TOYS R US VS. eTOYS
Value Vs. Euphoria
(August, 1999)
"Too many investors focus on outlook and trend. Therefore, more profit is made by focusing on value."
Sir John Templeton
As most of you are probably aware, there is considerable excitement about the Internet, especially the Internet stocks. While we share investor's enthusiasm of the Internet and truly believe that it is a revolution in marketing and distribution, we do not share the investor's euphoria when it comes to the valuations of Internet stocks. As a matter of fact, when we reviewed some of the Internet stock valuations we were beginning to wonder if the law of gravity had been repealed!
This euphoria can
best be illustrated by comparing a traditional toy company, Toys R Us,
to an Internet toy company, eToys, Inc. Let's first review the companies'
basic financial statistics. As you can see in the following chart, eToys
has sales of $34.7 million, is currently losing $73 million, and the market
is valuing this
company at $4.9 billion!
|
Toys
R Us Vs. eToys
|
||||
|
eToys
98*
|
Toys
R Us 98
|
eToys
99E
|
Toys
R Us 99E
|
|
| Current Price |
$37
|
$16
|
-
|
-
|
| Sales |
$34.7
Million
|
$11.17
Billion
|
$100
Million
|
$11.5
Billion
|
| Earnings |
($73
Million)
|
$376
Million
|
($123
Million)
|
$400
Million
|
| Sales per Share |
$0.26
|
$44.57
|
$0.74
|
$46.37
|
| Price to Sales |
142x
|
0.36x
|
50x
|
0.35x
|
| Earnings per Share |
($0.54)
|
$1.41
|
($0.91)
|
$1.61
|
| Price to Earnings |
Loss
|
11.34x
|
Loss
|
10x
|
| Book Value per Share |
($0.12)
|
$14.46
|
($1.03)
|
$15.90
|
| Price to Book Value |
Negative
Book
|
1.11x
|
Negative
Book
|
1x
|
| Shares Outstanding |
135
Million
|
250.6
Million
|
135
Million
|
248
Million
|
| Market Valuation |
$4.9
Billion
|
$4
Billion
|
$4.9
Billion
|
$4
Billion
|
| *proforma, after Baby Centers acquisition | E = Estimated | |||
Compare this to Toys R Us, which has sales of $11.17 billion, has net profits of $376 million, and the market is valuing this company at $4 billion. So, the market is saying that eToys is worth $900 million more than Toys R Us, even though eToys is losing $73 million and Toys R Us has net profits of $376 million.
Now, let's compare companies on a per share basis. eToys is selling at 142 times sales (note this is not times earnings, but times sales), while Toys R Us is selling for less than one times sales or to be exact, 0.36 times sales. This means that when you purchase a share of stock, you are paying $142 dollars for every $1 dollar of eToys sales versus paying 36 cents for every $1 dollar of Toys R Us sales.
Looking at the companies' book value, you will see another dramatic difference. Toys R Us is selling at 1.13 times its book value (net assets), whereas eToys has a negative tangible book value (net assets). This means that you are paying $1.11 for every $1 dollar of net assets that Toys R Us has and at the same time eToys has a negative tangible book value. What is truly amazing to us is that this extreme over-valuation of eToys still exists, even though the stock has declined 56% from its high of $85 per share.
Using 1999 estimates, Toys R Us will earn $400 million in net income. This is 4 times the estimated $100 million in total revenues of eToys. While we are paying 10 times earnings and less than 1 times revenue (0.36) for Toys R Us, the market appraises eToys at 50 times revenue (note: eToys will lose $100 million in net income for 1999).
Another way to make this comparison is to look at the new Internet division Toys R Us (i.e. Toys R Us.com) is creating. They are projecting sales for the first year to be $50 million, but let's be conservative and estimate $30 million because of potential delays. This is equivalent to today's eToys sales. To continue this comparison, let's assume that eToys is worth $4.9 billion (which we do not believe). This would mean that Toys R Us.com would add $4.9 billion of value to Toys R Us. This translates to $19.75 per share. This means that Toys R Us would be worth double the price it is selling for in the market today. While we do not believe that Toys R Us.com is worth $4.9 billion (the price that eToys is now valued), we do believe that the Toys R Us.com division combined with the traditional Toys R Us worldwide retail chain adds tremendous potential to the Toys R Us stock.
While we share the enthusiasm for the potential of the Internet, and recognize that it is an area for extraordinary opportunity, explosive industry growth does not always translate into explosive profit growth for individual companies. Within the Internet industry, the competition is fierce, the barriers of entry are low, and the margins are razor thin. We believe that the main beneficiaries of the Internet will be the traditional companies, which have the purchasing power to become low-cost providers. Considering Toys R Us.com is backed by the $11 billion of Toys R Us purchasing power, we feel confident in Toys R Us.com's ability to be the low-cost retailer of toys sold over the Internet.
One of the main attractions to the Internet is purchasing at a lower price. Established companies also have brand recognition, capital, seasoned management, and most importantly, in our opinion, the distribution system that will be able to inventory the products, deliver them in a timely manner, and provide customer service, such as merchandise exchanges at a local retail store. This is a service that eToys cannot provide. Add to these benefits the ability to become the low-cost retailer, and you can see what a formidable competitor an established company like Toys R Us can become.