Onsale's Emaciated Margins

Even as the online auction house's stock is rising, its profit margins are slimming.
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SAN FRANCISCO -- Margins are down, competition is up and

Onsale's

(ONSL)

business just might be between a rock and a hard place.

Onsale was up 56% to 68 Monday on news that

Yahoo!

(YHOO)

would link to Onsale's auctions from its Small Business page. Despite the effect today on Onsale's stock, the deal isn't likely to keep Onsale's margins from being pressured. And that pressure could hinder its profit prospects in coming quarters.

Since 1995, when Onsale emerged as the leading online auction house, the niche of online auctions has grown into a lucrative business. Onsale and others bought refurbished and close-out computer goods from original manufacturers and resold them to the highest bidders on the Web. Even as Onsale has expanded from computers to housewares, vacations and other offerings, the space for auctioning off refurbished and close-out goods is getting cramped, with

Egghead.com's

(EGGS)

Surplus Direct

,

uBid

(UBID)

,

Auction Warehouse

and

Affiliated Computer Auction

also in the space.

More competition and a limited supply of goods causes the laws of supply and demand to kick in. In addition, the manufacturers that Onsale and others buy their goods from are working to reduce their leftovers, which could further shrink the supply for the auction businesses.

"More people are competing for a slice of the pie," says Philip Leigh, an analyst at

Raymond James

. "It's getting more competitive to buy the merchandise. And the pie is going to shrink as PC makers take steps to construct business models that result in less inventory.

The auction companies are being pressured from both sides."

As more companies seek out goods to sell online, the original manufacturers can charge more to rid themselves of the excess goods, says Leigh, who rates the stock accumulate. That would cut into slimming margins. His firm has no underwriting relationship with Onsale.

As a percentage of total revenue, gross margins were 13.8%, 13.3%, 11.9%, and 10.6% for the past four consecutive quarters. (These figures are based on Onsale's new method of accounting for credit card processing. Onsale moved that expense -- about 2.6% each quarter -- out of cost of goods sold and into sales and marketing).

In a recent filing, Onsale, which still derives about 80% of its revenue from the sale of computers and related goods, attributed decreasing gross margins to lower margins on purchased inventory sales. That means that Onsale's customers weren't bidding up the price on the goods enough to keep its margins flush, says company spokeswoman Stefanie Elkins. Margins were also hurt because Onsale lowered its shipping and handling rates "to be competitive with similar companies in the industry," a recent

SEC

filing said, adding that "the effects of this reduction on gross margins are expected to continue into future quarters."

And Onsale operates in a business that manufacturers would like to eliminate.

Compaq

(CPQ)

, for example, has shown interest in emulating

Dell's

(DELL) - Get Report

successful direct-to-user strategy. The more PC makers take this route, the fewer products are likely to sit around in warehouses, says one hedge fund manager, who is short Onsale. That will dry up even more the pool of goods for auctions.

"Suppliers want to sell less rather than more. The goal is to sell it all

themselves rather than sell it to Onsale," the hedge fund manager says. "There is less around and more players trying to buy."

Steven Frankel, an analyst at

Adams, Harkness & Hill

, who rates the stock attractive, doesn't completely buy that theory. "There will always be goods available," he says.

Onsale has taken some steps to control margins through its Quick Buy program, which offers items at fixed prices -- and gives Onsale fixed profits. Leigh says it's a desperate measure to bandage an out-of-control problem. "You don't change things," says Leigh, "unless you're dissatisfied with the way things are going."

Satisfied or not, Onsale is clearly rethinking its focus on auctions, an area that many have seen as its strongest suit. "The business model is in flux," says Frankel. "I thought they had an edge in the auction format, but they seem to be going away from that."

In addition, Onsale recently started running ads on its Web site, which should help improve margins, says Elkins. In September, the company partnered up with Yahoo to run its auction site, and Onsale gets a portion of the ad revenue from that venture, says Elkins. Other than that, the company isn't disclosing any other margin-enhancing opportunities it is considering.

Some analysts say that Onsale will start selling new goods to boost margins. But that too is a crowded space. "If they do that, then they go against a whole new breed of competitors," Frankel says. "It's a tough battle.

Selling new goods is a very risky business change." Elkins says Onsale is always looking into ways to expand the business but says she is unaware of plans to start selling new products.

For more info on institutional holders of this stock, as well as financial statements and earnings estimates, please see the

Thomson Company Reports

.