FOOL ON THE HILL
An Investment Opinion
Certainly, both cases are compelling, when looked at in a vacuum. Amazon is a company valued on the market at $20 billion based on sales of $1.9 billion (trailing 12 months) and a per-share loss of $2.88. Clearly, all else being equal (and nothing else is ever equal), this is a rich valuation for a non-profitable company. At the same time, Amazon's 95% year-over-year growth and its leveraging of its brand name into more and more markets means that the company is removing some of the pure-play risk that would exist were Amazon still just selling books. This is not your father's Amazon.com. Hell, it's not even the Amazon.com you knew a week ago.
The answer to which view is correct will not be revealed in the course of this column. It will only come as Amazon either executes its business plan and turns profitable over the next few years, collapses under the weight of continued losses, or lands somewhere in between. But I've spoken of a few useful measures for unprofitable companies in the past, so it would not hurt to view Amazon using these as well. In the original article I demonstrated these methods using some pretty hollowed-out companies, sort of a worst-case fish-in-a-barrel approach. Amazon is a different beast entirely, and as I chose to approach this point I had no idea how it would measure up.
So let's see. And feel free to break out the 10-K and 10-Q for Amazon and check my work. For this exercise I'll be using the data field from the beginning of Q2 1999 through the most recent quarter's release, a period of one year.
Item 1: Growth in Gross Sales Sufficient to Discount Current Operating Losses
This is the simplest of the three measures to calculate (and by the way, none of them require any more than some basic calculations). This factor is built upon the concept that an unprofitable company unable to show sales growth is unlikely to ever improve its bottom line. The reason for this is simple: Unprofitable companies in immature sectors are being valued on potential. Low sales growth, low potential. Clearly Amazon has been valued by its investors as if it has a great deal of potential for bottom-line growth.
Amazon's topline growth rate for the defined period was 95%. And its expected long-term growth rates, if the analysts covering Amazon are to be believed, is nearly 65%. That's a big if, but the fact is that Amazon is growing gross revenues from a large base at an astounding rate. This measure is somewhat more effective at flagging bad companies than it is at identifying good ones. For while business losses plus a slow growth rate are a kiss of death for a company, losses coupled with a rapid growth rate does not necessarily portend future profitability. 'Course, that's why this is only one of the factors to take into account, but in this case, Amazon stacks up quite well.
Item 2: Gross Profits Compared to Sales and Marketing Expenditures
So Amazon is growing its sales at a really superior rate. Well, as I noted in the previous column, so is iVillage (Nasdaq: IVIL). Does this mean that every unprofitable company that is rapidly growing sales deserves a rich valuation? The answer, of course, is no. So we turn next to look at the effectiveness of Amazon's sales and marketing expenditures. What we need to see is that the company is leveraging its brand effectively, that it does not have to spend itself into oblivion to drive people to spend money there.
Marketing expenses are the investment that the company is spending to build its brand, something that Amazon has done very well. On the Internet space, most people who think books, think Amazon. Slightly less so for music and videos, and significantly less so for the newer Amazon sectors. By the way, the best way to look at these numbers is on an absolute, rather than percentage, basis. In the first quarter of 1999, Amazon had a gross profit of $64 million and a sales and marketing cost of $60 million, which means that these costs gobbled up all but about $4 million of Amazon's gross profit. This past quarter is a little more grim, as gross profit raced up to $124 million, but marketing costs surpassed the gross profit at $140 million. This means that not only are sales and marketing costs growing at a faster rate than gross profits, but that they now account for more than 100% of those profits.
This is not a positive trend for Amazon operations, and it is rightfully something that investors in the company should watch. Still, Amazon's numbers are not frightfully bad, as compared to some of the foundering Internet companies out there.
Item 3: Cost vs. Benefit for Each New Customer Acquired
This measures the expense to Amazon for acquiring each customer and compares this to the annualized revenue of the company. To measure this, you've got to have access to the total sales and marketing expenses for the lifetime of a company and the total number of customers acquired.
For Amazon, its total sales and marketing expenditures, for the existence of the company, has been $726.2 million. According to the company's most recent 10-Q, Amazon has served 20 million customer accounts. This means that Amazon has spent $36.20 in sales and marketing for each new account acquired. Compare this to eBay (Nasdaq: EBAY), which spends only $13 per new customer. But again, marketing costs that repay the company in short order are superior to those that take a long time to be recouped, if they can be at all. With Amazon's current 12-month run rate of $2.29 billion of sales, this means that the company is deriving $114.78 in sales per customer. Divide this by the cost of customer acquisition, and you'll find that Amazon regains in sales each dollar it spends on advertising in 3.2 months, a quick turnaround. This compares to eBay's turnaround of 1.7 months, but much better than America Online's (NYSE: AOL) turnaround time of 11 months.
The moral in this case is that Amazon is not showing profits on the bottom line, nor is it designed to be, yet. Amazon's sales and marketing costs will be a significant problem for the company's drive toward profitability unless they decrease to much lower levels -- this may be key to the company's eventual success. Amazon's management has been investing richly into building its brand name and its market share; what happens when the company has to ratchet these expenditures back in the name of achieving profitability?
Tune in for the future and find out.
Bill Mann, TMFOtter on the Fool Discussion Boards