<THE RULE BREAKER PORTFOLIO>
"It is Over Now"
Close the Internet, boys. It's over.
by Jeff Fischer (TMFJeff)
ALEXANDRIA, VA (April 29, 1999) -- "As of today, Internet stocks have lost their luster," according to some analysts. eBay gained $22, Priceline.com added $16 and RealNetworks rose $31, each rising at least 11%. Meanwhile, Amazon closed at $168, up 1,000% from one year ago, but down 13% today. Apparently, 13% is a luster-losing move. Some analysts took it one step further, saying of Amazon, "It is over now. You can sell it or even sell it short."
"Wise sir," the Fool asks, "will you stand behind that statement in five or ten years?"
Louis Corrigan wrote about Amazon.com (Nasdaq: AMZN) in this afternoon's Fool Plate Special. Losses are expected to be 2.5 times larger than the first quarter in future quarters, which is about three times larger than analysts expected. However, rather than Amazon "disappointing analysts," analysts should be disappointed in themselves. It is the analysts whose estimates called for sequentially lower losses, not Amazon.
Amazon is gunning for growth. Analysts, on other hand, consistently form financial models for the company based only on current operations. Then they use the simplest logic, logic which says: "As Amazon's existing business grows, costs will fall proportionally and losses will subside."
"Yeah, that's right," an analyst buddy would agree, nodding his head. "Costs will decline. Case closed. Let's get a drink."
Meanwhile, 3,000 miles from New York, Amazon is planning to increase spending on marketing, increase spending on branding, and increase spending on new businesses -- all of this resulting in the opposite of what analysts projected. Amazon wants to grow out, not only up. Analysts were projecting that it would only grow up.
So, Amazon's stock declines 13% as analysts adjust expectations. It's important to remember, however, that Amazon didn't surprise itself yesterday when it revealed its growth and spending plan. It only surprised analysts. Therefore, it's interesting that journalists are writing, "Amazon is getting killed after disappointing the Street," as if Amazon did something wrong. The more accurate statement is, "Analysts made the wrong assumption on Amazon's business model, so they're selling the stock in spite of themselves. Amazon wants to build something much larger, but it will take more years of spending. Some investors apparently don't care to wait."
As Louis Corrigan noted in his column, Amazon spent $66 million on marketing last quarter. $66 million represents 22% of sales, which is about what America Online (NYSE: AOL) spent for several years on advertising and on the marketing of free AOL disks. AOL withstood intense criticism for this cost. "It won't recoup its investment in marketing," was said as recently as two-and-a-half years ago. At the same time, we argued that once AOL reached a certain size, it could decrease marketing costs at will and thereby ratchet operating margins higher. It has since done that. AOL's operating margins improved to 16% in the recent quarter from 9% one year ago. Its sales and marketing costs were 17% of sales compared to the mid-20s, like Amazon now, three years ago.
AOL has been public about four years longer than Amazon. For a study of comparison, let's assume that Amazon can begin to decrease its marketing costs as a percentage of sales, in significant fashion, after approximately the same amount of time that it took AOL. If that proved true, Amazon would have about three more years of relatively inflated marketing costs. It likely has at least three more years of high infrastructure building costs, too.
Where AOL invested heavily in technology in the early years, Amazon must invest in technology as well as warehouse facilities and warehouse staff, a disadvantage that eBay and AOL sidestep. Amazon will buy or build warehouses so large that it'll only use portions of them initially, thus the overhead cost will outweigh the immediate benefit. Amazon's business should grow to fill the warehouses, however, and management would rather err to the side of excess than build too small and be forced to build again. The company is already growing more quickly than it expected, so it must spend more quickly, too.
About 25% of Americans have online access. About 12% to 16% of those have bought items online. To say that "it's over now" reminds me of what was said of Coca-Cola (NYSE: KO) a while ago: "The best days are behind the company. The growth prospects are limited." Something to that effect was said of Coca-Cola in the 1930s, hardly ten years after it went public. Amazon has been public for two years. The "Internet" itself has only been "coming public," piece by piece, company by company, since about 1995.
Amazon could be the largest book, music, and video seller in the country, online or off, in three years. Given reasonable growth and a strong fourth quarter, Amazon is on track to achieve sales of $1.4 to $1.6 billion this year. Last year, Barnes & Noble (NYSE: BKS) had $3 billion in sales and Borders Group (NYSE: BGP) had $2.6 billion. Amazon's sales could grow 145% this year, to $1.5 billion. If sales grow 80% in 2000 (to $2.7 billion), and 50% the next year (to top $4 billion), the company would likely surpass Barnes & Noble. This outcome could convince everyone of the concentrated power of online commerce. Offline commerce is scattered. Online commerce will be focused. The leading one or two companies will command a market with much more force than is possible offline.
Sure, you could sell Amazon now. In fact, if you don't have a five or ten year outlook, you might ask yourself why you're holding it.
eBay (Nasdaq: EBAY) snapped back 11% to close at $215. The company's business model is probably the best of any in this portfolio. It is, of course, the only company we own that doesn't carry inventory and the associated costs. eBay's acquisition of Butterfield & Butterfield Auctioneers Corp. is somewhat amusing. B&B was founded in the 1800s. It is the third-largest auction house in the U.S., behind Christie's and Sotheby's. It sells expensive treasures. eBay was founded a few years ago as a way to trade Pez toys. It went public nine months ago.
Butterfield & Butterfield earned $20.7 million in revenue last year and $2.5 million in profit, for 12.2% profit margins. This was achieved offline. The company has a website at http://www.butterfields.com.
By the way, don't miss this Foolish -- though obviously less than ideal -- story on eBay: a 13-year-old child -- with great taste -- bid $3.1 million for various items on the site with his parents' eBay account. Andrew Tyler, who lives in New Jersey, bid $24,500 for a red 1971 Corvette convertible, $500,000 for a Van Gogh painting and $1.2 million for a medical office in Florida. (Huh?) He also bid $900,000 for an antique bed said to have belonged to Sir John Macdonald, Canada's first prime minister. (That makes a little more sense than the medical office.) He was the high bidder on the bed, so he'd sleep pretty if his parents allowed it. The full story is here.
Word is that America Online might aid Comcast in bidding for MediaOne, which would pit the companies against AT&T's (NYSE: T) mammoth $58 billion bid. America Online is seeking avenues to provide high-speed Internet access to its service. It already has high-speed DSL connection agreements with Bell Atlantic and SBC Communications. Cable is the more viable near-term solution, however, and AT&T -- with TCI Communications and @Home Networks (NYSE: ATHM) -- is not about to relinquish its market position. Its consortium of companies is poised to dominate the high-speed cable Internet market for the foreseeable future. MediaOne or not, AOL's Steve Case said that "new possibilities [for high-speed access] have emerged over the past few weeks."
If and when AOL signs a sweeping, definitive high-speed Internet cable access agreement, @Home's stock will probably react. The market is large enough for both providers, however. The reasoning is, though, that the longer it takes AOL to offer the service, the better for @Home. Being shareholders in both companies places us in a fairly care-free position as long as one or the other company is leading in high-speed access.
It's simple, but it's incredibly exciting and interesting, too: the Internet is changing the world. It will continue to change the world, and how we conduct business, exceedingly over the next ten years. Then the next twenty. The companies that capitalize on the new medium and succeed will become world leaders -- just as Coca-Cola is a leader in the world beverage market -- because this medium is worldwide. It took Coca-Cola 100 years to build worldwide distribution, and it's still building. Yahoo! (Nasdaq: YHOO) has built an all-but worldwide presence in four years. Because of this ability, startup companies can rise to challenge the strongest offline companies in the world (Amazon vs. Borders, for example) with stunning speed online.
It's so far from "over" that it hasn't yet even begun. There are no guarantees, except that we're guaranteed to watch an amazing transformation of our business landscape in the coming decade. For more reading in this vein, The Washington Post has an article today titled Internet Distribution Threatens to Rewrite the Music Business.
Day Month Year History Annualized R-BREAKER -4.29% 1.49% 61.30% 1518.95% 80.13% S&P: -0.60% 4.39% 9.56% 206.50% 26.71% NASDAQ: -0.86% 2.71% 15.31% 251.08% 30.40% Rec'd # Security In At Now Change 8/5/94 2200 AmOnline 0.91 140.75 15386.60% 9/9/97 1320 Amazon.com 6.58 168.25 2457.29% 5/17/95 1960 Iomega Cor 1.28 4.88 280.74% 12/4/98 450 @Home Corp 56.08 142.25 153.65% 2/26/99 300 eBay 100.53 215.00 113.87% 12/16/98 580 Amgen 42.88 64.44 50.29% 4/30/97 -1170*Trump* 8.47 4.50 46.86% 2/23/99 300 Caterpilla 46.96 65.50 39.47% 2/23/99 180 Chevron 79.17 103.56 30.81% 7/2/98 470 Starbucks 27.95 35.94 28.56% 2/20/98 260 DuPont 58.84 72.75 23.63% 2/23/99 290 Goodyear T 48.72 56.25 15.47% 1/8/98 425 3Dfx 25.67 17.00 -33.77% Rec'd # Security In At Value Change 8/5/94 2200 AmOnline 1999.47 309650.00 $307650.53 9/9/97 1320 Amazon.com 8684.60 222090.00 $213405.40 12/4/98 450 @Home Corp 25236.13 64012.50 $38776.37 2/26/99 300 eBay 30158.00 64500.00 $34342.00 12/16/98 580 Amgen 24867.50 37373.75 $12506.25 5/17/95 1960 Iomega Cor 2509.60 9555.00 $7045.40 2/23/99 300 Caterpilla 14089.25 19650.00 $5560.75 4/30/97 -1170*Trump* -9908.50 -5265.00 $4643.50 2/23/99 180 Chevron 14250.50 18641.25 $4390.75 7/2/98 470 Starbucks 13138.63 16890.63 $3752.00 2/20/98 260 DuPont 15299.43 18915.00 $3615.57 2/23/99 290 Goodyear T 14127.38 16312.50 $2185.13 1/8/98 425 3Dfx 10908.63 7225.00 -$3683.63 CASH $9924.87 TOTAL $809475.50Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.
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