Boring Portfolio

Boring Portfolio Report
Friday, September 12, 1997
by Greg Markus (TMFBoring)

ANN ARBOR, Mich. (Sept. 12, 1997) -- Stocks departed from the usual Friday script by surging in the afternoon to close sharply higher. The Nasdaq rose 0.58%, while the S&P 500 zoomed 1.24%.

As for the Boring Portfolio, it ended the week on an “up” note, as well, gaining 1.10%. For the week, the Borefolio advanced 0.31%, as compared with a 0.55% loss for the S&P but a strong 0.83% gain for the Nasdaq.

There was no news of consequence on any Borefolio holdings Friday, which is fortunate because I devote this entire lonng-g-g recap to a company that’s come out of nowhere to stake a claim on the book-selling marketplace: namely, FoolFolio holding AMAZON.COM (Nasdaq: AMZN).

On Wednesday, I mentioned that, as a BORDERS GROUP (NYSE: BGP) shareholder, I’d offer a thought or two on Amazon today. Little did I know as I was tapping out my thoughts on Friday afternoon that AMZN was surging nearly 17% to close at $44 1/4.

Not only did this require that I quickly re-do the valuation calculations I had scratched down on my lunchbag, it also required that I pause for a few minutes, stare at the ceiling, and wonder whether perhaps I was wrong in thinking that in the high $30s (i.e., where the stock had been only hours before) AMZN was overpriced. Perhaps the head Fools, along with the entire equities-investing public, were right?

Perhaps so. But where’s my error?

I re-checked my calculations, making sure that I hadn’t mistaken a poppy seed for a decimal point. I reassessed my opinions about the degree to which Borders, BARNES & NOBLE (NYSE: BKS), and other competitors (existing and emerging) could crimp Amazon’s rush. I re-checked the news for word of a breaking development (and found none). I re-evaluated my sanity.

Alas, I ended up where I began: AMZN may well double for the Fools -- and I sincerely hope it does; but unless someone can help me out and show me the errors of my ways, it’ll double without me being on board. As Luther (Martin, not Lex) said, “Here I stand; I can do no otherwise.” Or in the words of the 20th-century philosopher, Popeye: “I yam what I yam.”

First, I want to stress that my problem is not with, the company. It’s with AMZN the stock. In fact, I like Amazon the company a lot. Founder Jeff Bezos is obviously a very smart and an entrepreneurial genius. Moreover, he’s assembled a top-notch management team and board of directors. The business model is a good one, and its execution has been just terrific to date.

Indeed, when I first discovered Amazon’s Website early this year and learned about their offer to have other online companies partner with them -- to direct traffic toward Amazon’s Website in exchange for a cut of the sales -- I urged the folks at Fool HQ to check it out.

I wholeheartedly agree with all the arguments about the terrific opportunities for selling over the Web. I agree with the value, both financial and otherwise, of facilitating online communities of interest. I agree with all of that stuff. Then there’s the opportunities for advertising online, cross-selling, the ease of gathering detailed market data on customers, etc., etc. All agreed, enthusiastically.

So then what’s my problem with AMZN?

Actually, I’ve got two problems. The first is with the “story” underpinning AMZN’s stock price. The second is with the stock price itself.

First, the story. Contrary to what others assert, I cannot come up with any advantage that’s Web-based sales model possesses that B&N or (especially) Borders cannot duplicate. I’ve heard the big-brand, bricks-and-mortar booksellers characterized as slow-moving, “mature,” and unable to match Amazon’s technological savvy.

I won’t speak for B&N, but as a Borders shareholder, I’ll say that if you think Borders is slow-moving or computer-illiterate, think again. Borders per-share earnings will more than double this year from where they were in 1995. The company has nimbly rationalized the Waldenbooks operation that it was paired with when KMART (NYSE: KM) spun them off, and they’ve opened new -- and profitable -- superstores at a breath-taking pace.

As for technology, Borders groupies know that one of the company’s greatest competitive advantages is its technological expertise. The original Borders team wrote a pioneering intelligent information system from scratch in order to manage inventory and customize the offerings for each store. Borders has quietly invested substantial sums in the Website it intends to launch ahead of the holiday buying season. We’ll find out very soon what they’ve been working on behind closed doors for months now.

As for the part about establishing an online community, I think that having a national network of real stores as well as a virtual one provides for terrific opportunities in that regard. With real stores, you can offer real get-togethers for cyber-shoppers, invite them over to the store to chat face-to-face with an author, have her autograph your book, watch a jazz trio perform, and more.

One fellow mentioned that he likes to go to the superstores to browse, but when it comes time to buy, he goes to Amazon. I’m sure that a lot of people do that. I’m also sure that a lot of people do what I did just the other day: I went to Amazon to browse and find out what recent books had been published on a certain subject ... and then I hopped over to Borders to buy them and bring them home that very evening rather than wait for them to show up in the mail days later.

As for Amazon’s reputed 2.5 million offerings, they make no claim to being able to provide many -- perhaps a majority -- of those books to you in a timely fashion, or ever. For the more than one million out of print listings, Amazon simply offers to make a good effort to track a copy down for you, eventually. That’s a wonderful service, and I expect to use it myself sometime. But there are plenty of independent bookstores -- including ones with Websites -- that can do that, too. And so can Borders or B&N.

I could go on -- and will, if asked. But let’s quickly turn to the numbers.

The presumption is that Amazon can clobber the dinosaur bookstores because Amazon doesn’t have to pay all those huge overhead costs -- and that’s true, but not nearly as much as one may think. Furthermore, much of Amazon’s advantage in that regard is offset by its trimmer gross margins, owing to the bigger discounts and higher shipping expenses it has to shoulder.

Since Amazon began increasing the breadth of its deep discounts, its gross margins have declined; and the company has stated that they will decline further, though management expects them to settle above 20%. Borders’s gross margin this year will come in around 29%. Amazon’s will be in the high teens this year.

Getting from gross margin down to net margin, Amazon and Borders end up looking not all that different. After all, Amazon is forking over millions for deals with AOL, Yahoo!, and others. And contrary to some claims, Amazon is indeed forking over a lot of money for bricks and mortar: additional offices and distribution centers, in the form of at least one additional warehouse on the East Coast, and also lots of expensive networking gear, and so forth. Borders already has a lot of that.

The Fool’s buy write-up notes that Amazon is currently spending 10% of sales on "product development" but that this should eventually drop to around “ 3% to 4% of sales.” Then there’s marketing and sales expenses. According to the write-up, they are expected to decline to between 11% and 14% of sales as the business matures; currently, the percentage is twice that amount.

To be generous, let’s take the best-case percentages: 3% for product development and 11% for M&S. Then there’s “general and administrative” expense: paying the management, rent on the office, the light bill ... stuff like that. That’s been running 6.5% of sales. It can go down some, but probably not a lot.

Let’s do the math: start with a gross margin of, say, 19%. Then subtract 3 points for product development, 11 for marketing and sales, say 5 for G&A, and you’ve got ... oh, my. It’s tougher to turn a profit than some may have thought. And once you do eventually begin to generate earnings reliably, you’ll also need to start paying taxes on those earnings. Borders has 3.5% net margins even after it pays its taxes.

I’ve seen it stated that Amazon hopes to make $1 billion in sales “sometime” around the turn of the century. I’ve also seen “sometime” translated into the year 2000. Let’s just say for now that I doubt that. Data from analysts at Jupiter Research suggest that 2002 is more likely -- and I think Amazon has a good shot at that. I really do.

But if you take $1 billion in sales and stick (generously) a 5% net margin on it, you’ve got $50 million in profits. Divide that up among the 23.9 million shares outstanding plus the 9.54 million in stock options that will be registered this year, and you’ve got $1.50 per share.

Now we need a multiple. I vote for 30 -- i.e., about what Cisco gets today. That makes $45 as a target price -- i.e., where we are today after this recent huge runup. Also, this assumes no additional share dilution between now and 2002. How plausible is that?

This is more than enough to bite off and chew for one Boring recap, so I’ll yield the floor at this point. But before doing so, I stress that the numbers I’ve used are wide open to criticism -- as are everyone else’s in trying to value a startup. And my opinions on the “story” are just that: opinions.

Something tells me that not everyone sees AMZN, the stock, the way I do. Something like a 17% price rise in a matter of hours, for one thing.

Enjoy the weekend!

Drip Portfolio -- Pfizer
The Fool Portfolio -- Fool Port getting closer.
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Daily Double
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Fool Four -- 23% annualized historically

Stock  Change    Bid
ATLS  -  5/8   26.00
BGP   +1       26.75
CSL   +1 5/8   44.50
CSCO  +  3/16  72.31
GNT   -  7/16  44.19
ORCL  -  1/4   38.63
OXHP  +  3/16  77.81
PMSI  -  1/16  14.19
TDW   +2 11/16  58.38
                   Day   Month    Year  History
        BORING   +1.10%   3.68%  26.09%  45.09%
        S&P:     +1.24%   2.72%  24.73%  48.63%
        NASDAQ:  +0.58%   3.91%  27.75%  58.44%

    Rec'd   #  Security     In At       Now    Change
  2/28/96  400 Borders Gr    11.26     26.75   137.65%
  8/13/96  200 Carlisle C    26.32     44.50    69.04%
  5/24/96  100 Oxford Hea    48.02     77.81    62.03%
   2/2/96  200 Green Tree    30.39     44.19    45.41%
   3/8/96  400 Prime Medi    10.07     14.19    40.91%
  6/26/96  100 Cisco Syst    53.90     72.31    34.16%
 12/23/96  100 Tidewater     46.52     58.38    25.47%
 11/21/96  150 Oracle Cor    32.43     38.63    19.09%
   3/5/97  150 Atlas Air     23.06     26.00    12.76%

    Rec'd   #  Security     In At     Value    Change
  2/28/96  400 Borders Gr  4502.49  10700.00  $6197.51
  8/13/96  200 Carlisle C  5264.99   8900.00  $3635.01
  5/24/96  100 Oxford Hea  4802.49   7781.25  $2978.76
   2/2/96  200 Green Tree  6077.49   8837.50  $2760.01
  6/26/96  100 Cisco Syst  5389.99   7231.25  $1841.26
   3/8/96  400 Prime Medi  4027.49   5675.00  $1647.51
 12/23/96  100 Tidewater   4652.49   5837.50  $1185.01
 11/21/96  150 Oracle Cor  4864.99   5793.75   $928.76
   3/5/97  150 Atlas Air   3458.74   3900.00   $441.26

                             CASH   $7890.00
                            TOTAL  $72546.25