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Friday, October 30, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale "Curbludgeon" Wettlaufer

Amazon Impresses Again

Amazon.com (Nasdaq: AMZN) returns to this space today, having reported strong results on Wednesday after the bell. The Seattle-based book and music store reported strong net sales of $153.7 million, more than four times last year's sales and up 32.5% sequentially. Compared to the prior quarter's 32.7% sequential sales gain, third quarter results stacked up very well.

A salient feature of this quarter's sales results was the company's full entry into CD retailing, which generated $14.4 million in sales. That's more than any other Web-based music retailer but less than the pro-forma results of the combined CDNow (Nasdaq: CDNW) and N2K (Nasdaq: NTKI). Nevertheless, if the average CD costs $12, then 1.2 million CDs shipped in the first full quarter of operations is pretty impressive. The established competitor, CDNow, recently reported Q3 revenues of $13.9 million and a sequential growth rate of 20%.

A further difference in the -- yeah, I'm going to use that word -- "stickiness" of the two retailers can be seen in the repeat business statistics the two companies cite in their press releases. For its most recent quarter, 59% of CDNow's business came from repeat customers while 64% of Amazon's revenues came from repeat customers. Given that repeat customer revenues are an important component of same-store sales results for traditional retailers, Amazon.com's performance here was clearly superior.

The company's progress still hasn't turned into earnings. Sales at present are not designed to convert to earnings and cannot reasonably be expected to convert to earnings given the demands of building a worldwide retail business from scratch. Surpassing a discussion of what should be self-evident, gross margin for the quarter was an impressive 22.7%, up slightly from 22.6% last quarter. Impressive is the adjective, yes. Let's look at a couple of highly successful retailers that sell price, service, and selection, rather than highly differentiated products, and examine what percentage of a sales dollar they bring to down:

Wal-Mart: 21.1%
Hannaford Brothers: 25.1%
Costco: 10.4%
Kmart: 21.7%

At its core, Amazon has to be judged as a retailer. It has to be remembered that as a retailer, it will never generate huge margins. Anyone who calls it a "tech company" is just plain wrong. The model of a retailer is to generate sales volume over as small a working capital base and operating expense structure as possible. Judging the company on these metrics is the key to assessing the company. Judging it against a company that has a monopoly in PC operating systems will not get you anywhere. On these metrics, the company did well for itself this quarter.

Inventory turns reached an annualized 26 turns this quarter, meaning the company sells out its entire inventory every two weeks. Ending days sales in inventory was 15.2. With no receivables and ending days in payables at 46.1, the cash conversion cycle for the quarter was negative 31 days. A company derives considerable benefits for its ability to expand and for its valuation if it can turn its inventory 26 times a year and pay the vendors financing that inventory 7.9 times a year. In a discounted cash flow model, the lack of working capital accumulation in the initial years shows up as a big plus in both the initial years and the out-years. This is because of a lack of working capital financing costs as well as the cash drain that inventory represents.

For the quarter, working capital minus cash actually decreased by nearly $20 million. Imagine you ran your own corner store and had to actually finance $20,000 for an increase in working capital, and you also wanted to put on a big $37,000 marketing push. By the time your 30-day payables rolled around, that would actually take a cash outlay of $57,000. Translating that to Amazon.com's quarter, $20 million in marketing and sales costs of $37.517 million was financed by negative working capital requirements. That's a net outlay on those two items of $17.517 million. That directly impacts valuation and financing throughout a cash flow model.

On the earnings front, reported earnings for the quarter were negative $45.17 million, with a per-share loss of $0.90. But let's look at what that entailed. $20.512 million in pre-tax merger and acquisition-related costs rolled through operating expenses. It would actually be helpful to see in the line-item the one-off costs for the quarter, such as the one-time charges for the Junglee and PlanetAll acquisitions, and what is ongoing amortization of intangibles. The company reported pro-forma net income of negative $24.658 million. That is by far the more useful figure because it ignores the amortization of goodwill and purchased intangibles that show up in the income statement.

Like many companies, Amazon.com could allocate a good deal of the difference between the purchase price of acquired companies and the book value of the acquired companies to "in-process R&D" and charge it off in a single quarter and be done with it. Or, electing not to do that, a company could choose a much slower amortization schedule than Amazon.com has elected to lighten up the amortization expense load. So far, though, the company has been going with intangible amortization schedules of roughly three years, which puts a lot of non-cash expenses on the income statement. And we're not the sort of people to treat depreciation as a "non-cash" expense, as if it were free and didn't represent an ongoing need to lay out cash. But amortization of intangibles is an entirely different thing. How a company allocates the purchase price of an acquisition, whether over 3 years or 10 years, doesn't change its cash flow and does not represent a reinvestment need to maintain its current competitive position.

The bottom line on the quarter was that net cash flow from operations was approximately negative $647,000. Net cash from operations will look roughly like this. The final classification of one-time merger charges, as to whether they're cash outlays or amortization, will become much clearer in the 10-Q, but the pro-forma income figure minus working capital investment gets us pretty much to the same point we reach below.

($ in thousands)

Net loss...$(45,171)
Adjustments:
Depreciation...$3,100
Amortization of intangibles
and unearned compensation...$13,400
Noncash interest expense...$8,400
Changes in operating assets and liabilities:
Inventories...$(2,737)
Prepaid expenses...$(5,138)
Accrued advertising...$1,886
Accounts payable...$12,490
Deferred charges...$(32)
Other liabilities and
accrued expenses...$13,155

Less capital expenditures of about $9.8 million, this is a pretty light cash hit for a company quadrupling its sales year-over-year and growing more than 30% sequentially. If an investor has a doubt as to whether Amazon can garner enough market share in books, CDs, and other retail markets to justify its current market cap, that's one thing. But it's not as if the company doesn't have the financing horsepower to do so. So far, the people running this company have made the right decisions and the market obviously has responded. Pundits will say, "Yeah, but I can get it $0.30 cheaper elsewhere, or I like the couches at Barnes & Noble." That's fine, but there are evidently people that don't have time to putz around at Barnes & Noble and who get sick of going into lame chain stores and finding the same commercial stuff on the shelves that was there three months ago.

At this point, the market believes the story and it's not going to stop believing it until the growth story breaks down and the fundamental cash flow story breaks down. As it stands right now, though, this company isn't sucking down hundreds of millions of dollars in cash each year to create 1) growth and 2) a dubious return on invested capital profile down the road. That's why Amazon.com's market cap is where it is. Not that one should readily agree that it's a wonderful bargain at the current market cap, but in my opinion that addresses the question better than the cries of "Internet mania."

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