Amazon Numbers, Pt. 2
...2001: An Odyssey

by Jeff Fischer

Chicago, IL (Aug. 26, 1998) -- We believed that the Cold War was over for the past decade, but it has resurfaced in a financial form. The old Cold War was represented by a build up of weapons, or the Arms Race. The new Cold War is apparently a race for financial failure. The Russian Federation's stock market and currency plunges, the U.S. stock market follows. The countries appear to be saying to each other, "Oh, you can go that low, well we can go even lower." At least this new Cold War is considerably less frightening than the original, plus it's more logical by several degrees.

In the midst of it, the Fool Port lost 1.47% and the S&P dropped 0.79% today. The Nasdaq sustained the brunt of the "chill," falling 1.66%.

Trump Hotels (NYSE: DJT) fell into the $3s on heavy volume, touching $3 3/8 at its low. One concern is the company's interest coverage ratio, as Paul Larson discussed when we reviewed Trump two weeks ago. Disappointingly, Iomega (NYSE: IOM) also hit the dreaded $3 range -- a range strife with landmines -- though it ended higher. It's been a rough year for the "little stock that once could," but perhaps, as management is hoping, we'll see profits from the company in the fourth quarter. If not, well... even the stocks of good companies suffer in a weak market, while those of money-losing firms are often left for dead, as Trump and Iomega intimate. Today Iomega announced a Zip deal with IBM's updated commercial computer line.

Meanwhile, Starbucks (Nasdaq: SBUX) can't buy a break. It's taking its cue from 3Dfx (Nasdaq: TDFX), whose stock touched a new low despite the significant announcement from Diamond Multimedia that 3Dfx's new Voodoo Banshee 2D/3D technology is being sold in Diamond's retail and OEM products. This represents a new market for 3Dfx -- the lower-end market.

Perhaps in light of 3Dfx, it's important for Fools to remember that a stock price frequently moves down (or up) regardless of the underlying long-term strength of the business that it represents. Due to market conditions, your companies' strengths are not always represented by their own stock prices (at least in the near term). Sometimes the stock market gives companies too much immediate credit, sometimes not enough.

Also of note today, our StockTalk team interviewed America Online's (NYSE: AOL) vice president of investor relations, Richard Hanlon. Check out the audio version right now and the written transcript tomorrow.

The day-by-day aside, today we continue our "Foolanalysis" of (Nasdaq: AMZN). Yesterday we introduced the topic and shared quarterly earnings estimates and annual revenue projections. Today we'll consider more in-depth numbers -- mainly, margins. First, consider Amazon's past numbers. Achieving $147.8 million in 1997 sales, the margins of the business broke down as follows (each percentage represents the amount of the figure compared to total sales):

Amazon Margins,          1997: 
 Cost of goods            80.5% 
 Gross Margin             19.5% 
 Marketing & Sales        38.6% 
 Advertising              14.2% 
 Product Develop.          8.4% 
 Gen. & Admin.             4.4% 
 Operating Expenses       39.3% 
 Operating Income        -19.8% 
 Tax rate                  0.0% 
 Net income              -18.7%
Consider 1997 against second quarter 1998 results:
Amazon Margins     1997    Q2 1998: 
 Cost of goods        80.5%   77.4% 
 Gross Margin         19.5%   22.6% 
 Marketing & Sales    38.6%   34.8% 
 Advertising          14.2%   10.8% 
 Product Develop.      8.4%    6.9% 
 Gen. & Admin.         4.4%    2.8% 
 Operating Exp.       39.3%   32.6% 
 Operating Income    -19.8%  -10.0% 
 Tax rate              0.0%    0.0% 
 Net income          -18.7%  -18.3%
Notable are the early increases in gross margins as Amazon begins to receive better bulk prices from suppliers, and the decreasing costs as a percentage of sales across the board as the company begins to build on a foundation rather than continuing to build the actual foundation itself. Once the online site is in place, it's a matter of updating it and keeping it current, which is less expensive than building it. You can also see how general and administrative costs decline percentage-wise as sales grow. You needn't employ too many more managers just because sales continue to grow.

Keep these numbers in your head as best you can. Though I have estimates for margins for each quarter over the next three years, I can't easily display all of them here, so let's jump forward (for now at least) to the years 2000 and 2001. My revenue estimates for these years (which will be explained) are $846 million and $1,010 million, or just over one billion. These are estimates based on potential growth in what is essentially a new marketplace, so, as with any estimates, please take them with a grain of salt. The margin numbers are slightly less speculative, however, because they're based on competing booksellers' current numbers and translated to a successful online selling model.

Remember the current margins from above, assume sales growth of 112% from this year to the year 2001 (that's $476 million in sales projected this year, $846 million in 2000, and just over $1 billion in sales in 2001), and let's look at potential expense and profit margins.

AMZN Margin Est.     2000     2001 
 Cost of goods       76.3%    74.5% 
 Gross Margin        23.7%    25.5% 
 Marketing & Sales   21.8%    18.4% 
 Advertising          2.6%     1.6% 
 Product Develop.     5.0%     4.1% 
 Gen. & Admin.        1.9%     1.8% 
 Operating Exp.      19.5%    15.9% 
 Operating Income     4.8%     9.9% 
 Tax rate             0.0%    38.0% 
 Net income           0.4%     5.5%
With gross margins increasing only about 1% from 1998 to 2000, the model shows them to improve by nearly two more points in 2001 as sales top one billion dollars. Next, each employee is represented by more sales, further decreasing sales, marketing, and administrative expenses on a percentage basis, and product development costs continue to decline as sales grow and the business matures. (Though keeping a website technologically current will always be an ongoing process.)

Note that with sales growing, the company can spend as little as 1.6% of total revenues on advertising and still be spending $10 million total, or the same absolute amount that it spent last quarter when it spent a whole 10% of sales on advertising. This is a key point behind the numbers. These economies of scale take place across the board as a successful company grows.

Revenue of $1.01 billion in 2001 is estimated on a customer base of 8,375,000, up from 3,140,000 today (an increase of 167% over three years), and average quarterly revenue per account of about $32 in 2001. The average account brought $38 in revenue last quarter. The estimated growth rate of total accounts -- from 3.1 million last quarter, to 5.9 million in 1999, 7.2 million in 2000, and 8.3 million in 2001 -- is based on industry growth rates and Amazon's independent growth the past two years. AOL's growth rate in the past was also considered, as well as Yahoo's! impression growth rate (merely for related-industry growth numbers).

The next chance we have, we'll go through more of the actual financials represented behind these potential margins. Cash flow is largely what this business is ultimately about (somewhat like Dell), and it is likely going to determine the company's valuation for the next three years (and beyond) much more so than profits or losses based on earnings per share. Amazon was cash flow positive by $1.1 million last quarter. It collects revenue dollars immediately and pays suppliers up to 45 days later, while carrying relatively low inventory. It's favorable model makes it easier to grow.

If you have questions now and in the time before or after our next column, please post them on the Fool's message board. This is just a start to something that has many facets to consider.

In Fooldom tonight, Tom Gardner discusses how to follow companies on a quarterly basis in the Cash-King Portfolio, and the Boring Port continues a retrospective which stretches back to early 1996.

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08/26/98 Close

Stock Change Bid ---------------- AMZN -4 3/8 127.25 AOL --- 110.63 T -1 1/8 56.50 DJT - 3/4 3.38 DD - 3/8 59.50 XON + 1/16 70.38 INVX - 7/16 12.56 IP -1 15/16 41.00 IOM - 1/4 4.19 KLAC - 15/16 28.19 LU + 3/16 87.38 SBUX -1 11/16 34.81 COMS - 3/4 29.25 TDFX --- 12.63
Day Month Year History Annualized FOOL -1.47% 1.19% 48.81% 399.42% 48.64% S&P: -0.79% -3.26% 11.72% 136.52% 23.63% NASDAQ: -1.66% -5.57% 12.59% 145.51% 24.78% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 110.63 2942.13% 9/9/97 580 19.11 127.25 565.86% 10/1/96 84 LucentTech 23.81 87.38 267.00% 5/17/95 1960 Iomega Cor 1.28 4.19 227.04% 4/30/97 -1170*Trump* 8.47 3.38 60.15% 8/12/96 130 AT&T 39.58 56.50 42.76% 2/20/98 200 Exxon 64.09 70.38 9.81% 2/20/98 215 DuPont 59.83 59.50 -0.56% 2/20/98 270 Int'l Pape 47.69 41.00 -14.03% 8/24/95 130 KLA-Tencor 44.71 28.19 -36.96% 8/13/96 250 3Com Corp. 46.86 29.25 -37.59% 7/2/98 235 Starbucks 55.91 34.81 -37.73% 1/8/98 425 3Dfx 25.67 12.63 -50.81% 6/26/97 325 Innovex 27.71 12.56 -54.66% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 78543.75 $75961.88 9/9/97 580 11084.24 73805.00 $62720.76 4/30/97 -1170*Trump* -9908.50 -3948.75 $5959.75 5/17/95 1960 Iomega Cor 2509.60 8207.50 $5697.90 10/1/96 84 LucentTech 1999.88 7339.50 $5339.62 8/12/96 130 AT&T 5145.11 7345.00 $2199.89 2/20/98 200 Exxon 12818.00 14075.00 $1257.00 2/20/98 215 DuPont 12864.25 12792.50 -$71.75 2/20/98 270 Int'l Pape 12876.75 11070.00 -$1806.75 8/24/95 130 KLA-Tencor 5812.49 3664.38 -$2148.12 8/13/96 250 3Com Corp. 11715.99 7312.50 -$4403.49 6/26/97 325 Innovex 9005.62 4082.81 -$4922.81 7/2/98 235 Starbucks 13138.63 8180.94 -$4957.69 1/8/98 425 3Dfx 10908.63 5365.63 -$5543.00 CASH $11876.47 TOTAL $249712.22

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