Rule Breaker Portfolio Trimming Amazon, Adding to eBay

We believe that eBay is a consummate Rule Breaker. We want to make it a bigger part of our portfolio. We are selling our Spiders and half of our stake in Amazon.com, in order to buy more. We're selling Amazon because its precarious financial state creates extreme risk from which we don't see an associated increase in potential reward. We just think that eBay is a better investment right now, and want to re-weight our portfolio accordingly.

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By The Breaker Team
March 2, 2001

It's a red-letter day for our little portfolio. We're announcing three trades! Not very often do we indulge our trading instincts to such a degree.

We intend to sell our newly acquired Spiders, or S&P Depositary Receipts (AMEX: SPY), and half of our stake in Amazon.com (Nasdaq: AMZN). We will move the proceeds from both sales into one of our favorite stocks, eBay (Nasdaq: EBAY), which was recently anointed as a Fool 50 stock. In accordance with our trading principles, we will make each of these trades in the next five trading days.

Reasons for buying eBay
We are making this trade for the same reason that we make any trade -- we think we have a better place to put our money. We think that eBay exemplifies all the qualities of a Rule Breaker business:

• As recent events have shown, it parlayed its first-mover advantage into becoming the undisputed top dog in an important, emerging industry. eBay has done nothing less than revolutionize how people buy and sell virtually everything.
• With competitors like Yahoo! (Nasdaq: YHOO) and Amazon left in the dust, it looks increasingly like eBay has a nigh-insurmountable sustainable advantage.
• Meg Whitman has developed a marvelous management team that held back from making cash or stock purchases when prices were high, but is now swooping in to make great acquisitions like Half.com and iBazar.
• eBay's brand name has become one of the strongest on the Internet. Look for it on Interbrand's list of best-recognized brands in the world next year.

As far as the stock criteria go:

• eBay has recently been called overvalued.
• It can possibly pull off 10x/5y (which would put its market cap at about $100 billion) though 10x/10y is more realistic.
• Its relative strength resides around 30, well short of 90, following a year in which its stock has fallen almost 50%. It retains, however, the strongest valuation of any pure play Internet company except Yahoo!, on which eBay is closing in.

Long-time observers will note that it's unprecedented for us to buy a stock that we already own. We have in the past spoken out against averaging down. We think that eBay is a special case, however. Its business has only grown stronger since we bought it just over two years ago, though the price has fallen 25%. We're happy to bring our stake in the company up to about 10% of our portfolio. We plan on reaping rewards from that weighting.

Reasons for selling Amazon
At the same time, we are rebalancing our stake in Amazon to represent 3% of the portfolio, down from 6%. We have discussed before the primary reasons that we question Amazon's market-beating potential. They include, but are not limited to:

• Revenue growth is projected to slow to 20-30% in 2001. This is a problem for three reasons: 1) Amazon must become cash flow positive by the end of 2001, and it needs top-line growth to achieve that goal; 2) Amazon's interest payments on its $2.1 billion in debt amounted to 3.3% of revenue in 2000, so its operating margins will have to expand at least that high for there to be any take-home money for the company; and 3) Amazon will need faster growth than that to justify even its greatly reduced market price, let alone realize market-beating returns in the future.
• Management has squandered its financing by overbuilding its distribution network; starting up impossibly difficult businesses (like lawn & patio items and tools & hardware); and investing in marginal, third-tier online retailers, like  gear.com and pets.com, which are now failing.
• Amazon has failed to move beyond the world of retail. It has not been able to leverage its community -- if its registered users can be called a community in any meaningful sense -- into other, more profitable ventures, like auctions or zShops. It is a retailer plain and simple, with better working capital characteristics than an offline retailer perhaps, but negative margins.

Reasons for not selling our entire Amazon stake
You may well ask, "If that is your opinion of Amazon's condition, then why aren't you selling your whole position?" It's a fair point. The truth is that we just can't bear to stop following the Fantastic Story of Amazon.com. While seemingly riskier by the minute, it's still a Rule Breaker. It could deliver handsomely on our current stake over the long run, especially considering capital gains taxes from our Amazon profits to date. It will have to overcome an ugly balance sheet to do so, but if it succeeds, we want to follow along as part owners of the company.

Superficially, it looks like Amazon simply follows in a long line of Rule Breakers that have gone supernova and proceeded to turn into cold rocks. Excite@Home (Nasdaq: ATHM), 3dfx, and Iomega (NYSE: IOM) all had their day in the sun before shriveling up like raisins. Their potential to change the world just wore off.

Amazon is different. Its final chapter is far from written. Amazon has won the spot that innumerable companies fought like dogs for: It is the King of Online Retail. Undisputed. It's not even close -- well, it's getting closer, as eBay's Half.com gains market share. Still, Amazon's annual revenue far exceeds that of its rivals. We think that it will continue to dominate that space, and, once it gets past its current debt problems, that it may well become a strong company with lots of real option value.

Our problem with it is simply that we feel it has dug itself a debt hole, from which it will be difficult to extricate itself. Its returns as a business, and therefore as an investment, have been pushed accordingly far into the future. We don't think that it can achieve worthwhile appreciation over the next 10 years or so, compared to the appreciation we should get elsewhere.

Why didn't we sell before?
Observers may point out that it used to be about 30% of our portfolio, with a share price topping $100. Had we sold then, we would have raised $130,000, rather than the $13,000 we are raising.

Yes, we could have sold it at $100, or $75, or $25 (when we proposed going short on the stock), or $17 (when we first suggested selling it). We are aware of this. We don't worry much about market pricing, however. We take a deliberative, business-focused approach to investing that sometimes causes us to sell late. It has damaged our returns on this occasion and on several others in the past, but it has often helped them too. Overall, we believe that our conservative sell strategy is still sound.

We aren't departing from these shares of Amazon empty-handed. Combined with our prior partial sale of Amazon shares, we've made over $30,000 on our initial investment in the company. On our current sale, we will probably realize at least a 200% gain over a three-and-a-half year holding period. That's good, but we look for better. We don't have the same confidence that Amazon will provide better in the future.

Farewell Amazon, in part anyway, and Spiders, and hello eBay. We have high hopes for you.

Fool on!

The Breaker Team may make decisions slowly, but we sure can dance. Jeff Fischer, Brian Lund, and David Gardner own eBay, and David owns Amazon. To see all the stocks they own, check out the profiles of Jeff, Brian, Paul Commins, and David. The Motley Fool is investors writing for investors.