The creation and widespread adoption of the internet has certainly changed the way we work, play and manage our daily lives. Pretty much everything can be done over the World Wide Web these days, and one of the biggest ways we use the internet is for shopping.
Dubbed electronic commerce or e-commerce firms, these companies have taken the antiquated concept of a direct mail-order catalog and placed it on the internet. Literally anything – from clothes and music to plane tickets and financial services – can be purchased over the web and shipped to your door. Twenty-four hours a day, seven days a week.
And with Americans already spending hundreds of billions on online shopping and e-commerce, stocks like Amazon.com (AMZN), eBay (EBAY ), Priceline Group (PCLN) and even Wayfair (W) have become major tech superstars. Today, e-commerce firms and consumer discretionary tech stocks make up about a quarter of the famed NASDAQ 100 Index.
However, despite the continued growth in online sales and retailing, investors seeking income are kind of left out of the e-commerce equation. Many simply don’t pay dividends. And that comes down to their business models.
Why Don’t They Pay Dividends?
The beauty of using the internet for commerce transactions is that it’s been able to reduce costs for consumers. By eliminating the middleman, consumers have been able to buy their favorite products cheaper; compare travel arrangements to get the best price; and even score discounts on various experiences. In the end, the rise of web shopping and market research is ultimately helping to drive down prices/costs for consumers.
The problem for stocks in the e-commerce sector is that those lower prices continue to reduce margins, in a big way.
As consumers have come to expect – discounting, profits and margins on various e-commerce transactions remain elusive. Online retailers still have many of the same overhead costs as regular brick & mortar retailers. However, with lower prices now the norm, there’s less money to cover those costs. And one of the biggest costs happens to be shipping.
The vast bulk of e-commerce firms uses large fulfillment centers. While these monster warehouses are highly productive, they take a lot of overhead to build and then operate. According to the Harvard Business Review, a fully automatic warehouse center can cost more than $250 million to build up. That’s more than 10 times what it would cost for a brick & mortar establishment to build a warehouse. Because of that, there are less fulfillment centers than needed for the rest in online sales. To counteract this and the slower delivery schedules, many online retailers have started offering various express problem offerings as standard.
However, offering the ability to ship furniture in just two days for free is problematic for the sector. An online retailer has the ability to make some money shipping a book or a t-shirt, but large items like furniture tend to be money-losing propositions.
In addition, most online e-commerce firms don’t really have much of an economic moat. It doesn’t take a lot to start a company that sells items over the internet: For every Amazon, there’s a Jet.com. As a result, that competition is great for consumers, but not so great for margins. Prices continue to dwindle, and you have a reinforcement of lower margins.
In the end, the combination of low prices, low margins and relatively high fixed costs means many e-commerce firms hardly realize any free cash flows – cash available after capital expenditures are taken out of operating cash flows. So they are able to keep the lights on, but not hand over excess cash to investors in the form of dividends.
As a result, investors tend to view and evaluate e-commerce firms based on their rising revenues. That is, they are considered “growth” stocks. The name of the game is to focus on firms that continue to see rising overall sales and market share. Those that are able to do that – such as AMZN, PCLN, Alibaba Group Holding Ltd (BABA ) – tend to trade at very high price-to-earnings (P/E) ratios versus their peers.
Closest to Paying Dividends
With margins razor thin for most of the sector, should dividend investors give up hope of ever seeing any sort of income from e-commerce plays? Not exactly. There are a few online players that do pay some sort of dividend, and there is potential for others to do so as well. And we aren’t talking about Amazon.com.
One of the closest would be travel site Priceline Group.
Of the various e-commerce names, the travel and booking sites offer some of the richest margins. There’s relatively low overhead in operating online reservation sites, such as Priceline.com, Booking.com and Agoda.com. There’s no need for warehouses or complex shipping arrangements. With that in mind, CAPEX spending at PCLN is practically nothing and has been under $100 million for quite a few years.
Meanwhile, the firm generates meaningful free cash flows (around $2.5 billion), due in part to its juicy margins. Combine that with its billions in cash on its balance sheet and it has the biggest chance of paying a dividend in the future. A 2% dividend yield would only cost Priceline around a billion in cash [per year. The only reason why it hasn’t yet done so has more to do with its penchant for M&A rather than its inability to pay a dividend.
Even so, dividend investors shouldn’t get their hopes up. The PCLN’s are rare in the e-commerce sector. The reality is that margins are just too thin for most of them to start paying their investors.
The Bottom Line
At the end of the day, the e-commerce stocks leave a lot to be desired from an income seeker’s point of view. The firms that do pay a dividend or have the potential to pay a meaningful dividend are few and far between.
The key to returns here is capital gains. This lends itself to more long-term investors who can handle the volatility associated with these stocks as they go through their revenue cycles. That’s not necessarily a bad thing, since it’ll take plenty of growth for retirees to get through their golden years. But income won’t be on the table for the sector.
For those investors still looking to get exposure to rising online sales and a meaningful dividend, retailers like Target (TGT ) and Wal-Mart (WMT ) have become omnichannel giants and have spent big bucks building out online and in-store operations. Both have long dividend histories and will be able to make the most of rising online sales. (For more about how dividends can power your portfolio, check out How to Turn $50,000 Into Nearly $900 Million)