For E-Tailers, the Shipping News Isn't Good

Just when you thought things couldn't get any worse for e-tailing stocks ... things might get worse for e-tailing stocks.

Next week a key policymaking group is expected to adopt an accounting change that will make gross margins at many e-tailers look even more pathetic than they are now. While the change won't cut into bottom-line earnings or cash flow, shriveling margins can only punish these hard-hit stocks, some of which have already taken a beating on concerns about slowing revenue growth.

Big Week for Accounting

Here's the fine print. The Financial Accounting Standards Board's Emerging Issues Task Force, whose recommendations have the force of the Securities and Exchange Commission behind them, will meet next Wednesday and Thursday to mull over 13 separate and thorny issues of accounting (sounds like a fun few days, no?). One of those deals with how companies should handle shipping and handling costs. That sounds like a simple thing, but it isn't.

That's because catalog retailers and e-tailers don't always charge customers exactly what it costs to ship goods. Some, like record and CD clubs and those late-night salad-spinner sellers, make money on the shipping (you didn't really think it cost $3 to ship a CD, did you?). Others, a la Amazon (AMZN Quote - Cramer on AMZN - Stock Picks) when it FedExed for free the latest Harry Potter book to thousands of anxious little Muggles, lose money on the shipping component of the transaction.

Muddying the waters further, companies that lose money on shipping often fail to "provide any separate disclosure of shipping revenues and costs," FASB notes. That makes it hard for analysts and investors to figure out exactly how much a company is spending to pick and pack goods. So in an effort to clear things up, the FASB's task force tentatively concluded at its mid-May meeting that shipping and handling costs should be classified as costs of goods sold. If the task force finalizes those conclusions at its meeting, as most analysts expect, the changes will go into effect soon -- though due to the complexity of reclassifying old expenses, perhaps not immediately or in the next quarter, the usual time frame for implementation of this kind of policy change.

No big deal, except to students of accounting minutiae, right? Maybe not. Gross margins, one of the many figures followed by analysts and investors, are calculated by dividing gross profit (revenue less the cost of goods sold) by revenue. So if shipping costs suddenly show up in cost-of-goods-sold category, gross margins will decline. A lot, in some cases. That will look troubling, since companies, absent earnings, often tout margin improvements as an important measure of progress.

Grossed Out FASB ruling could squeeze e-tailers
Company	First-quarter gross margin		Recent price
	As reported	As restated*
Amazon.com (AMZN:Nasdaq)	22.3%	10%	35
Barnes & Noble.com (BNBN:Nasdaq)	19.4%	6.6%	6 7/16
eToys (ETYS:Nasdaq)	20.5%	-6.5%	5 5/8
Drugstore.com (DSCM:Nasdaq)	5%	-15%	7 1/4
PlanetRx.com (PLRX:Nasdaq)	15.6%	-1.4%	7/8
Source: Lehman Brothers. *As estimated by Lehman analyst Holly Becker in a June 1 report.

As the chart shows, Lehman Brothers estimates that under the proposed change, eToys (ETYS Quote - Cramer on ETYS - Stock Picks) would have taken a big margin hit, swinging in the first quarter to negative 6.5% from positive 20.5%. Drugstore.com's (DSCM Quote - Cramer on DSCM - Stock Picks) margins may drop to negative 15% from positive 5%, according to Lehman. (Companies without any inventory and, therefore, no shipping costs, such as priceline.com (PCLN Quote - Cramer on PCLN - Stock Picks) and eBay (EBAY Quote - Cramer on EBAY - Stock Picks), obviously won't see gross margins plunge.) Doug Reynolds, a practice fellow with FASB, says he's received only a few comment letters from companies, most of them worrying about the impact the change might have on their margins.

(Lehman, which hasn't underwritten for any of the companies listed on the chart above, rates Amazon buy, Drugstore.com outperform, and eToys neutral. It doesn't cover Barnes & Noble.com or PlanetRx.com.)

'Perception Issue'

So what does this really mean? "It's truly a perception issue," says Michael Gross, an analyst with Lehman Brothers. "It has no impact on the bottom line." He's right. But investors in e-commerce stocks have been notably skittish lately. Amazon's shares fell 20% the day that Lehman credit analyst Ravi Suria questioned the effectiveness of the company's business model. Its stock still hasn't recovered. (The company reports second-quarter earnings on July 26.)

There's no catalyst in sight for these stocks, nothing on the horizon that might provide investors with some optimism. The summer is slow for retailers in general, and while there might be some excitement in the second half about the prospects for online holiday shopping, investors remain jaded. What they really want is the now-cliched path to profitability, or a road map of how the company is going to eventually make money.

So while the FASB's proposed changes may not alter that timeline for profitability, the restated gross margins will only emphasize that the original dream for e-tailing -- far lower real estate and inventory costs, leading to better margins -- is faded at best. "The reality is that the costs of getting products to the customer's house seem to have offset many of the perceived advantages," says Lehman's Gross.

And so one more reminder, in the form of degraded margins, that the e-tailing dream is over may be exactly what the sector doesn't need this summer. Sure, it doesn't change the fundamentals behind e-tailing, but it may well provide another excuse for a summer selloff.