BUSINESSWEEK ONLINE : MAY 1, 2000 ISSUE
COVER STORY

As the E-Tailing Field Clears, Will Amazon Flower?
Considering how many challenges remain, investors will have to keep close watch on the numbers

The Nasdaq has delivered its verdict loud and clear: E-tailing is out. And the casualties are legion. Value America Inc. (VUSA), dropped from its IPO high of 74.25 last April to its current low of around 2. EToys (ETYS) hit its high of 86 in mid-October. It's now trading at 6. Pets.com (IPET) went public at 14 in mid-February and is now at 3 3/8. Buy.com (BUYX) has dropped to 6 1/4 from its February high of 35 7/16. Drugstore.com (DSCM) hit 70 on its mid-August IPO and is now foundering at 8 1/16.

It makes you start to wonder if the e-tailing business model has any redeeming features. At 52 3/8, even Amazon.com (AMZN), that paragon of New Economy business modeling, is trading in the bottom fifth of its 52-week range.

Though the sad story of Value America seems to cast a pall over e-tailing, Wall Street still believes that if anybody can make that business pay off it's Amazon's Jeff Bezos. The company's fans say the Nasdaq's rout has cleared the field and left the e-tailer as the last player standing in a lucrative space. But more cautious voices warn that bricks-and-mortar competition may finally be ready to give Amazon fits. Estimates of the stock's value are as extreme as the recent swings on the Nasdaq, with analysts' 12-month targets as high as 175 and as low as 65.

GOT A RABBIT? Given where the stock is trading, the consensus is that Amazon definitely has upside potential. But investors should back off the idea that its upside is unlimited. Now that Amazon is in a sector that has fallen out of fashion, the stock's performance is bound to be volatile. More than ever, investors need to assess the Amazon's value proposition as a business. Look at it that way, and it seems that unless Jeff Bezos can pull a rabbit out of his hat when he announces first-quarter earnings on Apr. 26, the top end of analysts' 12-month target prices are unrealistic.

No doubt, the Nasdaq's drop has cleared out a lot of e-tailing's dead wood. Not only are the publicly traded dot-coms wobbly but venture capitalists are no longer pumping money into new entrants, only to watch them blow untold amounts to build brands and win market share. That means Amazon should be able to spend less on marketing -- and perhaps edge closer to profitability. "The competitive landscape has never been more favorable for Amazon," says Tim Albright, equity analyst for Salomon Smith Barney. "Like AOL, Amazon has achieved megabrand status. That means media spending has become discretionary for Amazon, not the oxygen that it needs to survive."

Maybe. It could also turn out that the bricks-and-mortar gang, as it moves onto the Web, will force Amazon to keep spending. These companies could be so far behind in their understanding of cyberselling as to pose no threat to Amazon, argues Michael Mauboussin, a managing director and chief U.S. investment strategist at Credit Suisse First Boston.

TAG TEAMS. While traditional retailers haven't had tremendous success with online strategies so far, the recent trend of teaming up with an online veteran could reverse this pattern. Sears and Wal-Mart have teamed up with AOL. Kmart has an agreement with Yahoo. Those are threatening combinations to an online-only retailer that still hasn't figured out the economics of its own business.

Despite the elegant simplicity of Amazon's original business model -- cash comes in before it buys its inventory -- the company's management has learned some tough lessons about inventory flow. In 1999, to fill holes in its operations, it spent $369.6 million on acquisitions of companies and another $287 million on fixed assets.

Expanding its product line through acquisition may have turned out to be an ill-timed decision. The company's potential losses from consolidating its minority holdings, all of which have suffered at the hands of the market correction, could amount to as much as $2 or $3 per share, according to Sara Farley, a first vice-president and e-commerce analyst at PaineWebber. Farley's 12-month target on the stock is $65, if you subtract the impact of these losses. Combine those with its diminished stock price, and Amazon will have to eat into its $1.2 billion cash horde to continue its acquisition strategy.

NOT ENOUGH SCALE. Meantime, Amazon's effort to create a distribution and fulfillment network to support its pastiche of unrelated retail businesses has yet to pay off. Farley says Amazon is using only 20% of the 4.5 million square feet of distribution space it built last year. "It doesn't have the scale [in sales] to support it," she says. Analysts, both bullish and bearish, estimate that the company's gross margin -- revenues less cost of goods sold, which for Amazon includes shipping and packaging -- stands at around 19%.

"If you're selling $20,000 items, 19% is great," says Farley. But Amazon's average sale is $35 to $40. "That's why it's so important to them to get the volume. They need it to maintain their gross profit." Books, music and DVD, and videos accounted for about 80% of Amazon's revenues in 1999 -- and that division still turned in a $31 million net loss for last year.

With 17 million customers, 73% of whom bring repeat business, Amazon can certainly claim to have the potential for volume. And its strategy of expanding into patio furniture, consumer electronics, and other high-margin items could offer the best of all worlds -- a high volume, high-margin business. But this strategy also leads to a logistical dilemma: How to achieve its goal of saving money by packaging and sending these disparate items together. Five books and a CD easily fit in one box. If customers order in chunks like that, it clearly costs Amazon less to ship it than if each item had to be shipped separately. But how do you package a Weber grill with a copy of Don Quixote? Let alone warehouse and manage the inventory of these items?

LEARNING TO DRIVE. Getting costs under control seems to be the key, since even bearish analysts such as Farley see healthy revenue growth. From 1999 revenues of $1.64 billion, Farley expects Amazon to amass sales of $2.75 billion in 2000, and $4.1 billion in 2001. But she foresees losses of $466 million and $145 million, respectively, in those years. Even Salomon Smith Barney's Albright, who has a 12-month target of 130 on Amazon's, expects a loss of $403 million in 2000 on revenues of $2.96 billion.

"They've built the car, and they're learning to drive it," says Albright. Let's hope so. With the Nasdaq's unforgiving slide, Amazon has a lot less room before it hits the wall.

By Margaret Popper in New York

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