The Amazon Question

SAN FRANCISCO (07/03/2000) - To understand how polarizing the debate over Amazon.com Inc. (AMZN) has become, consider the difference of opinion at Lehman Brothers.

Holly Becker, an Internet analyst for the investment bank, calls Amazon "an incredibly powerful brand" and says "the company is rapidly evolving into a world-class retailer." While she has concerns about management's ability to reduce costs and succeed in its many new businesses, Becker rates the stock a "buy," putting a target of $80 on the shares, more than double their current price.

But Becker's colleague, bond analyst Ravi Suria, says Amazon.com shows the "financial characteristics that have driven innumerable retailers to disaster throughout history." In a detailed financial analysis, Suria contends Amazon has been unable "to make cash per unit sold" and describes its credit as "extremely weak and deteriorating." On June 23, the day Suria's report was released, the company's shares dropped nearly 20 percent, hitting their lowest level since 1998.

The debate, of course, reaches far beyond the walls of Lehman and the financial community - echoing across America at watercoolers, dinner tables, Internet message boards and television programs. Traditionalists say the company should stop living on borrowed cash and start making money or close its doors.

Believers say Amazon is investing in the future, and it's only a matter of time until it proves it is the next big thing in retailing and an icon of American business on the scale of a Cisco Systems (CSCO) , a GE or a Wal-Mart.

The debate is also about much more than Amazon. The giant online retailer of goods ranging from books, toys and CDs to tools is not simply a bellwether of e-commerce. It is retail e-commerce - at least pure-play e-commerce. If Amazon.com can't make a go of it, most of the companies that have sprung up in hopes of becoming the "Amazon of something" - jewelry, furniture, cookware - have little chance of making it. In other words, the Amazon debate is really about the future of e-commerce: Everyone knows it's great, but who can say it's good business?

It wasn't supposed to be this way. In the early days of the Internet, companies were expected to sustain heavy losses because they were investing generously for tomorrow. Eventually, the thinking went, they would show investors that their business models worked. While some prominent Internet companies - most notably America Online (AOL) and Yahoo (YHOO) - are profitable, no major e-commerce concern, other than Net auctioneer eBay (EBAY) , has ever made any money. In the case of Amazon.com - despite more than three years as a public company, spectacular sales growth and repeated assurances from management that the business model will prove itself - the picture remains cloudy.

Arguably, the debate has grown only more polarized. Those who believe in Amazon - and there are many - say that as the ranks of online retailers grow thinner, the company will be among the few left standing. But skeptics continue to shake their heads, saying the site will never amount to much, despite its undeniable success in building a trusted brand that has lured more than 20 million shoppers.

The bulls, which include many veteran Amazon watchers, believe the company is closer than ever to showing a profit in some of its operations. But the bears seems to have the upper hand: If the stock price is a reflection of a debate between buyers and sellers, then Amazon shares, which are near historic lows, show there are more skeptics than ever.

With nearly half of Americans invested in the stock market, it isn't surprising that the public pays attention to Amazon's ups and downs. But the debate has struck an emotional chord not just with investors, but with the public at large, dividing those who have benefited in some way from the Internet and those who have not.

"The animosity and anger toward the prices paid for dot-com companies is quite visceral," says James K. Glassman, an Amazon believer who has recently traveled the country promoting his book, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. "That is a manifestation of ignorance and fear that something is happening in the new economy that they don't understand.

The symbol of that anger has become Amazon," adds Glassman, who also hosts TechCentralStation.com, a site that examines issues at the intersection of technology, finance and public policy.

But beyond Amazon, the symbol, what are the issues with Amazon, the business?

First, there is no question that the company has been bleeding cash - lots of it. Since its launch in 1995, Amazon.com has lost nearly $1.2 billion, a staggering figure by any standard. Furthermore, Amazon incurred more than half of those losses just in the last two quarters.

More important is where those losses come from. The majority of Internet businesses lose money because they invest heavily in the future, with lavish marketing, expansion plans and acquisitions. Those costs certainly account for much of Amazon's red ink.

But in his analysis, Suria argues Amazon loses money on every sale. The company has reported positive gross margins - the ratio between sales and the cost of those sales. But in his financial model, Suria adds costs such as marketing expenditures, product development, warehousing and fulfillment to the money Amazon pays wholesalers and distributors for each item. He argues that adding those costs is essential, because without those budget items, Amazon's sales would stop growing.

Suria's skepticism runs even deeper. As Amazon builds more warehouses brimming with inventory, it has dramatically reduced the speed at which goods move in and out. That costly slowdown in inventory turnover has made Amazon look more like a traditional retailer - and less efficient than the "virtual" retailer it had promised to be. Suria says the inventory concerns show Amazon is "woefully lacking from an operational aspect," and he expresses little confidence that management can turn things around.

To finance its growth, the company first tapped private investors, public investors and the debt markets, issuing over $2 billion in bonds. Saddled with debt and a poor business model, Amazon could burn quickly through the $1 billion in cash it has left, putting the company "under extremely high risk," according to Suria.

Other traditionalists scoff at the scale of Amazon's borrowing. "This is a phenomenon of Ponzi financing, which is allowing companies with a flawed business model to operate," says David Tice, portfolio manager of the Prudent Bear Fund and president of research firm Tice & Associates.

Some suggest Amazon might eventually be caught in a catch-22. "If it is the case that Amazon's model is better [than traditional retailing], it will get so much competition that margins will be forced down," says Brett Trueman, a professor of public accounting at the University of California at Berkeley's Haas School of Business. "If it is not so good, then it will not have competition, but it will not make much money."

Of course, e-commerce done right is not easy. The threat to Amazon from brick-and-mortar giants like Barnes & Noble and Wal-Mart has been overstated before. For now, Amazon sits comfortably on top of the e-commerce world, with a lead over rivals that is arguably larger than ever.

Amazon first dismissed Suria's report as little more than "hogwash." But two weeks ago, the company went into more aggressive damage control. CEO Jeff Bezos used part of his keynote speech at PC Expo to attack the report, saying the company would soon generate positive cash flows and would not run out of money.

Meanwhile, Amazon Treasurer Russ Grandinetti attacked the report in more detail, disputing Suria's basic assumption. "Every time we ship a product, we are generating a certain amount of dollars that we use to cover the fixed costs of running the business," says Grandinetti. Amazon's inventory turnover will increase again, he adds. He contends that Suria made the mistake of projecting Amazon's heavy losses in the first quarter of this year into the future.

Merrill (MER) Lynch analyst Henry Blodget, one of Amazon's most vocal apologists, praised Suria's report as thorough. But Blodget largely agrees with Grandinetti, noting Suria looked at Amazon's past operations and concluded they needed improvement. "We agree with that, but we believe they are improving," says Blodget.

He notes that Amazon's stock could be on the verge of a dramatic turnaround similar to that experienced by America Online in 1996, when that company's troubles keeping up with demand made it the laughingstock of the Internet community. "Amazon shares many of the characteristics that made AOL worth the risk even in its darkest hours," adds Blodget.

Such a rosy outlook underscores the deep-seated differences between believers and skeptics. The polarized views are a sign of the "immature state of the market," says Erik Brynjolfsson, codirector for the center for e-business at MIT. A believer in Amazon, Brynjolfsson has no doubt pure-play e-commerce will work. "I just don't know how big it is going to be."

With Amazon far from being able to show profits and equally far from going out of business, the debate is certain to continue. Brynjolfsson suggests the discussion will take a different form. "I don't think there should be so much doubt that you can sell profitably on the Internet," he says. "I think things should evolve to a more nuanced analysis."

That's likely to be true - as long as Amazon delivers on the promises of its executives.

--------------------------------------------------------------------------------Amazon at a Glance Revenues 1999 $1.6 billion Loss 1999 $719 million Revenues 1Q00 $573 million Losses 1Q00 $308 million Employees 7,600 Stock Price June 29 close $37.14 52-week Range $32.44 to $113 Product Lines Books, CDs, DVDs, toys, cookware, software, electronics, hardware Key Investments Owns stakes in online retailers Ashford.com (ASFD) , Della.com, Drugstore.com, Pets.com, Kozmo.com, Greenlight.com, HomeGrocer.com and WineShopper.com * Source: Bloomberg and Amazon.com

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