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Industry Analysis: e-Commerce
The e-Commerce Industry is comprised of companies that produce and sell software to businesses and corporations of all sizes. The wide range of products and services offered work to improve and expand customers’ information technology (IT) capabilities, by enhancing such internal tasks as inventory management, tracking purchases, and operations management.
Although the Value Line page for an e-Commerce stock appears in our standard format, it is important to focus on certain key factors to gain a better understanding of the company and its shares. The current and future prospects of the economy also play a prominent role when analyzing these equities. In addition, new product releases are continuous, with many companies providing similar offerings and services. Thus, stiff competition, enhanced by merger and acquisition activities, is present.
When analyzing an e-Commerce company, one needs to focus on a few key metrics. First, since members of this industry are constantly introducing new products and services, research & development plays a prominent role. Accordingly, heavy investment in R&D, ranging from 10%-15% of revenue, is a characteristic of note. If a company scrimps on R&D, it will likely rapidly lose customers and market share. Second, a company’s financial position should be closely monitored. Debt can often help fund operations and R&D, but if it is used too liberally, interest and repayment requirements may hamper operations and profits instead. The strength of a company’s balance sheet should be given careful attention before taking a position in an e-Commerce stock; an average debt to total capital ratio for the industry is 30%. Lastly, most e-Commerce companies incur large stock-based compensation expenses, which can often cause steep share losses from one quarter to the next. It is important to factor in share-based compensation in an investment analysis, since those companies that post related losses may prove more risky than profitable competitors.
Although many industries struggle during weak economic periods, e-Commerce companies, overall, fare relatively well. Typicallly, during lackluster economic times, most corporations aggressively seek cost-cutting strategies. As such, they are often eager to upgrade their IT capabilities, which usually leads to improved operations and expense reduction. Thus, e-Commerce companies can receive large orders during lean economic times, and a few may even post record revenue and profits. In addition, several companies within this group derive a good percentage of their profits from outside the U.S., which can help them weather domestic challenges.
Industry players often offer similar products and services, leading to an aggressive fight for customers and market share. In addition, most in the e-Commerce space must directly compete with IBM, Microsoft, Cisco, and other IT giants, who can often offer customers more services at lower prices. Thus, it is difficult to determine which e-Commerce corporations will become, and remain, successful from one quarter to the next. This competitive dynamic can lead to inconsistent revenue and profit streams from year to year. Not surprisingly, then, a number of stocks within this group carry low scores for Earnings Predictability. To repeat, e-Commerce companies should invest heavily in R&D, targeting new software offerings at customers’ needs in order to better compete with larger competitors.
This industry also possesses low barriers to entry. Indeed, new companies offering a quality suite that is well received can take a sizable bite out of another firm’s existing business. This industry continues to grow at a rapid rate. With more and more corporations focused on improving their IT capabilities and bolstering their presence on the Internet, this group should continue to achieve record revenue and profits over the next several years. However, discovering which companies will perform well over that time frame has become very difficult.
Mergers & Acquisitions
M&A activities play a major role in the e-Commerce space. Microsoft, IBM, and other large players are constantly seeking new technologies that can bolster their product offerings and market reach. In many cases, it is cheaper for them to purchase smaller firms, rather than internally fund the development of software suites. For instance, this appears a part of Microsoft’s current strategy. Thus, e-Commerce companies are constantly getting picked up by the larger players. Indeed, during weak economic periods, their stock prices are usually down from previous highs, and the IT giants are likely to be active on the acquisition front searching for bargains. In turn, when the economy is performing well, financing can usually be procured under favorable terms, which can also fuel purchases despite higher valuations. In sum, e-Commerce companies are often acquisition targets, and rumors of a purchase can lead to wide swings in stock prices. That, along with inconsistent revenues and profits from one quarter to the next, causes most e-Commerce stocks that are covered in the Value Line Investment Survey to possess Below Average ranks (4 and 5) for Safety, and low scores for Stock Price Stability.
A great number of factors can impact an e-Commerce company and its corresponding stock. In our view, investors will be best served if they focus on e-Commerce corporations that have a strong commitment to R&D, a healthy balance sheet, and a history of successful products. However, the majority of these equities are risky, so conservative investors may want to remain on the sidelines.