Dueling Fools

Dueling Fools
June 30, 1999

Amazing Amazon
Bear Argument
by Rick Aristotle Munarriz (tmfedible@aol.com)

What if? Check your venom toward me at the door and ask yourself that simple question. I know, I know, how dare I belittle the bellwether e-tail company. I am not a good person. Still. What if?

What if sales growth continues to slow? Sales climbed 838% in 1997. They rose 313% last year. Amazon.com started out this fiscal year with revenues 236% higher than last year's first quarter. See the trend? The momentum is slowing. Yes, a company growing the top line at 236% is amazing. But as that number continues to shrink will investor enthusiasm follow?

What if Amazon never earns a penny? You have to be worried here. Each and every year since the company's 1995 founding it has lost more and more money. The more Amazon.com is selling, the wider the deficit. That's not right. I know many bulls might say that Amazon.com is not about today. It's about tomorrow. Well, none of the 23 analysts tracking the stock expect the company to turn a profit this year or the next. Keep betting on the future. I won't wait up.

Why? Because I almost bought the story. I, too, once boo-hissed the bricks-and-mortar retailers. How could they stand a chance competing against the nimble players of the online world? Low overhead. Global expansion just a website away. The Age of the Landlord was going to come to an end. Well, it didn't quite turn out that way. It was too easy and the simplicity of it all was its downfall.

"There is no reason why anybody here couldn't go into competition with Amazon literally by this afternoon," media tycoon Michael Bloomberg said to members of the American Chamber of Commerce in Singapore last week.

He's right to a certain extent. And where he's wrong it spells an even bleaker outlook for the company. Sure, you can open up an online bookstore overnight, outsourcing most of the fulfillment until you're big enough to open up a distribution center or two. However, you would also have to spend millions in portal advertising. Then, despite selling already steeply discounted wares you would have to give webmasters 5-15% off the top for the traffic. Between the tabs necessary to keep the name visible in the mainstream sites and the hobbyist affiliate programs, poof, there goes that low overhead advantage everyone was expecting.

Then you have competition, just a click away, that is the ultimate margin killer. If someone is discounting hardcover bestsellers by 35%, someone else will slash them by 40%. Oh, it's 40% now, let's try 45%. The bricks-and-mortar stores have the convenience of distance to make them partly immune from the competition. With the emergence of free comparison shopping sites like E-Compare, every online retailer has to shave prices to rock bottom levels in order to survive. So, poof, there goes those high margins.

I think my argument will be made clearer if we take the time to pull the first quarter income statements for Amazon.com and Barnes & Noble (NYSE: BKS).

Let's see:

                          Amazon.com       Barnes & Noble   
Sales                      $293.6              $718.3
Cost of Goods Sold         $228.9              $526.0
Selling & Administrative    $95.4              $178.5
Operating Profit               ($30.7)              $13.8
Where did Amazon fail in trying to turn a profit? Right away you see that the cost of the books, videos, and CDs being sold by the chain eats up 78% of the cybersales. At Barnes & Noble the cost of the items being sold only chews away 73% of the total take. Then we hit the selling and administrative expenses where you realize the "low overhead" you counted on can't be counted on. At Amazon.com that eats up 33% of the top line, compared to just 25% at Barnes & Noble.

What if Amazon.com can't get 78% and 33% to add up to less than 100%? It's the Honeymoon Suite at the Deficit Inn. Now, I'm not saying one should buy up Barnes & Noble instead. Actually, B&N and Borders (NYSE: BGP) were better companies with more enticing margins before they went online. Right now the Internet is like a birthday pot going around to buy a present for a co-worker. You won't get anything out of it materially, but if you don't contribute your peers will think less of you.

Which begs the ultimate question, what if the Amazon.com business model is flawed? The company is not making money selling books and it's further away now that Amazon.com is selling pre-recorded music and movies. I can't imagine that the recent investments in online pharmaceuticals and pet supplies will bring Bezos & Co. any closer to profitability paydirt. No matter where Amazon.com turns there will always be a competitor taking a battering ram to list prices. With every upstart on a kamikaze mission to steal market share, the established players will have to respond and I think this scene will play itself out in perpetuity. That is, of course, unless we come to a day and age where the public is no longer interested in bidding up Internet stocks. If that happens, all e-commerce players young and old will be hard-pressed to find an investment community willing to subsidize their losses.

What if this plays out just as I described it?

What if I'm right?

Next: The Bull Responds