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Friday, June 4, 1999

An Investment Opinion
by Warren Gump

Yet Another Slant on Amazon

To regular readers bored with discussion about (Nasdaq: AMZN), I apologize for today's column. The entire Fool site has been brimming with Amazon cheerleaders this week after Barron's pummeled the company in an article titled "Amazon.bomb." At the risk of alienating myself from 90% of the Fools worldwide, I want to throw in my two cents with an opposing viewpoint (thanks, David... it's actually 99% of Fools who will disagree). While I concur with the perspective that the company is positioned to be a major force in e-tailing, I am not yet convinced that it will be able to develop a business that will justify its valuation in the next few years.

I'm not going to bore you with a discounted cash flow model as I haven't done one recently. With the Internet world changing so rapidly, I think such a forecast would be virtually meaningless. (In fact, I did try one several months ago and it has proven to be worthless... I was way too optimistic projecting a loss of $71 million for the year, whereas on a pro forma basis Amazon bled $31 million in the first quarter, a number expected to soar in future quarters.) Trying to develop a reasonable forecast for Amazon over the next year is hard enough, much less going out ten. Unfortunately for investors, though, all of Amazon's value is based on what will happen in those years and beyond.

You can develop a model by extrapolating the current Internet market environment and assuming that Amazon will face only minimal competition for eternity. Of course, that would be scarily shortsighted. As the Internet becomes an important means of distribution, the competition will intensify greatly. Rumor has it that Wal*Mart (NYSE: WMT) is discussing its Internet strategy with analysts today. Even if it wasn't divulged, we can expect it soon, along with those of many other established firms. While the barriers to a serious entry into the Internet market are significant (and increasing), you can safely bet that the world's largest retailer has enough resources to put up a valiant fight. The Arkansas team may or may not be successful, but blood will be shed before Amazon (or anyone else) becomes victorious.

I know that no one really wants to look at Amazon's current financial statements because everything about the company is based on the future. Nonetheless, I think it will be helpful to take a peek. Many people extol the company's positive operating cash flow of $31 million last year, a remarkable attribute for a rapidly growing retailer like Amazon. The figure isn't really as impressive as many perceive.

First of all, that cash from operations figure includes $24 million of "noncash" interest expense. Last May, the company issued 10% Senior Discount Notes that will accrue interest through 2003, meaning that the company will defer the cash layout for this interest expense for several years. This note structure exhibits deft capital management by Amazon's management, but cash flow statement followers should realize all of this interest (compounded at 10% annually) will be paid at a later date. I would hardly consider that "free money."

Another big item missing from Amazon's cash flow statement is employee compensation paid with options. Due to accounting regulations, this figure is excluded from almost every company's income and cash flow statement. While valuable as a motivational tool, I personally consider options a more expensive form of compensation than cash since they dilute the interests of current shareholders. With cash, you just pay out the money. With options, you still pay employees (although it is basically self-printed money) and you give away partial company ownership.

Looking at Amazon's 10-K disclosure, the company is a prolific issuer of employee options. Last year, net of cancellations, the company paid options on 16 million shares to employees. Based on the 161 million outstanding shares at the end of February, the company agreed to sell employees a 10% stake for only $400 million. (The current market value of the company, excluding options, is in the neighborhood of $17 billion.) No trace of this grant is found on the income statement and cash flow statement, except via understated employee compensation expense.

The third highlight of the operating cash flow statement is the jump in accounts payable relative to inventory. Amazon's management should be commended for developing such highly efficient capital management. A question lingering in my mind, though, is how sustainable this model will be. From what I understand, book publishers offer retailers some of the most lenient terms in the retailing world.

As Amazon moves into other industries, will it be able to command such generous terms? Particularly as it builds warehouses and begins to stock a little more of its merchandise? I will concede that I might be overly pessimistic on this item. Up to this point, Amazon has superbly managed its inventories and payables and management has earned the benefit of the doubt. That being said, concern about lower relative net cash flow from inventory and payables lingers in the back of my head.

Amazon has accomplished enormous feats over the past few years that should impress almost anyone, as it has risen from an upstart with an idea many thought loony into one of the leading Internet retailing brands. Combining that cachet with a smart and nimble management team, a cash horde of $1.4 billion (note: debt stands at $1.5 billion), and a powerful acquisition currency -- its stock, the company has a tremendous arsenal with which to fight an Internet retailing war. Despite these strengths, the company has not clearly demonstrated that it can, or will be able, to operate profitably.

Making the assumption that sales will continue to soar, margins will be maintained, and marketing costs will plummet lead to a very rosy picture for the company. In my mind, I find it hard to believe that such an environment will exist as competition intensifies. Maybe I'm wrong (it would not be the first time); perhaps Amazon is poised to bully ahead unimpeded by competitive threats. I just don't think that's very realistic. Before taking the Amazon plunge, be sure to consider the potential risks as well as the potential rewards. While many seem to think evaluating risk is unpatriotic or idiotic, it can also lead to higher portfolio returns.

Have a wonderfully Foolish weekend.

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