<THE RULE BREAKER PORTFOLIO>

Amazon Floods into eBay
Is Amazon's business going to the dogs?

by Jeff Fischer

ALEXANDRIA, VA (March 29, 1999) -- Not since Moses parted some water have so many earth-shattering events taken place in one day. The Dow closed above 10,000 for the first time (the day's least significant event -- for thoughts about it, see Dale Wettlaufer's article), Amazon announced that it'll go head-to-head with eBay, Microsoft is dividing its business into five branches, and the Rule Breaker scored a new all-time rocky mountain high, up 1,382 % in its history and 4.4% for the day. The S&P 500 rose 2.1%.

Despite all the excitement, there's only one story worth telling: the battle of the online behemoths.

Amazon.com (Nasdaq: AMZN) advanced 7% on word that it'll launch a full blown person-to-person auction service tomorrow, called Bid Click. It all began with books, where Amazon was #1 online from the beginning; then came music, where Amazon became the leader in one quarter; next came videos, soon a # 1 category for Amazon as well; and now comes an auction service to compete with eBay (Nasdaq: EBAY). Unlike past categories that Amazon attacked, auctions have a strong leader in eBay and the niche won't so easily be taken by Amazon, but if any company can challenge eBay in this area, this low-margin bookseller is it. (Err... book and music seller. And videos. And now auctioneer.) (Sorry bears.)

Consider the two contenders. Amazon had over 6 million registered users as of December 1998, which compared to eBay at 2.1 million. All Internet commerce sites will live or die based on critical mass of users, but with auctions, critical mass is even more important because both the buyer and seller value the size of the market tremendously and will gravitate to the largest market that offers the most selection and the most potential buyers -- guaranteeing selection for the buyer and a good price for the seller.

Amazon should open with tens of thousands of auctions, while eBay has 1.8 million auctions taking place right now. When it comes to starting size, Amazon does have 4 million more registrants than eBay, but the question being asked is: How many of Amazon's customers will want to use the auction service? Currently, a full 33% of Amazon users will need to use auctions to put Amazon on equal footing with eBay.

So does Amazon really have a size advantage?

The answer could be: "Yes, eventually." Because Amazon has the advantage of cross promoting its auctions with any regular product that a customer searches for and, oddly, it's in Amazon's best interest to sell an auctioned item and receive the service fee rather than sell its own inventory at razor thin margins -- so Amazon will be pushing the auctions heartily. If you search for a book by F. Scott Fitzgerald, in the future Amazon will inform you that early editions of Fitzgerald's work are for sale in auctions. If you look for music by B.B. King, Amazon will tell you that B.B. King's guitar picks are on sale in an auction -- "Just $20, wouldn't it make a great gift?" The cross promotion possibilities are endless. Movies: buying a Star Wars video? Check out the 400 auctions on Amazon offering Star Wars products.

The auction business, as it grows, could improve Amazon's profitability margins considerably. eBay had $47 million in 1998 revenue (which, you should know, means that hundreds of millions of dollars worth of transactions took place on its site, because eBay only collects about 1% to 2% of each sales amount in fees), and on that $47 million in revenue, eBay had $40 million in gross profit. That 80% gross profit is phenomenal. It's because eBay isn't selling its own inventory -- it isn't selling anything. It merely offers an area for others to transact, an area that can expand and scale effortlessly.

Even while ramping up its technology and adding staff more quickly than a fresh downpour adds umbrellas to a New York City street, eBay was able to achieve 20% operating profits last year because its revenue is based on other people's sweat -- when you sell or buy on eBay, you're responsible for holding the inventory, shipping it, payment collection, and so forth. Therefore, like eBay, Amazon will be able to leverage its customers into its auction business without needing to add much back-end support like fulfillment offices, inventory warehouses, and billing services. It simply provides an area to transact and collects a slice of profit from each and every auction.

Life is indeed beautiful.

Amazon's auction is slightly different than eBay's from the start, however. Though insurance will be offered on eBay soon, so far the company hasn't taken responsibility for fraudulent auctions. By contrast, Amazon will offer buyers a guarantee up to $250 -- an insurance -- that if an item is paid for but not delivered, Amazon will reimburse the buyer. Though risky for Amazon and likely to create extra costs and headaches (instead of committing fraud against other users, some people will conspire to commit fraud against Amazon to claim a payment), the guarantee might go far to make current Amazon customers more ready to partake in auctions.

Many Amazon users have never used an auction before, and they probably never thought they'd need to. If Amazon -- a site they trust -- offers guaranteed auctions, their opinion could change as soon as they see something that they like up for auction. (And you can be sure that Amazon will put those very products on their customer's computer screens by knowing a user's tastes.)

Buy why is Amazon jumping headlong into auctions rather than adding a new retail product line as it has in the past?

Because auctions are the ideal business for the Internet. It is a high margin, highly scaleable operation for the host. eBay has been profitable since inception and as long as it continues to increase usage, it will only become more and more profitable. As long eBay's community abides, only a major bonehead move by management could ruin the company's long-term profitability.

Beyond strong margins, in Amazon's case the addition of auctions will enrich its product offerings more than adding any other specified product line ever could. Adding a new product line takes one year for Amazon. Now, in one fell swoop, Amazon will add thousands of product lines without adding any inventory or significant buildout costs. In doing so, it enriches its product breadth for users and promises to gain yet more sales per visit -- its longtime goal -- without much more cost.

Amazon's mission, as witnessed by its Shop the Web service, is to help people find and acquire anything they want to buy online (even if they don't know what they want). Auctions can offer the richest diversity of product anywhere.

So what does this mean for eBay? The stock fell a scant 4% on the news. The online auction leader has a community that is probably closer to 3 million than 2 million now, and most users won't have any reason to leave unless Amazon can grow more quickly than eBay and offer even more buyers and more sellers. The quest for fast growth at eBay has become heightened as of... NOW. There won't be much rest for management in its quest to keep the eBay community ahead of Amazon's. (Perhaps a partnership will be in order eventually?)

Of more difficulty for eBay than keeping current users will be grabbing future Internet users -- those who first visit Amazon to buy something and find the auction service and stay. eBay lacks Amazon's advantage of offering conventional retail products -- a natural recurring draw to Amazon's site.

Amazon offers books, music, videos, toys, and electronics, and it owns 46% of Drugstore.com and today it announced it was taking a majority stake in pets.com -- a leading online petstore. Increasingly, Amazon represents e-commerce of any and all kinds. If management can fold auctions into the offerings, it will become a major player in the field, probably hurting second and third-tier players the most. eBay could thrive as the pure play in auctions, being the Top Dog and First Mover, but where we didn't see a significant competitor on its horizon in the past, now we do in Amazon.

Do we live in exciting times OR WHAT??? (Please allow me that teenager-esque expression, like, OK?)

For more Foolishness on Amazon and eBay, see the Fool's Lunchtime News and hit the Rule Breaker, eBay and Amazon message boards. And as if there weren't enough mayhem taking place today, the Fool has a new article on none other than the Y2K countdown. Read the article and head for the hills? Finally, Drip Port finished a five-month oil study without a purchase. Today the lessons learned are reviewed.

Invest for the long term and Fool on!

What's up with Harry Jones today?

03/29/99 Close

Stock  Change    Bid 
---------------- 
AMZN  +10 9/16 149.63
AMGN  +2 5/8   77.25
AOL   +5 5/8  131.63
ATHM  +8 13/16 159.69
DJT   -  1/16   3.94
CHV   +3 1/8   89.94
CAT   +  7/16  47.25
DD    +1 3/4   57.25
GT    +  1/4   50.06
IOM   -  5/16   4.50
SBUX  +1       29.38
TDFX  +  7/8    12.38
EBAY  -6 23/32147.78
 
                   Day   Month    Year  History  Annualized 
      R-BREAKER  +4.41%  30.01%  47.66% 1382.10%  78.65%
        S&P:     +2.13%   5.80%   6.90%  199.37%   26.62%
        NASDAQ:  +3.04%   8.95%  13.69%  246.14%   30.64%

    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    131.63   14382.59%
   9/9/97  1320 Amazon.com     6.58    149.63    2174.20%
  5/17/95  1960 Iomega Cor     1.28      4.50     251.45%
  12/4/98   450 @Home Corp    56.08    159.69     184.75%
 12/16/98   580 Amgen         42.88     77.25      80.17%
  4/30/97 -1170*Trump*         8.47      3.94      53.51%
  2/26/99   300 eBay         100.53    147.78      47.01%
  2/23/99   180 Chevron       79.17     89.94      13.60%
   7/2/98   470 Starbucks     27.95     29.38       5.08%
  2/23/99   290 Goodyear T    48.72     50.06       2.77%
  2/23/99   300 Caterpilla    46.96     47.25       0.61%
  2/20/98   260 DuPont        58.84     57.25      -2.71%
   1/8/98   425 3Dfx          25.67     12.38     -51.79%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 289575.00  $287575.53
   9/9/97  1320 Amazon.com  8684.60 197505.00  $188820.40
  12/4/98   450 @Home Corp 25236.13  71859.38   $46623.25
 12/16/98   580 Amgen      24867.50  44805.00   $19937.50
  2/26/99   300 eBay       30158.00  44334.38   $14176.38
  5/17/95  1960 Iomega Cor  2509.60   8820.00    $6310.40
  4/30/97 -1170*Trump*     -9908.50  -4606.88    $5301.63
  2/23/99   180 Chevron    14250.50  16188.75    $1938.25
   7/2/98   470 Starbucks  13138.63  13806.25     $667.63
  2/23/99   290 Goodyear T 14127.38  14518.13     $390.75
  2/23/99   300 Caterpilla 14089.25  14175.00      $85.75
  2/20/98   260 DuPont     15299.43  14885.00    -$414.43
   1/8/98   425 3Dfx       10908.63   5259.38   -$5649.25

                              CASH   $9924.87
                             TOTAL $741049.25

Note: 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.

</THE RULE BREAKER PORTFOLIO>

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