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April 7, 1999

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Subject: Why I'm a Bear
Author: dcardno

Douglas403 issued a call to bears to explain why they are bearish, and to deal with the low-inventory, high-turnover business strategy that underpins Amazon. I admit that some of the bearish posts have not risen much above "Bezos is the devil, and Blodgett is his infernal servant." To be quite honest, I am not sure why that argument doesn't satisfy the bulls - I propose to rest my case there, with only a few further observations . In fairness, some of the bullish posts have not gone much further, either, but I accept that with Mr Market making his tentative pronouncement, the onus is on the bears, not the bulls. Now for those observations:

I love to think and talk about Amazon. To paraphrase Mark Twain's observation about science: nowhere else can we get such a wholesale return of conjecture for such a small investment in fact. Any conclusions about Amazon's attractiveness have to be coloured by your answer to the 'really big question' about the company: are there barriers to entry? This (or the equivalent question, "is there a first mover advantage?") is the prerequisite for deciding whether they can maintain margin, and Amazon is nothing if not a margin-sensitive business. We have gone over that issue at length, but every Fool will have to come to an answer that satisfies them. Because this qualitative issue is so enormous, we will never come to a convincing answer - the best we can do is to reach a suggestive or indicative result, in the hopes that it will inform our discussion, and indicate the degree of sensitivity to the qualitative considerations.

Implicit in the discussion of Amazon is the assumption that the business model will 'scale up' - if we knew that AMZN in ten years would look much like the AMZN of today, or even that it would look like the AMZN of today with all financial statement items multiplied by a factor of ten, it would be trading in the penny/share range. No one has any interest in a business that continuously loses money, and for the moment Amazon does that in spades! The scaling argument is that Amazon can increase its sales without (materially) impairing its margins, and without (materially) increasing its overhead costs - the result will be an enormous increase in Gross Profit, and ultimately a profitable enterprise. This assumption is essential to the conclusion that Amazon has any value.

How reliable IS that assumption, and when will Amazon become profitable?

The quick and dirty answer is that Amazon had sales of $609M last year (unless otherwise attributed, figures [and there aren't many, folks - you can get through it!] are from the 1998 form 10K) against a cost of sales of $476M, for a gross margin of 22%. Operating costs before interest, M&A costs, and taxes were $195M, so the break even point is $195M / 22% = $886M. Easy! just another $280M in sales, and Amazon has turned the corner!

"That brings up one small question: previously on this board I have read that Amazon's pricing strategy is to sell books for 30% off the list price, but they can still make a profit because trade practice is to wholesale books at 40% off list. Assuming sales of $100 worth of books (at list) that would lead to an expected gross margin of $10 on $70 of sales, and $10 / $70 = 14% margin - about two thirds of the observed margin. The difference is either due to an error in my recollection of the comments on the board, or an improvement in Amazon's realized pricing or terms from the book trade. No matter, I can continue using the actual margin, but can anyone clarify that point?"

In fact, to show positive operating cash flow, Amazon only has to cover operating expenses less depreciation, or $185M, so the cash break-even point is $185M / 22% = $847M.

"I love to think and talk about Amazon. To paraphrase Mark Twain's observation about science: nowhere else can we get such a wholesale return of conjecture for such a small investment in fact."

I would add a couple of caveats: first, Amazon's operating expenses are not fixed - some of them are volume-dependent. The most obvious is credit-card sales. It has been a long time since I worked in retail, but when I did the credit card issuers charged between 2% and 3% of the value of each transaction, depending on transaction volume and average size. Assuming Amazon is at the low end of that range (to get the low rate your average used to have to be >$500 transaction - I doubt that Amazon gets that high - on the other hand, they are a high volume customer, so they can probably insist on a good deal), this will reduce their effective margin from ~22% to ~20%. As well, the marketing and sales line item includes the cost of running fulfillment centres. I think a reasonable estimate of the cost of shipping and handling (not postage or courier delivery) is about 3% of sales. This implies that it would take 15 minutes of a $9/hr (all-in) employee to assemble the order for an average sale of $70. This seems plausible, although I am sure the process is highly automated, but let's not talk about maintenance costs in materials-handling systems!

If these costs are considered as reductions in margin, they have to be excluded from the denominator in calculating the cash break-even point for AMZN.

The figures I come up with are:

Including credit card charges: cash costs of $174M, margin of 19.4%: B-E = $171M / 19.4% = $871M

Incl. credit card & fulfillment: cash costs of $155M, margin of 16.9%: B-E = $152M / 16.4% = $918M

That is only a 50% increase on 1998 sales - well within AMZN's historic growth rate. So why be a bear? Well, there are some optimistic assumptions buried in there. The most obvious is in relation to costs: along with AMZN's 300% increase in sales (1997-98 year-over-year), operating costs increased by over 200%. That's positive operating leverage, but it isn't as good as the zero increase assumed in the B-E analysis above. If we assume that operating costs increase by 100% (ie - they double) coincident with the growth in sales to come to the break-even point the calculation changes to:

Incl. credit card, fulfillment, and incr. operating costs: cash op costs of $311M, margin of 16.4%: B-E = $1.84 Bn. If cash operating costs increase by 150% the Break-Even sales volume increases to $2.29 Bn

This is more like the AMZN we know and love - tripling the sales volume and still not making any money, despite the fact that cost increases have been contained, growing at only 100% per year compared to sales increasing by 300%. The question, though, is how quickly might they get to that point? It is no secret that over the past two years Amazon has increased sales dramatically - from $16M in 1996 to $148M in 1997 and $610M in 1998. In percentage terms this is an increase of 840% year over year in '97 and 310% in '98.

Since the third quarter of 1997 quarter on quarter sales increases have been running at just over 30% with the exception of the fourth quarters of each year. I am going to ignore the fourth quarters, on the basis that the concentration of seasonal sales makes them non-representative (I warned you that there would be a very small investment in fact in this piece, didn't I?), and claim that Amazon's quarter-on-quarter sales will increase at an average of 33%, for a compound annual sales increase of 3.17x (ie just over 200% growth) through 1999. In following years, I expect revenue growth to decline further - it is a truism that it is easier to double sales from $25M to $50M than from $1Bn to $2Bn.

Amazon's customer base, obviously, is made up of people who have internet access. Taking AOL revenue as a proxy for the growth of internet accounts, growth in internet subscribers has slowed from 250% annually in 1995 to approximately 45% in 1997 and 1998. Sooner or later, I expect AMZN's growth to be constrained by the overall growth of the internet, and eventually by the growth of the economy as whole, which implies a further reduction in growth rate in coming years. My guess for AMZN's revenue growth is:

Year Revenue Costs
1999: 3.17x 2.50x
2000: 2.25x 1.50x
2001: 1.50x 1.25x
2002: 1.33x 1.25x
2003: 1.25x 1.15x
2004 etc 1.20x 1.15x
This represents a compound growth rate in revenue of 54% if it continues until 2006. I believe that these growth assumptions may be too optimistic - as the customer base enlarges the demographics will decay: people who paid $2K or so for a Pentium II two years ago are both more financially attractive customers than those who pay $600 for a Celeron now, and more importantly they are more likely to be the early adopters and heavy users of the service. This factor weighs particularly on a seller like AMZN, who is selling a discretionary purchase, and I would not expect AMZN's average order or average sales per customer account to stay at their current levels. I expect revenues to increase faster than cash costs throughout the period - Amazon will exhibit positive operating leverage, although the degree of leverage will diminish. This is in accordance with the MD&A in the 1998 10K, although management does not quantify the amount of the expected increase.

These increases in sales and costs would lead to Amazon generating roughly $1 Bn in annual operating cash flow by 2008. Since I have assumed positive operating leverage and increasing revenues, the cash flow improves every year up to that point. Allowing for income tax at 40% leaves $950 Million as an estimate of after-tax income, ignoring the effect of Amazon's financial structure (I am also ignoring depreciation as a non-cash item - currently it is non-material). By applying a PE multiple (using this cash flow as an estimate of net income) we can value AMZN's operating business - but what multiple?

Retailers like Sears and Lands' End trade at multiples of 16x and 30x, respectively. I would argue that there is little to distinguish AMZN from Lands' End, while staunch bulls would argue that AMZN should be (and will be) valued in the same was as AOL - at approximately 500x eps. I will return to the strained analogy between Dell and AMZN - they both operate a high-turnover, low-inventory "box assembly" operation. They both have a significant, although not overwhelming, first mover advantage. Dell has, I think, higher barriers to entry: when ordering from AMZN I have no concern about compatibility of the goods in my box - there is no risk that ordering "The Dilbert Principal" will cause problems when shipped with "C++ Cookbook" or that the ski mountaineering guide I buy in two years will not inhabit the bookshelf happily with my order of today without scrambling to find a new 'page-driver' . Assuming that a Dell-like multiple of 75x will apply, the value of AMZN's operating business will be $72Bn in 2006.

An investment in AMZN today is exposed to considerable market risk, so the future value of $72Bn has to be discounted back to a present-day value at an appropriate discount rate. Long-run the Foolish Four returns better than 20% annually with little risk, and I would expect to get at least that return on AMZN, plus a risk premium of -say- 5%: discounting the value of $72Bn in 2006 to 1999 at 25% results in a present day value of AMZN's operating business of $12.01 Bn

As we all know, AMZN has some other attributes besides the core business of selling books (and sorry, but until they show something other than future promise, "it is about books"), including two outstanding financings aggregating $1.8 Bn and investments in pets.com, drugstore.com, and the announcement of that they are going to move into the on-line auction business.

Turning to the investments first - obviously it is even more difficult to value them than AMZN itself.

Pets.Com: the press release on the purchase set the market for pet food and supplies at $23 Bn. Let's assume 10% net margin, which I think is pretty high for what is largely a food business, and a 75% overlap between pet supplies buyers and internet users. I don't know what proportion of that market is appropriate for internet purchasing (ie - I can see the value in paying shipping on a $70 book order - I am not so sure about the 50 Lb. economy-size bag of kibble!) - lets assume one-third. That gives us an addressable market of $17 Bn, of which a third is a realistic target, for potential profits of $575 M. What market share will pets.com get? Given that pet supplies are sold in the same outlets as pet food, which is unlikely to become a big internet market, and there are already mail-order pet supply houses (presumably with similar pricing to pets.com), I would be surprised to see them pick up more than 10% market share (actually, I think that is generous). Call their potential profit $58 M. Even at a risk-free rate of 5%, that's not worth much more than $1 Bn, and I think there is a lot more risk in there than that, and not much growth potential - the demand for pet products is not that price-elastic. Call it a $400 M value, of which AMZN owns half, for $200M.

Drugstore: I have trouble with the argument that John Doerr sold 46% of drugstore for drastically less than it was worth; KPCB are generally regarded as being pretty sharp. Let's assume that there was a 10-fold increase in value due to the immense synergy between the two operations (which implies that KPBC couldn't appropriate any of that synergy value for themselves by arranging a bidding contest between AMZN, YHOO, EBAY, etc - remember the results that last time synergy was widely used as a justification for business combinations!). That puts a value on AMZN's share of DS.com of $300M.

Auctions. Well, as you no doubt know, I have ALWAYS maintained that first-mover advantage on the internet is virtually absolute - there is no way AMZN will EVER catch eBay. Actually, I have no idea what the auction business is worth. As a quick take, it should be worth less than eBay was prior to the AMZN announcement, because the pool of potential buyers and sellers didn't expand overnight just because Jeff decided to get into a new line of business. From what I have read on the board, the fee structure is pretty similar. I don't ascribe a lot of value to an announcement that AMZN will enter a new business, although obviously the market does!

The last item to consider in determining a value for AMZN is their financial structure. As noted above, AMZN has outstanding debt of roughly $1.78 Bn - at the same time they hold cash and equivalents close to that amount. The best case for AMZN is that the company will find value-creating ways to deploy that capital. The worst case is that they will not - say by investing heavily in eMeringue! At this point, we cannot say - as a bear, I am not sure that there are that many value-enhancing investments in this sector, and as an investor, whether bull or bear, I am reluctant to invest in a blind pool, which is essentially what these funds represent. I assume that on average AMZN can invest the cash to earn at least their cost of funds on the debt, so the value of the debt is offset by the cash on hand. In fact, the zeros were actually issued to yield slightly over 10% until interest begins to be payable in 2003 and 10% thereafter, so the assumption of offsetting income is not quite accurate, but in this instance we are talking about a difference of a couple of million in present value terms - not enough to be concerned about.

The other financial advantage AMZN holds is the "negative cost" inventory system - the fact that they are able to pay for their inventory long after they have collected for it, and in the meantime they have use of the funds - essentially they obtain a short-term, zero interest loan from their suppliers. This float is worth something - assuming that it is invested at money-market rates the float will generate roughly $156 M in after-tax interest income in 2006, assuming that ALL inventory is obtained in this way. This is unlikely to be the case, but we are only looking for a first approximation. I assume that the market will value this income stream at a 25x multiple, but because investing the float in the money market is a pretty low-risk activity, I have assumed a discount rate of 15%, to yield a present value of the float of $1.28 Bn.

In summary, the total value I determine for AMZN is:

Operatingbusiness: $12,013M
Pets.com 200M
drugstore.com 300M
ValueofFloat 1,276M
Total Value of Company = $13.79 Bn, or $86/share. Assuming 38 M options are exercised at an average price of $13.375/share the value is diluted to $72/share, while a conversion of the convertible debt (assuming that the stock price made it advantageous) would be anti-dilutive, increasing the value to $76/share. When I compare that value to AMZN's current price of approximately $175/share, I am a bear!

Ausfahlm cites a quote by Joy Covey in the 4/05/99 Forbes: "The mistake people make it to get concerned about what percentage we get on sales," Covey says. "We could have a very low return on sales and still have a huge return on invested capital because our model is so scalable."

"Personally, I have enough trouble with the assumption that any retailer, particularly one selling discretionary items, will grow at a rate significantly in excess of the economy as a whole over an extended period of time."

I agree - AMZN's return on invested capital could be quite extraordinary. That is not the point. Buyers of AMZN today are not investing in AMZN - they are buying the investments of others who invested in AMZN (or of people who bought from others who invested...). While the return on original invested capital may be perfectly satisfactory, and even extraordinary, the return on that capital when purchased in the market for 30 - 100x its original book value is unlikely to be as attractive.

Disputed Assumptions

We wouldn't have any fun here on the AMZN board if we all agreed with each other. I can see the following areas of disagreement over fundamental assumptions:

Margins: Bears will argue that margins are going to fall, either because of competition, or because AMZN is pursing lower-margin goods. I have read on this board that CDs and videos have lower margins than books, but have been unable to verify this. Can anyone help? A reduction of 3% points in margin would reduce AMZN's value to $60/share prior to options and debt conversion.

Growth Rate: Bulls will argue that AMZN will continue to grow at much higher rates that I have reflected, while bears will argue that I have been too generous in my assessment of AMZN's prospects. I have seen claims that AMZN will enjoy a compound rate of growth of approximately 70%. If that is applied over the next eight years, and if costs grow at a rate 10 percentage points below revenues, that would imply a valuation of AMZN at $127/share. The current market value of $175 implies assumed annual compound revenue growth of 77.5% (and sales of $60 Bn in 2006).

Personally, I have enough trouble with the assumption that any retailer, particularly one selling discretionary items, will grow at a rate significantly in excess of the economy as a whole over an extended period of time. I think that the growth rates I have assumed are conservative, but I expect a wide variety of opinion on that issue, whether expressed or not . It will be interesting to see how revenue growth continues through this year, but the fact that AMZN has had to issue discount coupons to retain customer interest indicates either that over the long run margins will come under pressure, or the vaunted "eight million pairs of eyeballs" in their customer base are not as attractive an asset as they would like to believe.

Cost Increases: Who knows whether AMZN will be able to contain their cost increases to be below their revenue increases, and by what margin?

Multiples: As I said, I see no real difference between AMZN and Lands' End - both operate state-of-the-art fulfillment operations, both are selling a discretionary purchase to a generally affluent client base. To a certain extent, LE has the advantage, since they are selling a proprietary good, rather than a commodity. I think the comparison to Dell is flattering to AMZN - as noted Dell has brand equity in the goods it is selling, and I place a higher value on that than a retailer's brand, particularly for commodity items. If the market begins to perceive AMZN like a retailer, and assigns a multiple like LE's (plus -say- 10 points for the higher growth rate) then we would see a multiple of about 40x, reducing the present value of a share of AMZN to $37/share. On the other hand, if AMZN remains the 'harbinger of a new retailing paradigm' and is assigned a multiple of 200, then the present value is $141/share, before options, etc. I cannot see even this sort of multiple, let alone higher, but perhaps some can.

Discount Rate: There are surely some bulls who see no risk in AMZN, so anything higher than a risk-free rate to discount its future value to present is too high. Applying a discount rate of 7% to the future value of the operating business yields a current fair value of $180/share before options or debt conversions, which would dilute per share value by just over $30/share.