Some Risks[Fool on the Hill] May 25, 2000

An Investment Opinion

Some Risks

By Warren Gump (TMF Gump)
May 25, 2000

With so many flowery articles written about (Nasdaq: AMZN) on this site, the most value I can add on the subject is pointing out some of the risks that many people overlook when evaluating the company. Topics that will be covered include the pitfalls of Amazon's hefty convertible debt, the not-so-meaningful statement that Amazon's operating cash flow will be positive over the next three quarters, and the risk associated with related-party transactions in the Amazon Commerce Network. The word "risk" was carefully chosen to describe these three subjects. They are possible -- but by no means certain -- reasons that the Amazon story may not end up being as exciting as many people think.

How Convertible Is That Debt?
As we all know, Amazon has suffered substantial losses since inception. The company has lost a total of $1.2 billion since 1995, with annual losses increasing every year. To cover the negative cash flow associated with these deficits, Amazon has aggressively tapped into the debt markets... to the tune of almost $2 billion worth of convertible bonds over the past 18 months. A couple billion dollars of debt is quite a bit for most organizations, particularly one expected to bleed red ink for the foreseeable future.

The astute student in the front row yelps, "Stop! Didn't you say that the debt was convertible? Doesn't that mean that it will be converted into equity so it won't really need to be repaid?" That could be true, but one important condition must be met before that happens: Amazon stock must trade above the exercise price on the bonds when they are called for redemption. Otherwise, bondholders will politely but firmly request to be repaid with cash rather than stock.

The conversion price on its E690 million (that's Euro, worth about $626 million) bond issue is E105 per share ($95), although it could be reduced to E85 ($77) under certain circumstances. The company's $1.25 billion domestic convertible subordinated notes have a conversion price of $78 per share. All of these exercise prices are well above Amazon's current trading price ($45 1/2 as of today's close). If the stock price doesn't regain traction over the next few years, bondholders will not convert these securities and Amazon will be forced to cough up cash (the notes aren't due for eight to nine years, so there is some time here). In the meantime, Amazon will be forced to pay bondholders $102 million a year in cash interest expense. Ouch! That hurts when you aren't making any money (particularly if the capital markets aren't responsive to new issues).

Did You Say Cash Flow Positive?
Analysts up and down Wall Street (and dare I even say Fool Avenue?) lauded the statement that Amazon management made in its first-quarter earnings release: "We believe that over the next three quarters combined, will be operating cash flow positive." This statement sounds terrific on the face of it, since most of its e-commerce brethren seem caught in an abyss of negative cash flow. Be careful, though. This statement absolutely doesn't mean, as some might extrapolate, that Amazon will be operating cash flow positive over a 12-month operating cycle.

As a retailer, most of Amazon's sales occur in the fourth quarter, around the holidays. The company buys lots of merchandise during this period, most of which will be paid for at some later point. Because of this, accounts payable surge at the end of the fourth quarter, leading to a commensurate increase in operating cash flow. Since payables are short-term debt, however, the money needs to be paid back in the following quarter. This ends up reducing operating cash flow in the subsequent first quarter.

What does this specifically mean for Amazon? The company's payables increased by $226 million between September 30 and December 31 last year, boosting operating cash flow by a like amount. Unfortunately, this cash surge didn't stay with Amazon: During the first quarter of 2000, payables decreased by $207 million, erasing 92% of the fourth-quarter gain from this line item. A similar phenomenon will likely recur next year. Anyone who interpreted Amazon's statement to mean that it had entered a period where it will be cash flow positive on an annual basis will probably be disappointed when results are reported. Commerce Network (ACN): Yippee or Yikes?
Many investors have been intrigued by the prospect of the ACN, where Amazon buys minority stakes in strategic partners, which in turn enter into agreements to sell products and services in co-branded areas of the Amazon website. The business logic behind ACN is impeccable. By helping market other companies' products to its vast and growing customer base, Amazon can bring substantial amounts of extremely high-margin revenue into its business model.

However, investors need to be fully aware of issues surrounding these deals and their associated revenue. Due to the structure of these deals, it is entirely possible (and legal) for Amazon to almost single-handedly boost its revenues by signing new deals.

Let's say that Amazon decided to add $50 million to its annual revenue. The company could make a $50 million investment in, an upstart Internet-based poodle grooming service. In return for taking this stake, agrees to enter into a one-year marketing deal, paying $50 million for space on its website. With the signing of a pen stroke, Amazon will have added $50 million in revenue over the next year.

Should investors really count the PoodleGroom revenue? Amazon basically took $50 million off its balance sheet and sent it through its income statement via an affiliated company. To the extent that the transaction was done at "arms length," on terms that non-related businesses would enter into, it makes sense to count the deal in the company's performance.

On the other hand, if the investment in PoodleGroom caused the deal to be stacked in Amazon's favor, the income from the transaction is not very clean. Losses from the PoodleGroom venture will ultimately flow through Amazon's income statement (through either equity losses in affiliates or net investment losses), but company management will likely try to write those off as a "one-time" event that should be ignored for analytical reasons.

If you believe an important part of Amazon's growth lies with the ACN, it could be worth your while to evaluate the financial viability of the ACN partners. Some of the larger ones are (Nasdaq: DSCM), (Nasdaq: IPET), (Nasdaq: ASFD),,,, and If these companies have solid businesses, Amazon will reap the rewards of this high-margin income as well as the appreciation from its equity stake in the companies. If they are built on little more than Internet ether and Amazon's cash, however, the double whammy of dramatically lower-than-expected ACN revenue and substantial losses on its investment in partner companies could hit Amazon shareholders hard.

Related Link:
Rule Breaker, 5/25/00: How Much Is Amazon Worth?