Problems at eToys Raise Questions for Amazon

Updated from 2:55 p.m. ET

Henry Blodget published a worrisome thesis Monday morning: the eToys (ETYS) washout could mean that Amazon.com (AMZN) shareholders are up the creek.

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The Merrill Lynch Internet analyst's assessment comes in the wake of eToys' announcement Friday that it wouldn't just miss its month-and-a-half-old estimates for fourth quarter sales; in fact, it wouldn't even make it to the correct hemisphere.

eToys' shares on Monday fell 75 cents, or 73%, to 28 cents. Amazon was down $3, or 13%, to $19.88.

Now that eToys' revenue for the quarter ending Dec. 31 is expected to grow a maximum of 22% over last year's fourth quarter, not the 95% to 125% previously expected, the shortfall raises a troubling question, says Blodget: If e-commerce is supposed to amount to 10% to 15% of retail sales someday, how come a category leader is growing at such a piddling rate? Year-over-year revenue growth of 15% to 20% just won't cut it.

The troubling conclusion that Blodget draws is that, in fact, maybe the online toy business and all the other e-commerce categories won't ever carve out that 10% to 15% of retail that he and others have expected, or if they do, it will be too far into the 21st century to matter to investors in 2000.

Sure, e-commerce leaders Amazon and eBay (EBAY) might meet expectations for growth in the current quarter, with Amazon revenue up 50% from a year ago and eBay up 66%. But it just might be that Amazon's retail gains are coming from market share wins from other e-tailers, not market growth for e-commerce as a whole. And this raises an important question, Blodget writes: "What happens to the growth rate, when, by the middle of next year, all of the weaker e-tailers have thrown in the towel and there is no more market share to gain?" It was concerns about growth rate -- not profitability -- that Blodget said led to his August downgrade of Amazon.com from buy to accumulate. (Merrill hasn't been an underwriter for Amazon or eBay, but was a co-manager of eToys' 1999 IPO.)

A scary thought, says Blodget. If the endgame isn't as valuable as he once thought it was, and the growth peters out, you've got to worry about Amazon's price. At a compound annual growth rate of 40% over the next five years, the Seattle-based e-tailer is undervalued at its Friday close of nearly $23; at 30%, its shares are fairly valued, and it's still a good investment. At a compound annual growth rate of 20%, it's expensive. Right now, Blodget estimates 30% to 40%, but he'll be taking a close look at Amazon's fourth quarter to see whether he can sort the market share from the market growth.

But will there be enough information there? As documented in a recent TSC story securities analysts' are griping that Amazon doesn't provide enough information about various aspects of its finances. On Monday, however, a fair number of people thought they'd seen enough.

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