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Wednesday, June 2, 1999

An Investment Opinion
by Louis Corrigan

The Flow on Amazon

Stocks often have a hard time going up when there are no new buyers. That's one reason lots of folks who follow "the market" like to look at the "money flow" into mutual funds. New money alone can fuel buying by fund managers. The Fool has followed famed stock picker Peter Lynch in a different kind of money flow, or rather, money-not-flowing analysis. We've always thought it's great fun to buy promising companies before lots of institutions have bought them. That's because Wall Street analysts and money managers operate with a herd mentality. They find it safer to jump aboard a hot stock after a company's business, and stock, has already taken off.

With the rare upstart that races toward becoming a gorilla, Wall Street's embrace often induces a buying panic. That's when the fund manager who thought a stock ridiculously overvalued at $60 a share will find he absolutely has to own it at $180 a share. His competitors own it, and the surest way to at least match the competition is to buy what they're buying. Individuals clever enough to pick such a stock before the institutions embrace it can often enjoy a wonderful ride as the conversion process sweeps Wall Street. Institutional ownership figures give you a quick read on how far along the process has gotten.

Of course, this process also plays out in the mainstream financial media. Indeed, the "media flow" often reflects and shapes the money flow. I think that's one reason the Fool's David Gardner defines a Rule Breaker, in part, as a stock vilified as grossly overvalued by a major financial news source. At the very least, such denigration suggests that the herd of money managers are a long way from buying into the bull case. So the stock may have considerable upside if the company proves as terrific as seems possible.

This rumination was triggered by two recent articles in the financial press. The first is Joe Nocera's cover story on Yahoo! (Nasdaq: YHOO), "How Yahoo Became a Blue Chip," in Fortune's June 7 issue. It nicely describes and embodies the conversion process. The subhead says it all: "A tale of how Wall Street and the rest of us learned to stop worrying and love an insanely valued Internet stock." This story signaled that most everybody who wanted to buy Yahoo! these days probably already had. Indeed, the article points out that the stock's market cap swelled from $12 billion last fall to a high of $50 billion in March as institutional ownership rose to a high 60%.

That's why savvy traders probably sold Yahoo! when this cover hit the stands. The media flow confirmed what the money flow had already done to the stock. For traders, that's a good time to leave the party. Smart move so far. Yahoo! was at $158 when the story went to press in mid-May. It's since continued its recent slide, sinking as low as $120 1/2 in recent weeks and closing today at $142 1/2. It doesn't hurt that Nocera's got ace credentials as a contrary indicator. His "Requiem for the Bull" cover story last September appeared at a perfect time to buy stocks.

Still, investors need to look behind the cover. What interests me at least as much as the amount and tenor of the media flow is what I'll call the "intelligence flow." To what extent does the media, and thus Wall Street, actually seem to understand a stock's story? The answer, in this case, is "less than you might suppose." Fortune's subhead suggests what the text confirms: This story is about investors abandoning their "valuation bias." Though Nocera entertains several ways in which analysts and money managers value or attempt to value Yahoo!, he concludes that no one has found a way to justify the stock's price. Its valuation must be explained by investors' insatiable desire for Internet stocks and management's "picture perfect" execution.

That's true to an extent, but it can't be the whole story. The market just isn't that dumb. The market is always working to price in certain assumptions, imprecise though they are. Assumptions about Yahoo!'s business model and its audience reach get translated into projections of revenue growth and profit margins, all of which can be plugged into a discounted cash flow model. Whatever Yahoo!'s proper price is, you can't begin to piece it together until you think you can. Nocera thinks the opposite, and argues that this is Wall Street's thinking as well. To the extent that that's true (and it may be), there's potential opportunity for a Yahoo! investor here.

The weekend cover story in Barron's on (Nasdaq: AMZN) -- "Amazon.bomb" -- offered still more negative media flow on this leading e-tailer. That suggests an even greater opportunity for investors -- assuming Amazon is for real (and I think it is). What's more, the intelligence flow is still surprisingly low.

Here's a major financial news source still dissing Amazon with the same old arguments. We're told that Amazon is just a middleman that faces tough competition from publishers selling direct online and from independent booksellers fighting back. We're told that electronic books are improving and will eventually be downloaded over the Web -- and for that matter, so will CDs. We're told that WalMart (NYSE: WMT) will compete online, and that Amazon's growth in book revenues will slow significantly from the 825% rate seen in 1997. Were these things not obvious two years ago? Barron's certainly has been repeating them for that long, even as Amazon's stock has soared.

More mind-blowing, though, is Barron's promotion of financial illiteracy. Reporter Jacqueline Doherty attacks Amazon's "gimmickry" in reporting pro forma earnings that exclude goodwill amortization. She doesn't seem to understand that, however well-established, GAAP is simply an accounting convention. To avoid relying on a distorted picture, savvy investors often modify a company's GAAP earnings, particularly when they include lots of one-time or non-cash items. Many smart corporate managers also routinely ignore GAAP earnings because a preoccupation with reported EPS can promote decisions that destroy economic value. Amortization charges are non-cash charges. Amazon is simply trying to help investors focus on numbers that come somewhat closer to the firm's real cash economics. Would Barron's have cable investors key off of GAAP earnings rather than operating cash flow?

Bulls highlight Amazon's terrific cash-flow dynamics resulting from the combination of low inventories, zero accounts receivable, and high days payable. Because Amazon's assets turn over faster and are largely financed by suppliers, those assets are very productive. The company also needs relatively little new working capital to expand its business. Barron's pretends to understand all this but contends Amazon is fast becoming less "virtual" as it builds warehouse space and inventories. That's true, but Amazon will need to take on massive inventory to narrow the gap that separates it from traditional retailers. At the end of the first quarter, Amazon had about 14 days of inventory ($45.2 million) based on Q1 sales while Barnes & Noble (NYSE: BKS) had 119 days worth ($940.3 million) based on its Q1 sales. And that's after Amazon's dollar value inventory nearly quadrupled year-over-year.

Even with additional inventories, Amazon's asset needs should remain structurally different from those of brick-and-mortar retailers. The implications of that remain enormous. The Fool's Dale Wettlaufer puts it this way: "If you have $850 million in net inventory, the capital costs on carrying that will be around $85 million per year. Even assuming a higher cost of capital for the 'riskier' company, $200 million in net inventory will result in capital costs of $30 million per year. The difference between those, in just one retail category, is a net benefit to investors of $1.1 billion, capitalized at 20 times. It would take a difference of at least 770 basis points of gross margin, assuming no difference in operating expenses, to overcome the disadvantages of a high-inventory, high margin model."

By fixating on static profit margins while ignoring the nitty-gritty of Amazon's overall capital asset management, Barron's has screamed that it doesn't get Amazon's business model. That's why Doherty gives us the tired cliche, "Increasingly, Amazon's strategy is looking like the dim-bulb businessman who loses money on every sale but tries to make it up by making more sales." Major negative media flow with such low intelligence flow suggests there's likely opportunity in Amazon's recent swoon. Frankly, all this surprises me. I thought we had reached the point where even Barron's must understand Amazon.

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