ALEXANDRIA, VA (August 23, 1999) -- Merrill Lynch analyst Henry Blodget boosted Amazon (Nasdaq: AMZN) last week with positive comments regarding year-end results and long-term potential. However, many investors have difficulty with the notion that Amazon will create value for shareholders given its current market cap of above $19 billion.

The original argument was that Barnes & Noble (NYSE: BKS) would kill Amazon. B&N was valued at $2 billion; Amazon should never be valued above that. This silly comparison is less valid now than ever. The new argument is that Wal-Mart (NYSE: WMT) will kill Amazon. This argument, as with the old comparison to B&N, is rarely presented with more detail. Instead, the argument is usually summarized in the following way:

"Wal-Mart will kill Amazon! Get out now! You'll thank me later!"

When people do take the time to post a thought-out missive, the Amazon bears most frequently cite Wal-Mart's vast distribution capacity as a serious asset in Wal-Mart's treasure chest. Humorously, while some investors compliment Wal-Mart for its many warehouses from one side of their mouths, from the other side of their mouths they criticize Amazon for building warehouses.


Let's entertain the idea that Wal-Mart is going to kill Amazon for a moment. This means, apparently, that Amazon's 11 million customers are going to flock to Wal-Mart as soon as it issues its press release describing its online service. Nevermind that Wal-Mart is already selling online (including books, music, and videos) and has been doing so for months. Also, nevermind that the site is clunky and boring in its present incarnation. That's not important, because as soon as Wal-Mart makes its online business "official," with some sort of magic public announcement, the company will kill everybody in the marketplace -- especially Amazon.


Wal-Mart is valued at $211 billion, so it could take something away from Amazon and Amazon could still create future value for shareholders if this game is one of size; there is plenty of market share to go around. As is often the case, we don't believe that this will be an "either, or" situation. We believe that both can succeed. I allow for this possibility even though Amazon has many early advantages online. (Allow me that small joke, because it is true.) Amazon was the first to scale in online retailing. Amazon has amazing technology, created in-house, and it is leveraging it. According to a recent study, Amazon also has the stronger brand name of the two.

Now, I'm not naive and I don't want to give Amazon bears a raging heart attack with my last sentence. Wal-Mart is more widely known (and perhaps hated?) than Amazon. Much more so. However, when an Interbrand study computed the 60 most valuable brands in the world -- which David Gardner shared this summer -- the list included Amazon, but not Wal-Mart. In fact, of the 60 companies, only three were retailers: Amazon, Gap, and IKEA. No other retailer made the list. Retailers don't typically become top brands. (Here is the list.)

What does this mean? It means that Amazon has strong recognition with its customers and with that, strong loyalty. The number of purchases made by repeat customers continues to rise as a percentage of total sales, to above 70% last quarter. These customers are not likely to quit 1-Clickin' at Amazon in a mass exodus to Wal-Mart online. If they were, why haven't they yet?

We started with a question on Amazon's valuation, and we have side-winded our way down the page -- not unlike a snake -- without touching the topic again. It isn't poison and we've discussed it before, but I won't touch the topic today except to quote Henry Blodget:

"We expect... that online retailing will eventually amount to about 10% of the total $2.3 trillion annual retailing market, or about $230 billion. has clearly indicated its intention to be involved in most aspects of this market, and in most markets, the industry leader usually ends up with 30% to 40% share. 30% of $230 billion is about $70 billion. 5% (an estimated net income margin) of $70 billion is $3.5 billion. A P/E of 40 times $3.5 billion would generate $150 billion market capitalization -- about 7.5X Amazon's current market capitalization of $20 billion. If it took the company 15 years to achieve this market capitalization, the long-term investor would recognize a 12% annual return (assuming 3% annual share-count dilution). If it took ten years, the return would be closer to 20%."

Obviously, Mr. Blodget's numbers are vague, general estimates, but they do serve to make a long-term thinker think large. That isn't always easy, even when trying to think 10 years ahead. Blodget estimates $3 billion in year 2000 revenue, and $10 billion in 2003. The 5% net margin I could agree to or not. Amazon could reach 2% net margins and still have a very attractive business based on inventory turns and its cash conversion cycle. However, the stock's valuation would be two-fifths of what Blodget proposes in his model of reasoning.

Either way, thinking large about Amazon and eBay (Nasdaq: EBAY) are two of the most entertaining aspects of being a shareholder. In the decades ahead, how large can these companies grow? If you aren't comfortable investing in such an open-ended question (one with a great deal of risk), then you shouldn't invest in such companies.

Speaking of Rule Breaking companies, we have a new Rule Breaker message board devoted solely to the discussion of them. The new board is the "Rule Breaker - Companies" board. It complements the existing Rule Breaker board, which is now called "Rule Breaker - Strategies." The strategies board is used to discuss RB-related investment strategies, questions that you have, general topics introduced in these daily columns, and so forth. The companies board is a purist board. It is used only for discussion of recognized and potential Rule Breaker companies. We hope to see you on both of these message boards.

We also would like to see you here in Fool HQ! There are many Fool jobs open and many are in editorial -- writing, editing, managing. Interested? Visit Fool Jobs and let the Fool know, because "We're looking for a few good Fools." (Envision parachuting from helicopters into a choppy blue sea, driving tanks over muddy hills, piloting an F-15 over endless desert, blasting a hole in an enemy submarine one mile down in the darkness from the safety of your battleship perch, and so forth. You get the idea. We're looking for YOU.)

To close, 3dfx (Nasdaq: TDFX) announced second quarter earnings after the market called it a day. The company had record revenue, but it lost $0.50 per share and a $0.04 per share profit was expected. The 3dfx message board has details and thoughts from many Fools.

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