eCost's Growth Plan Follows a Familiar Road

Investors wonder if the company will follow other dot-com burnouts with its heavy advertising spending.
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Is (ECST) an (AMZN) - Get Report in the making, or is it the next dot-com disaster?

To the extent that they've paid any attention to the e-commerce upstart, investors are still trying to figure that out. The company is posting strong revenue growth as it rapidly expands beyond core sales of computers and PC accessories. But eCost's strategy isn't so different from that of Onsale, Cyberian Outpost and -- e-tail companies that crashed and burned during the tech bust.

Indeed, the market seems to be ambivalent. On the one hand, eCost's stock is up more than 41% since its initial public offering in late August. But the company's shares are still trading below the initial pricing range it gave for its IPO -- a range it had to cut due to lack of interest.

With a market capitalization of just $143 million, the company seems to be flying below the radar screens of many investors and analysts. Thomson First Call, for instance, doesn't list any Wall Street analysts who cover the company.

But at least some investors think the company could be a hit.

eCost is a spinoff of catalog marketer

PC Mall


, which owns an 80% stake that it plans to eventually distribute to shareholders. As such, its management ranks are imbued with people who understand direct marketing, said one hedge-fund analyst, who asked not to be named.

eCost's management is "doing the cold hard math on customer acquisition economics at all times," said the analyst. They "can make money and generate cash." (The analyst's fund is long eCost.)

Regardless of the long-term prospects, some investors think the company could fare well heading into the holiday season. As with the broader retail industry, e-commerce companies typically see surging sales in the fourth quarter. In past years that has typically translated into swelling share prices during the quarter.

"It looks to me like the Internet retailers are getting a boost in anticipation of a strong holiday season," said James "Rev Shark" De Porre, a contributor to's

sister site,


. "

(OSTK) - Get Report

was hot and that means traders will look for other similar stocks." (De Porre is long shares of eCost.)

But eCost's story is a bit muddled. The company's average order size has declined steadily as the company has moved beyond computers to DVD movies, sports gear and housewares. Just two years ago, an average order placed on eCost was worth $564, or about two-thirds larger than one placed in the first half of this year.

And while the revenue is rising, the company is bringing a smaller portion of its sales to the bottom line. The company's gross margin -- the difference between what a company charges customers for its products and its direct costs of producing them -- dropped to 9.4% of sales in the first half of this year from 10.2% of sales in the first half of last year.

Meanwhile, operating costs have surged in recent quarters, rising to 9.4% of sales in the first half of this year from 9.1% of sales in the same period last year.

Those combined factors have cut into eCost's bottom line. In the first half of this year, for instance, the company posted an operating loss of $25,000. In the same period a year ago, eCost posted an operating profit of $547,000.

In its filings with the

Securities and Exchange Commission

, eCost attributed the decline in its operating results to a jump in advertising and various promotions.

But that decline doesn't bother the hedge fund analyst. "My sense is that they're sacrificing a little bit of profit to get to several hundred million to a billion dollars in run-rate revenue," the analyst said.

But others may question the wisdom of eCost's strategy. During the dot-com boom, many e-commerce companies focused on boosting revenue at the expense of profit by offering discounted products and spending huge amounts on advertising. While Amazon succeeded with that strategy, it lost billions of dollars before it posted its first quarter of profitability. Dozens of others died trying to duplicate Amazon's efforts.

More recently, has attempted something similar. But while it has grown revenue significantly, the company has seen its bottom line decline. The company's loss in the second quarter, for instance, was

more than double that of the year-ago period. In the meantime, Overstock -- like Amazon before it -- has repeatedly had to

go back to the capital markets for injections of cash.

Amazon and Overstock focused on advertising to establish their brand names as a way to distinguish themselves from hundreds of other online stores. Establishing and building a recognized brand can be a pricey proposition, but without it, online retailers are often forced to compete on price.

On the Internet, physical distance from a store is all but irrelevant. A growing number of customers are going to online stores via shopping search engines such as and


(GOOG) - Get Report

Froogle service. Customers using those services often choose to buy from stores that offer the best price.

In its SEC filings, eCost acknowledged that much of its advertising to date has been on price comparison sites such as The question is: Will the company be able to move away from such price-based advertising?

"I do share

that concern: What is their differentiating factor?" said a hedge fund manager who also asked to remain nameless. (The fund manager received a small allocation of eCost's stock at its IPO and subsequently sold it.)

Still, some are sold on eCost's business. Indeed, the hedge fund analyst thinks the company and its prospects look good in contrast to shares of Overstock, which has nearly doubled this year.

eCost's management's expertise in direct marketing has led them to approach customer acquisition and advertising in a "scientific way," carefully evaluating the mix of banner ads, keyword searches and the like, said the hedge fund analyst.

"That's what the eCost folks think about all day every day," the analyst said. "I guarantee that's not what

Overstock CEO Patrick Byrne thinks about all day every day."

"The proof will be which company in

the fourth quarter makes more money. My guess is it's

eCost," the analyst added.