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By howardroark
November 30, 2005

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I haven't thought about Amazon in while, mostly because I have no one left who's willing to discuss it with this board having gone the way of Joe Galli, but it's crossed my mind recently.

Specifically, I've been thinking about whether Amazon might just now start to have an accelerated, delayed effect on the B&M superstores. For a while there, the market was pricing BGP and BKS like they were about a tenth as healthy at video rentailers today -- I think BKS was at something like 5X FCF in summer of 02 if you shorted out the Gamestop and the BNBN stakes. And also for a while, BKS and BGP seemed to be doing okay outside of the mall, while Amazon's North American BMV sales growth had largely screeched to a halt.

But now, a lot has changed. BKS, in particular, is liked again, trading at roughly 18X forward earnings (albeit with what is likely a hefty capex pickup) and being snapped up routinely by Riggio. But the continued growth of online retailing in general, and Amazon's aggressive strategy of driving absolute gross profit dollars with low pricing via 2-3% shipping losses have helped kick start sales growth again. North American BMV is no longer flatlined, but is actually up 18% YTD after growing double digits in 2004. But that's not the real story.

More important is that (1) The sales growth is coming on a larger base, meaning more gross supply is being added to the market and (2) The actual sales Amazon is likely generating in North American BMV is much higher than its reported numbers since it only reports its commission when it sells third party units.

As for (1), I think it's surprisingly common to see people initially overestimate the impact of a competitive threat to a market, but then underestimate the impact once the threat has entered, slows its superficial growth rate, but exhibits gross annual sales growth that can really make a dent in the existing industry. Wal-Mart has been the obvious example of this in various geographies -- and it will be interesting to see if it happens again to competitors in California as they add a sizeable amount of square footage building Supercenters (as opposed to discount stores) at a "rate" which people perceive as low or troubled.

Amazon will probably end 2005 with about $3.1b in North American media sales, up around $490m from last year, when it basically pulled even with the domestic Borders Superstore sales. So they're already at the point where they add around 1/5 of the Borders chain in reported sales every year, and growing. But then you have to factor in third party sales reported on a net basis.

Unfortunately, Amazon's third party disclosure is flimsy given how important those sales have become to the business. Really, they don't say much beyond the fact that third party sales were 30% of total units in the quarter. You can make some logical assumptions about third party sales, though, for example (a) Third party units are clearly tilted toward to the US where the third party business is better developed, such that a larger % of US units are third party than 30% (this is also obvious when you see that North American Q3 gross margins exceeded 28% despite a 2.5% shipping loss, since third party sales commissions probably carry near 100% gross margins with most or all related expenses lower down the P&L) (b) Within the US, third party sales may still be more tilted toward Media than other categories.

Let's assume that third party North America Media units are then much higher than 30% -- maybe over 50% -- but that average unit price is lower given the amount of used merchandise. It is still reasonable to guess that media sales would be at much as 35% higher if taken on a gross merchandise basis. That would mean North American Media sales of over $4b this year, up maybe $700-$800m from last year. Depending on when their recent sales growth slows, it will only be a year or two before Amazon is adding $1b a year -- about 40% of Borders' current run rate for domestic superstores. That's a lot of low-priced capacity coming onto a moderate sized market.

I realize there are all sorts of holes in this kind of thinking -- Amazon "media" includes stuff BGP, BAMM and Borders don't have to make lots of third party assumptions...there could be some small double counting here...Amazon may be adding to aggregate book demand...Amazon's growth could be peaking here...but the absolute growth at these levels seems for the first time, at least to me, intuitively threatening to the superstores, who are still building themselves.

According to the Census data, bookstore sales (including superstores which were obviously up), after rising a little over 2% per year in both 2002 and 2003, declined 0.8% in 2004 and were down 2.3% YTD through September (Borders has also shown some weakness while BKS has performed well). Supposedly the independents have continued to gain share, though I kind of wonder if that's really the case. Clearly, some capacity from Walden and B Daltons has drained out in the last few years, via both comps and store closures, but that effect is pretty much going to wane toward insignificance, while Amazon factor (not to mention eBay and Overstock) is going in the other direction.

All the early calls for serious damage to BKS and BGP at the hands of Amazon and online retailing have gone unanswered six or seven years later, but with Amazon's volume-driven pricing strategy and platform-driven third party growth, I wonder whether the scary part hasn't just started for the B&M superstores. Any thoughts?

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