Internet Retail Grabs Market Share

Two weeks of punch-drunk markets and stumblebum management of global, sovereign debt have left many investors dazed.

Despite the uncertainty, 318 of 457 S&P 500 companies to report second-quarter results through Thursday topped consensus expectations. Earnings reached a record level, according to S&P analyst Howard Silverblatt. More important, third- and fourth-quarter outlooks are also holding up, pointing to record earnings levels for those quarters as well.

One industry group in that camp: Internet retailers. The group is receiving a particular boost as consumers dig deeper for bargains and aim to save the gas normally budgeted for shopping trips.

That, and the ongoing migration to online shopping, helped drive Internet retail sales ahead 14% in the second quarter to $37.5 billion, according to digital researcher comScore. It was the third straight quarter of double-digit increases and the biggest gain since Q3 2007.

One of the group's top players, eBay (NASDAQ:EBAY - News) outflanked what is typically a seasonally weak second quarter for retailers, reporting its revenue up 25%, well above analyst views. Per-share profit rose 20%, also above expectations.

The online pioneer's marketplaces platforms — its classic auction site — as well as its PayPal online payments and mobile commerce businesses, all posted healthy gains. Analysts call for a 20% gain in sales this year, to nearly $11 billion.

Chief Executive John Donahoe reiterated the company goal of annual revenue of $15 billion by 2013. "Six months into that plan we've delivered two strong quarters, and our outlook for 2011 says we are well on our way. We feel more confident about our opportunities and our competitive position," he told analysts during a conference call.

EBay has become a microcosm of the Web. It helps millions of sellers find buyers while offering a payment service enabling secure purchases online, says Scott Kessler, an analyst for Standard & Poor's equity research services.

"Historically, people associate eBay with either being able to use it to get good deals or find some items that they might not otherwise need, and PayPal continues to be a very strong growth story," he said.

EBay is also a microcosm of the Retail-Internet industry group. The 18 stock group has held steady since June in the top 50 of the 197 industry groups tracked by IBD.

1. Business

Unlike traditional retailers, e-commerce companies sell goods only over the Internet. The group is driven by a few key players.

At the top is Amazon.com (NASDAQ:AMZN - News), the world's largest generator of online retail sales and traffic. EBay, the leading online auctioneer and sales channel for small businesses, places a close second.

MercadoLibre (NASDAQ:MELI - News), the leading online retailer in Latin America, holds the group's top EPS Rating, a 94, from IBD.

The rest of the group is smaller and scattered among specialty markets. The thinly traded Liquidity Services (NASDAQ:LQDT - News) sells excess inventory for companies online. Shutterfly (NASDAQ:SFLY - News) operates a marketing, editing and storage site for photographs.

The top 25 online retailers accounted for 66.4% of online sales in Q2, down from 67.7% a year ago and vs. a peak of 69.9% in Q3 2010. The reason: Small and midsize online retailers are regaining lost market share, ComScore says.

One out of every 10 dollars of discretionary spending is now spent online, according to ComScore. That helped lift Amazon.com's second-quarter sales 51% to $9.91 billion vs. estimates for $9.38 billion.

The Seattle-based operation started as an online bookstore, and has come to dominate the emerging electronic book market with its Kindle reader device.

The company has diversified into a broad array of retail categories, as well as co-branded credit cards and providing fulfillment services for other online retailers.

But the costs of building new fulfillment centers — the warehouse/distribution facilities needed to complete sales — have dented margins and eaten into EPS over the past two quarters, despite monster leaps in sales.

Amazon.com's Q2 profit slipped to 41 cents a share. That was six cents above the Street's forecasts, but down from 45 cents in Q2 2010.

MercadoLibre is based in Argentina, but sees the bulk of its revenue from Brazil through online auctions and classified sales on its website.

It also operates an online payment service similar to eBay's PayPal service. EBay owns a minority stake in MercadoLibre.

• Name of the Game: Maintain a best-in-breed online presence and capitalize on cost advantages. E-commerce firms sell and market online, and generally avoid the cost of physical stores and offline advertising.

2. Market

E-commerce is on a roll.

By 2015, sales of products over the Internet in the U.S. alone will reach $279 billion, up from $157 billion in 2009, says market tracker Forrester Research. Physical stores still dominate retail. But online is gaining. In 2015, 11% of all retail sales in the U.S. will take place online, up from 8% in 2009.

Roughly 70 million U.S. consumers shop online. Bargains are only one factor, says analyst Sucharita Mulpuru with Forrester. "It's not just price. It's selection, it's easy and convenient," she said.

Budding overseas e-commerce markets will also provide hot spots. Online sales in Brazil will jump to $22 billion by 2016, up from $7.9 billion in 2010, Forrester says.

3. Climate

Challenges loom for e-tailers, even amid some promising opportunities.

Amazon owns about 65% of the e-book market. By 2015, more than half of all books sold in the U.S. will be in an electronic format, up from 1% in 2008, says Mayuresh Masurekar, an analyst for Collins Stewart, and the Association of American Publishers.

But the next few years could be, well, taxing for Amazon. The company has vowed to fight states that intend to collect sales tax from Internet retailers.

Up to now Amazon has relied on a 1992 Supreme Court ruling that says retailers must pay state taxes only if they have a physical presence such as a store in a given state.

Amazon has cut ties with some of its marketing partners, small businesses and bloggers that had linked to the retailer's website, after some cash-strapped states began trying to include them in the ruling's interpretation, says Masurekar.

"They are trying to bend the definition of physical presence to tax Amazon specifically and only Amazon," he said.

Meanwhile, e-commerce companies are also using acquisitions to boost revenue. In January, Amazon purchased the remaining shares it didn't own of LoveFilm, a movie rental and streaming service in Europe, to better compete with online video leader Netflix (NASDAQ:NFLX - News). In March, eBay shelled out $2.4 billion to acquire GSI Commerce, which helps companies sell online.

In the first half of the year, venture funds poured more than $335.5 million into e-commerce companies. That's more funding than the sector has received in each of the last eight years, says PricewaterhouseCoopers and the National Venture Capital Association.

The recent Internet IPO frenzy likely sparked the rush, says Tracy Lefteroff, global managing partner of the VC practice for PricewaterhouseCoopers.

"When you see IPOs for Zillow (NASDAQ:Z - News) and LinkedIn (NYSE:LNKD - News) and the rumors about Facebook, that is what attracts money into the space," he said.

4. Technology

In Q2, eBay said search improvements such as removing duplicate items made it easier for consumers to find what they want to buy.

Search is just one component, says Standard & Poor's Kessler.

"They have been spending pretty aggressively on making their technology more robust, flexible and user-friendly so people are going to get what they want in terms of a user experience," he said.

Some e-commerce companies are also jumping on the social media bandwagon.

In October, Amazon started selling diapers for Procter & Gamble (NYSE:PG - News) on Facebook, the world's leading social networking service. Consumers can use their Amazon account to order those products on the site.

Amazon is counting on Facebook's social camaraderie to help spur sales, Masurekar says.

"It's a much easier way for Amazon to get people to buy something," he said.

Mobile could also help. By 2016, sales of goods purchased on the Web using smartphones in the U.S. will reach $31 billion, up from $3 billion last year, Forrester says.

Many companies haven't adapted their websites to mobile devices. But increasing numbers of smartphone users will likely push retailers to do so, says Forrester's Mulpuru.

"Because more people will have access to smartphones, retailers will likely spend more on their mobile sites," she said.

EBay's early adoption of mobile platforms seems to be paying off. Donahoe says consumers are using eBay's mobile platforms to buy more than 2,000 cars and 70,000 auto parts each week.

5. Outlook

Much of the e-commerce growth is fueled by consumers looking for bargains and quick purchases.

Amazon often wins on both counts, Masurekar says.

"Amazon is taking share from other online players and also from some of the offline players, and that is why it's growing at this superstrong pace," he said.

EBay also benefits from buyers looking for deals and sellers hoping to find new communities of buyers, Kessler says.

"There is a fair amount of people being a little more adventurous or daring when it comes to trying new things online if they think doing so will yield benefits," he said. "People are looking toward the Internet for value."

• Upside: One of eBay's biggest selling points is PayPal. The Web's leading payment service ended Q2 with 100.3 million registered accounts, up 15% from a year ago. PayPal delivered revenue of just more than $1 billion, up 31% from the same period last year.

MercadoLibre's biggest advantage is having no big rivals.

• Risks: Amazon forged much of its lead in online retail through sales of DVDs and video games, and is vulnerable to increased competition in those categories, says Masurekar. Also, Amazon's margins could take a hit as it builds more fulfillment centers to keep pace with demand for larger items like TVs. State could also begin to tax Amazon's sales volume.

Analysts say MercadoLibre's biggest risk could be adverse economic changes from political leaders.

EBay's PayPal could also face stiff competition in mobile payments from credit card companies, mobile carriers and Google (NASDAQ:GOOG - News).