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Fool On The Hill

Thursday, June 3, 1999

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Wanted: Financial Writer With a Clue

Apply at Barron's, New York, New York. Yesterday, Louis Corrigan came up with some interesting thoughts on Barron's treatment of Amazon.com (Nasdaq: AMZN) last weekend. But since I like Amazon.com so much and since I think Barron's is so weak, I thought, why not take a few more shots at its article.

First of all, what really made me laugh when I read it was that the writer referred to earlier "analyses" of Amazon.com that indicated its intrinsic value to be $10 per share. I remember one of those -- it was someone's reckoning that the thing should trade at a certain low multiple to sales. It was pretty lightweight stuff and doesn't even come into the universe of analysis as I see it.

The article quickly moves onto the observation that investors have pumped these shares based on the charisma of Jeff Bezos. I think Jeff Bezos is a really interesting person, but I don't think anyone who has followed the company for a while would call him particularly charismatic or say the market value of the company is based on his charisma. That's like saying Bill Gates is a highly charismatic person. He's very intelligent and there's a certain charisma in that, but my impression is that neither of these people are the sort of guys that light up a room and have investment bankers rolling on the floor in presentations. I think the observation is a clueless one.

Let's move to the part of the article that really demonstrates the financial illiteracy of the writer: "So far Bezos has been able to mollify most investors by telling them that his company is not just an online bookseller, but instead a retailer of many things. He has, in fact, moved into selling music CDs and drugs online. But these products can have even lower profit margins than books." Barron's static look at margins without a concurrent reconciliation of asset turnover and other capital management consequences is totally sloppy. There are some concepts that are almost Newtonian laws for financial analysis. One of those is that margins and asset turnover are equal in their ability to effect returns on capital.

Here's a basic model for returns on capital: Asset turns * profit margins = return on capital. Neither has primacy. If you decrease gross margin by 10% (and I hope Barron's gets the difference between saying that and saying "ten percentage points") and leave the asset turns unchanged, you'd get the same return on capital result as if you left gross margin unchanged but decreased asset turns 10%. Thus the whole idea of big box retailers. You lower your margin but you increase capital turnover. Voila! The story of late twentieth century retailing! You deliver more value to the customer by lowering prices and you generate tremendous value for your investors.

Hopefully Barron's can master that concept, because the next one is a little harder: Not only do you need to analyze the income statement and look at a company's margins, but you also need to the look at the cash flow statement. That's the funny looking financial statement that you usually find after the balance sheet and income statement in a company's federal filings or annual report. It actually reconciles the difference in operating cash flow and earnings and the changes in the balance sheet with the income statement over a period of time. If you don't pay attention to all three financial statements, then you're going to develop an affinity for companies that show lots of earnings but can't show any cash flow. Earnings are an estimate in the world of accrual accounting and cash is a fact.

The fact that Amazon.com actually generates operating cash flow while growing at triple digit rates might not impress Barron's, but it has obviously impressed a lot of investors. When you write for a living and haven't had actual experience in building a business that requires lots of off-income statement cash disbursements, it is hard to understand, but it doesn't excuse the ignorant indictment of a company that has figured out how to slip these bonds. The faster a company like this grows, the more cash it generates, and that will be the case until the growth goes away or its working capital model changes drastically.

"Despite all the hoopla surrounding Amazon, Bezos has not really revolutionized the book industry at all. In essence, he is a middleman..." the article says. If this is an exercise in semantics, okay, then Sam Walton's not a revolutionary either. He's an evolutionary. Whatever. Good tactic for debate class, but it's sort of sophomoric in Barron's analysis.

"Here's another potential threat to Amazon: What's to stop famous authors from establishing their own Websites to sell their books? If Madonna can have her own record label, the theory goes, why can't Stephen King or Danielle Steel have their own book imprint?" the article asks. I have a question. Does the author know how e-commerce works? There's actually a back-end to selling stuff. That is, you have to be able to fulfill customer orders. Fulfillment abilities, servicing the customer, and merchandising well are differentiating factors in e-tailing. You screw up and you stand the chance of losing the customer. Convenience, merchandising, and brand -- learn it, know it, live it. You can't just throw up a website and expect people to show up. My advice to the author: Read some books about retailing, ask some retailers how they do things, and then maybe try working for a real Internet-based company before just spewing that it's really that easy.

The article goes on to say that "In other words, Amazon is buying a lot of costly bricks and mortar, the very stuff that is supposedly bloating costs at traditional retailers." As Louis quoted me yesterday, it's not the bricks and mortar that costs a lot, it's the slow-turning inventory that bloats capital costs.

More cluelessness: "Adding to Amazon's woes is its decision to build warehouses. In the past, Amazon very often would simply take an order and turn to a wholesaler such as Ingram Book Group to buy the book. It meant that Amazon didn't have to keep huge inventories of books on hand. Now that Barnes & Noble is attempting to acquire Ingram, there is some question whether Amazon will be able to rely on the wholesaler as it has in the past." Well, that deal has been shot down. And in any case, why the heck does the article talk only about the book business when Amazon.com is in multiple retail categories and plans to add other retail categories? Also, "woes?" Nice McCarthyite trick there. The company's sales are soaring, as is its stock, and the CFO, CEO, and company are executing very well in an entirely new retail reality. There are hardly any woes at the company outside of dealing with writers that don't know how to discuss financial concepts beyond margins and net income.

My further advice to the writer would be to learn how to do a discounted cash flow. If you look at the problem in that way, a dollar loss today to generate three dollars of net income off a much larger base of business five years down the road is more preferable than five years of showing a smooth $0.05 of earnings each year and ending up with a smaller business. It's not such a hard concept to deal with. You just need to apply yourself to the task of understanding some basic concepts before you start to tear down others.

Would you work for a bunch of Fools?

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