An E-Commerce Recession Bodes ill for Many Investment Darlings.

In general terms, a recession is defined as two consecutive quarters of GDP decline. If one were to apply such a term to specific sectors, then it would logically represent a decline in revenues for two consecutive fiscal quarters.

Online retail e-commerce sales had declined in fiscal Q1, 2022. April e-commerce sales have also declined. Supply chain issues persist; even in discretionary items, there is less to buy online, so consumers are shopping offline to fulfill their needs vs wants. In just a few more weeks, May figures should cement Q2 as the second consecutive quarter of diminished e-commerce revenue.

Online Retailers Take Hit in April as More U.S. Consumers Spend In-Store

At this pace, it appears that in online retail, most companies participating in the sector will be entering a unique recession.

For most e-retail and e-payment firms, who were publicly listed after 2013, their management will have NEVER experienced a slowdown in business before. This could represent a seismic shock for all sector participants. Investors who are budgeting for revenue growth in 2022 at their favorite firm(s) are presently being savaged and most are in outright denial. To investors, it just does not compute; how does an e-commerce or online fintech payment processor, historically growing at a 20% plus annualized rate, reverse course on a dime and now look to produce lower revenues in 2022?

The distress should extend well beyond retail holders of equities; mutual funds and ETFs are also hurt in an e-commerce recession.

Wall Street street analysts are overwhelmingly forecasting double digit revenue growth for 2022 with their selection of darlings. Wall Street is presently frozen in a sort of groupthink inertia; lacking a single reputable star willing to initiate a sector sell, based upon an e-commerce revenue decline for 2022, the remainder of the analyst herd mills around, ruminating on publicly available data , constrained by an inability to obtain divisional approval to incorporate the new data into models. Corporate impediments leave analysts with little choice but to chew their cud and maintain forecasts within the margin of error from the analytical mean. Everyone knows that e-retail business conditions have turned negative, but nobody is yet willing to put that point, on paper, in a research report.

By far and away, the greatest pressures will be observed on the bottom lines of e-commerce firms themselves; most are ill prepared for even a flatline in revenues, let alone an absolute decline. Yet, a decline seems in the cards, driven by inflationary spending on more staples and a reversion to in-person spending vs online. There is only so much money in the pockets of consumers and with the rampant food price and fuel inflation, overwhelmingly purchased offline, there is just less money in the typical family budget for online e-commerce purchases. The inflation wave favors offline spending on essentials and hinders online discretionary spending. This shift seems real and will be persistent for some time.

E-commerce operations are entirely built on an expansion premise.

They overbuild capacity, which compresses margins at the outset, so as to benefit from margin expansion as slack is taken up. Universally, e-commerce firms have bloated overheads and expense billions annually on share option and grant packages as standard incentives for employment. Many engage in serial acquisitions of unprofitable firms anticipating the continuation of 20% growth rates. A “lean-and-mean” e-commerce firm represents an oxymoron in the public investment space. None exist in the real world.

For CEOs and their CFO colleagues in E-commerce, a temptation to massage or smooth earnings throughout a period of revenue decline might lead to ruination for an entire sector.

There is no executive depth at most e-retailers and little corporate expertise at most online fintech to circumnavigate a sectoral recession. The entire industry is akin to a professional football conference that scouts only offensive talent and fails to contract out even a college level defensive team; moreover, most teams in the conference don’t bother to hire a defensive coach and coordinators. The assumption is that e-commerce firms will always carry the ball, will always pile up yardage, will always score against offline retailers, and they need to have more offense than other teams in their conference, so why invest in defense?

Lacking defensive attributes, e-retailers and e-commerce firms might refuse to acknowledge a slowdown even exists, rather than accept it and improve post-recession. Just as denial can represent a pressing issue for many investors, so too can refutation plague CEOS and their executive appointees. For those e-commerce heads with a god complex, to diminish the likelihood of a wholesale crash in their e-commerce shares, there exists a real possibility that management of certain firms might choose to play fast and loose with accounting guideline, so as to maintain a pretense of financial superiority vs sector peers.

I’m reviewing financials of many firms and there are some worrisome signs. PayPal, by way of example, in their recent financial report, informed the global investment media that Q1 quarterly profits were $.88 US per share and indicated operating margins of 20.7%. However, neither of those two figures are even loosely comparable with generally accepted accounting practices (GAAP).

GAAP numbers were much more modest; GAAP EPS fell to .43 US per share, down by more than half year over year. Operating margins on a GAAP compliant basis fell to just 11%, the weakest reported operating margin in the public history of PayPal. Such a spread between the non GAAP numbers and the GAAP compliant figures are sufficiently high that by now, at least one major investment firm should publicly indicate the divergence in a report, yet zero have done so. If the non-GAAP and the GAAP numbers were remotely comparable, they wouldn’t differ by more than 100%; therefore, one can state, with some degree of certainty, that one set of figures is not worth spit. The failure of analysts to refer to the GAAP numbers while instead deferring to the non-comparable figure, represents a cardinal sin in investment analysis, the sin of omission.

What’s even more unusual, specific to PayPal, is the fact that their GAAP figures do not represent the final profit amount indicated in the most recent 10-Q. In determining the GAAP numbers, PayPal notes that they have excluded mark-to-market movements in the investment portfolio they hold. PayPal also excluded certain foreign exchange movements to arrive at the underlying profit. In a separate series of line items, called “Other comprehensive income (loss), net of reclassification adjustments” Paypal indicates that forex losses and investment portfolio losses for the quarter served to reduce overall profits by a further $308 million.

The net result? Paypal earned just $201 million in the first quarter of 2022, a decline of $1.027 billion over the same period of 2021. The true net profit decline was down by more than 83.6% in Q1.

To a skeptic, one could make a case for arguing that 3 sets of books now exist at PayPal; a “non-GAAP” set of figures that are aspirational but also irrelevant, excluding so many expense items that they have little bearing on reality. Next, there is a GAAP compliant set of books, only mentioned as an aside to analysts and investors, yet even they still miss a bunch of non-cash expenses that are highly material for modeling and analysis over the course of a fiscal year. These books look much worse, less than 1/2 as good as the non GAAP figures. Even with GAAP figures, there exists the potential for wiggle room, deferral and smoothing. Finally, buried in the financials, where no retail investor seems willing to tread, and where no analyst seems objective enough to query, are the real “comprehensive” numbers, which are less than 1/2 as strong as the GAAP reported figures. Investors, analysts and the media were advised via press releases that PayPal generated $1.029 billion in net profits for Q1; this rings hollow when compared to the $501 million GAAP figure and against the $201 million comprehensive profit buried in the 10Q.

Investors look at the freefall of many e-commerce players and ancillary businesses in the space and think that the shares for many, being down by 50% or more, are “cheap”. I respond that they only become cheap when hopes are completely dashed due to a meaningful immersion into the ice-cold reality of a sector recession. Thus far, analysts refuse to acknowledge the risk of a year over year decline in real revenues for e-commerce.

As previously reported, I sold PayPal in the last quarter. Some would ask why I would mention PayPal again as an example; after all, I should no longer have any skin in the game. Well, when anyone participates in the ownership of equities, even in disparate sectors, there exists the potential for friendly fire that hurts the share price of hard working companies when a whole sector goes into recession. Markets can survive recessions; but markets lose trust in entire sectors when companies, based upon a need to appease and placate shareholders, maintain option incentive awards, coddle and beguile analysts, put too much focus upon non GAAP numbers when it is the GAAP number that matters at the end of the day. If PayPal has to produce 3 sets of profit figures in any quarterly report, do they have yet more figures, privately? And if management at PayPal condones such permutations, whose only purpose seems to be to confuse and divert, what does that suggest about other public firms both large and small, in the e-commerce space? It only takes one bad apple, who bends the rules of accounting until something breaks; then trust is lost in the entire sector, which hurts us all. So, while I have no dog in this hunt, I am aware of the risk of collateral damage for markets overall, should investors hang their valuation modeling upon flawed logic and faulty data, driven by too many sets of numbers to comprehend.

E-commerce stocks will not bottom, convincingly, until evidence appears to support an uptick in online revenues and we will be the last to know when the trend reverses; that valuable data is sold to the highest bidders. Visa and Mastercard produce volume sets monthly, maybe daily, possibly hourly; they process the lions share of transactions over their interchange networks so their data is reliable, actionable, trustworthy. These raw figures are aggregated and sold to third parties, who we can safely assume are sophisticated institutional investors and hedge funds, firms that make modeling and allocation decisions independent of Wall Street research vendors.

The looming question to me is less recessionary, more existential; can e-commerce firms tolerate a decline in revenues, given their bloated overhead, fat compensation packages and lack of profitability from too many acquired money losing divisions? How overbuilt and overextended is the e-commerce space?

Finally, are the books of major participants squeaky clean, because recessions can lay bare accounting irregularities in the blink of an eye.

Were some companies engaged in the smoothing of earnings in the upcycle, attempting to manage expectations based on a premise that they could step back gradually and incrementally, without creating a share panic? The e-commerce sector does not need their very own Enron or a WorldCom; nervous markets in general won’t like one either. Let us hope that the new crop of CEOs and CFOs remember that far back, I am becoming quite suspicious that some do not.

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