reality for a company like Pillowtex, whose operating margin last year was less than 4% and whose net cash outflows for property, plant, and equipment have outstripped cash inflows from operations by a 3-to-1 margin over the past three fiscal years. By comparing the company's capital needs relative to the availability of capital in general, a rational investor would have realized Pillowtex's cost of capital was truthfully much higher than any mathematical determination would let on.

The remaining pure-play e-tailers who manage to make it through the current holiday season and hobble into the new year face a cost of capital predicament not all that dissimilar from what Pillowtex confronted. The great promise of online retailing was that a company could build enough scale to become a sustainable business without loading up its balance sheet with the fixed assets of the bricks and mortar world. The e-tailer's scale building efforts were expensed on the income statement instead, in the form of outsized sales and marketing expenses. The magic ingredient was capital, which was thought to be free in 1999 but has become prohibitively expensive for e-tailers here in the late stages of 2000.

As eToys' Lenk lamented in a Wall Street Journal interview earlier this month, the company is being "abandoned right before the finish line." With an additional dose of capital, it may have crossed the sustainable business hurdle as soon as the next fiscal year. Now, only Santa will know for sure if that belief was ever true or not.