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Analyst warns of price war as Internet stocks lose ground

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Should investors get ready for a cyberspace price war?

Internet stocks lost some of their buoyancy last week, despite a partial bounce back in price on Friday. The trigger for the decline was an analyst's warning that a price war could break out as some online retailers, including OnSale Inc. and Buy.com, move toward selling books, compact disks, videos and computers at wholesale prices.Amazon.com Inc. fell more than $33 a share Wednesday and Thursday -- a two-day decline of 24 percent -- before regaining $17, or 16 percent, to end at $123 a share in Nasdaq Stock Market trading on Friday. The catalyst for the fall was a warning by CIBC Oppenheimer analyst Henry Blodget that the coming price competition could hurt shares of the online bookseller.

"Amazon is sentiment driven, and the biggest fear out there is that their margins will go to hell," Mr. Blodget says in an interview Wednesday. Indeed, he says, a shoot-'em-up price war is the last thing Amazon needs, with Wall Street already worried about a slip in Amazon's margins that will turn up when it reports fourth-quarter results Tuesday.

Fears of a price war began surfacing last week after OnSale announced Tuesday that it will launch a service called "atCost," which will offer a broad selection of computer products at the same prices it pays manufacturers and distributors. (The money would be made from advertising aimed at the customers, the thinking goes.) Buy.com has a similar strategy offering not only computer-related products but also books, music and videos. Even though these services may not be truly selling at cost -- think "car dealer" here -- the prospect of a price war is unsettling to investors.

Such worries about online price slashing have helped to drag down much of the Internet group, including bellwether Yahoo! Inc., which dropped $58 Wednesday and Thursday, before retracing $21 to end at $286 in Nasdaq Stock Market trading Friday, a three-day decline of more than 11 percent. The worries even spilled over to eBay Inc., which is technically an Internet auctioneer and not a retailer. The company's stock fell more than $48 in two days before recovering $15, or 8.2 percent, to $196.75, still down 14 percent from its Tuesday close.

It's not just the online retailers that are being hurt by the pricewar.com trend. Some hedge funds say they are even laying bets against some traditional retailers such as Wal-Mart Stores Inc., Costco Cos. and Nordstrom Inc. on the theory that the retail business is a "zero-sum game," meaning any market share online retailers pick up through price cutting will be taken out of the traditional retailers' hides.

"It doesn't take a major siphoning off of revenue to really hurt the traditional retailers. You don't have to take much away from the guys with a 1 percent profit margin to start to lose money," Mr. Blodget says.

Of course, retailers say they don't see it that way -- although they are dabbling in Internet sales to figure out how the enemy operates. "Certainly the Internet is going to change the dynamics of retailing," says Richard Galanti, chief financial officer at Costco. The company started up Internet sales in November, and now sells about 500 items over the Internet. But its "warehouse" stores, real "brick and mortar" establishments, sell 4,000 items and account for the vast bulk of the company's sales, and Mr. Galanti says he has no fear of cyber price wars: "We don't believe long term you can sell stuff at or below cost and survive."

Still, Borders Group Inc. offered a glimpse at how shares of retailers with a lagging online strategy can get hit two weeks ago, when its shares fell 22 percent after it said it will miss Wall Street's fourth-quarter estimates, a misstep investors and analysts attribute to online competition with Amazon and Barnes & Noble. Borders wouldn't comment; a release earlier this month attributed the shortfall to bad weather and higher gift-certificate sales.

Some investors are laying bets that music retailers like Trans World Entertainment Corp. may be next to feel the heat from an online price war. (Trans World, which recently started an Internet site, says it hopes the Internet will expand its sales -- and doesn't think online price wars will affect it.) Others point to the toy retailers, including Toys "R" Us Inc., as a retailing category that is vulnerable. Shares of drugstores, too, may also eventually come under pressure, says one analyst, pointing to an expected initial offering soon from an online drugstore retailer.

Jerry Kaplan, co-founder and chief executive officer at Onsale, says the company's tactic will work because the company plans to make money from areas other than advertising (such as manufacturers' co-op funds, and processing fees), and that advertising itself offers "a significant gross profit opportunity for us."

While Mr. Blodget remains skeptical that the strategy will generate profits over the long run, he says their shares could rise in the short run because the market has been "willing to fund any Internet business opportunity at any price." He calls their strategy "smart," because it allows them to try to build their brands and customer bases."

Though Mr. Blodget believes Amazon does generate enough traffic to potentially offset the drain on profits from a price war, the pricing rout will "let the wind out of the sails of Amazon for a while." He adds that Amazon may have already begun an overdue correction.

A spokesman from Amazon didn't have any comment Friday.