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March 18, 2011, 2:54 p.m. EDT

Online Fashion's Achilles' Heels

By Renée Schultes

Online-fashion retailers have become as hot with investors as the latest looks to hit the runway. But with valuations reminiscent of the dot-com bubble, it wouldn't take much to throw a stiletto into investor expectations.

Take Yoox, which reported a 70% rise in 2010 operating profit Wednesday. Having more than doubled since its Milan float in late 2009, Yoox's shares are trading at 44 times forecast 2011 earnings. London-listed Asos (LON:UK:ASC) is trading at 54 times, and its stock is up more than 300% in little more than a year. By contrast, traditional luxury retailer Burberry Group is trading at just 20 times.

Both Yoox and Asos were founded more than 10 years ago at the peak of the dot-com bubble. Yoox made its name selling discounted out-of-season designer fashion, although it is now diversifying into selling this season's collections on behalf of labels like Emporio Armani. Asos sells mostly current season mainstream fashion. Both managed to deliver 40% sales growth in 2010, and the market expects roughly 30%-35% growth this year.

That seems a good bet. Penetration of high-speed Internet access is rising in Europe, and websites are getting better at using multimedia to display garments. Luxury-goods groups are supportive; they prefer to shift unsold stock discreetly online than hang it on discount racks. Many labels don't have the technology or logistics to go it alone online.

But online stores' earnings growth may struggle to keep pace with sales growth. For one thing, as their scale increases, they may need to open more distribution centers. Asos, for example, which makes half its sales outside the U.K., could need two to three distribution centers globally long term compared with one today. Further, free shipping already is eating into Asos's gross margins.

And more websites are selling discounted luxury goods, including BuyVIP bought by Amazon.com last year. The competition could push up costs for popular items, denting retailers' single-digit-percentage margins. In response, Yoox hopes to generate half its revenue by 2015 from undiscounted current collections, where average order values are higher but margins are lower.

Highlighting the issue: Burberry is expected to post 24% higher earnings this year on a 15% increase in sales, while both Yoox and Asos are expected to show roughly the same earnings boost as sales.

To justify their giddy valuations, online retailers will need to persuade investors they can continue to do significantly better. That is starting to look more challenging.

Link to MarketWatch's Slice.