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Thursday, February 18, 1999

An Investment Opinion
by Louis Corrigan

Amazon and the Future of E-Commerce

Yesterday, I highlighted Onsale's (Nasdaq: ONSL) atCost site, which is now selling a broad line of new computer equipment for a low, flat-fee markup. In short, it's now competing directly with CompUSA (NYSE: CPU) and everybody else in PC retailing, online or off. In the near future, atCost will no doubt venture into consumer electronics, competing even more completely with Best Buy (NYSE: BBY), Circuit City (NYSE: CC), and everybody else in that notoriously tough but recently booming business. While Onsale's strong customer base makes it well positioned for this fight, the company won't be alone in this move toward a light, high-volume, low-margin online business model. Many other firms will use the same game plan to try to capture a piece of the e-commerce pie.

A few observations seem obvious. First, every store-based retailer of commodity-like hard lines will have trouble competing with the atCosts of the world. Their brick-and-mortar cost structure is just too high to slash prices low enough. People will browse for PCs, TVs, or boomboxes at Best Buy, but they'll increasingly buy from a reputable, low-cost online vendor. This change may be gradual, but the market will begin to discount the extraordinary competitive pressures on these well-known retailers. After all, it's begun to discount the fact that Borders (NYSE: BGP) was too slow in launching its online bookstore and thus fell way behind (Nasdaq: AMZN) and Barnes & Noble (NYSE: BKS), leaving it simply caught in a bind. Borders must now pay up to promote its website, cannibalizing its store revenues with low-margin online sales that may not necessarily expand its market. Or, it can simply hope that the Web goes away. Shareowners of many still-strong retailers should ask what Borders has to teach them, and the lesson may be, "Get out now!"

Second, e-commerce has generally been thought of as a process of disintermediation whereby buyers and sellers can now bypass those parties that once took a slice of the profits despite adding little or no value to the transaction. The clearest example may be the way discount brokers like Schwab (NYSE: SCH) reduced stock transaction fees by convincing millions of investors that full-service (that is, high-priced) brokers didn't add enough value to justify their commissions. Now, online brokers like E*Trade (Nasdaq: EGRP) have convinced millions more that even talking to an order-taker over the phone is of minimal value.

What the gold rush in the online brokerage business really suggests, though, is that traditional business-to-consumer commerce is undergoing a process of re-intermediation. Old business is being conducted through new (or simply different) intermediaries that offer customers a new value proposition and thus depend on different profit centers. What used to cost a lot of money (a stock trade) is increasingly inexpensive or free. Companies that provide excellent service and a competitive price on this repeat, commodity business will be positioned to benefit from other revenue streams (say, getting you to invest in their own mutual funds) or from a greater volume of traditional, though once-downplayed revenue streams (say, from interest on margin loans). You have to be lean, though, to make money this way.

Third, despite Onsale's experience, sound management, and established customer base, it too could have a difficult time competing in this game without additional financing. The key here is the unusual nature of competitive advantage in the world the Web is creating. In short, brand matters, and matters hugely, but in two very specific ways: its ability to produce an increasing volume of customer traffic and transactions, and its related ability to ensure that a company has access to unlimited financial resources. Brand won't ensure that a company enjoys (much) pricing power up front. But it will definitely help a company survive in an environment where no one is supposed to have pricing power but where someone eventually will.

What I'm suggesting is that e-commerce may work like a poker game in which the players capable of raising the stakes high enough will never lose because competitors will simply have to fold. Clearly, Amazon may be best-positioned to play this game. Although the Amazon bears have repeatedly argued that there are no barriers to entry on the Web and that price competition will destroy the company, they're not just wrong, but diametrically wrong. The dynamics they identify as a threat actually speak to precisely why Amazon is so strong.

Nonetheless, because we're all still coming to grips with competitive advantage on the Web, Amazon's stock will likely take a huge hit at some point. For FY98, Amazon reported gross margins of 21.9%, up from 19.5% in FY97. Despite fears that lower-margin CD sales would cause gross margins to decline, they still increased to 21.1% in Q4 versus 19.6% a year ago (though they did decline sequentially from 22.7% in Q3). Jeff Fischer, co-manager of the Fool's Rule Breaker portfolio, is not alone in projecting that gross margins should continue to rise, perhaps to 25% by 2001. Yet, at least in terms of product sales (as opposed to commission or advertising revenues), I now think the atCost model will exert tremendous pressure on gross margins.

Ask yourself how investors would react if Amazon's CEO Jeff Bezos said the company would pursue a strategy of achieving zero gross margins on product sales for a period maybe measured in years. That would be a shock. Investors would be seriously stumped about how you can operate a business in such a fashion. Yet, if e-commerce becomes as competitive as everyone seems to believe, then such a strategy could well be Amazon's most rational response, a natural extension of the current strategy of accepting net losses while growing the business.

A pithy way to summarize Amazon's competitive advantage is to say that it may be the only company capable of adopting a sustained zero gross margin strategy on product sales without simply going out of business. Amazon's first-mover cachet, stellar brand, smart management, and daunting 6.2 million customers (1.7 million new customers in Q4 alone) have allowed it to raise a stunning amount of cash via convertible debt offerings: $326 million last spring and $1.25 billion in February. It's now got about $1.62 billion to use however it likes to remain the top online retailer. Competitors can probably get their hands on more cash, but a quick snapshot of a few shows Onsale with $46.7 million, N2K (Nasdaq: NTKI) with $36.2 million, CDNow (Nasdaq: CDNW) with $49.0 million, Best Buy with $409.4 million, and Circuit City with $118.0 million. So Amazon has a lot of money to build out its distribution infrastructure (as announced), boost ad spending, make acquisitions, create content, or whatever.

Amazon could even use its cash hoard to support cutthroat pricing that drives competitors out of the market. On an operating basis, Amazon reported a FY98 net loss of $74.4 million, a gross profit of $133.8 million, and sales of $610 million. Even adjusting for tremendous sales growth, Amazon could afford to drop gross margins substantially without risking its future. Indeed, it may be one of the only companies for which such a strategy would not only not be suicidal but might even be smart. How many competitors could afford to suffer massive losses for years to come while simultaneously finding a way to eventually make money in a low gross margin environment where Amazon already enjoys a huge head start and greater economies of scale?

To be clear, I'm not saying Amazon will pursue this strategy, only that it can if it must. However, Bezos probably will decide at some point that lowering gross margins makes more sense than increasing advertising spending, though these are really just two sides of the same coin paying for long-term market share. The main point is simply that e-commerce will likely remain a game of who can afford to lose the most money for the longest time while keeping investors convinced that its strategy makes sense. Keeping Wall Street hooked is really the only reason why any of these companies wants to turn a profit sometime soon. From a pure business angle, it would probably be smarter for Amazon to postpone profitability for another decade.

That's not a joke either. Whether you imagine Amazon continuing to grow its infrastructure largely by allowing its vendors to fund its working capital needs or whether you imagine Amazon moving increasingly toward a kind of atCost fee-for-service model (which seems likely), the fact is that Amazon is positioned to be a player when everybody who wants to lose money venturing into e-commerce has thrown the dice and come up snake-eyes. At that point, margins from product sales will firm and then climb. Meanwhile, the stream of advertising revenues that Amazon has only begun to tap should just get bigger and bigger so that it becomes a significant if not the major source of profits.

Working out the actual numbers and putting a valuation on the business is a challenge, but I think these tasks can only be addressed once you figure out where the industry is going in terms of price competition and what firms can maintain good financing options. I've personally come around to the view that the Web will prove so competitive that competition will disappear. That's a bizarre formulation that's not literally true, but it at least points to the logic of the system. E-commerce may simply be so weird that we had better re-wire our brains if we hope to understand it.

Call Your Boss a Fool.

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