BUSINESSWEEK ONLINE : JULY 10, 2000 ISSUE
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COVER STORY

Can Amazon Make It?
Some investors are wondering if the e-tailer will ever turn a profit

Since the beginning of the year, it has been evident that Wall Street has become disenchanted with its former Internet darling, Amazon.com Inc. Sure, Amazon (AMZN) still had its impressive customer base, over $1 billion in cash, and expanding sales. But as with the smaller dot-coms, Amazon seemed a long way from profitability and was boasting an increasingly unjustifiable valuation. Top tech-fund managers began to reduce and even eliminate Amazon from their portfolios. It was the end of Amazon's fairy-tale existence as the one e-tailer with seemingly unlimited prospects. After hitting a peak of 106 11/16 on Dec. 10 and trending downward until mid-June, Amazon's stock price appeared to settle into a trading range between the mid-40s and mid-50s.

HOLY WAR. Nonetheless, Amazon still had plenty of true believers among investors and the equity analysts. For them, it was the world according to Amazon CEO Jeffrey P. Bezos: The dot-com's balance-sheet negatives could be easily overlooked. Why? Because the company went into the red to build up a dominant position in e-commerce, and as triple-digit growth rates and expansion into new product lines led to far heftier sales, Amazon would eventually cross over into profitability.

Then, on June 22, Lehman Brothers Inc. debt analyst Ravi Suria released a scathing report about Amazon's deteriorating credit situation. And the Holy War began in earnest.

Suria painted the picture of a company hemorrhaging money. The only triple-digit growth that mattered, he argued, was in Amazon's cash-flow losses. The report shook many remaining stalwarts, and the stock dropped 19% in one day. Suria addressed Wall Street's darkest fears: that the business model on which Amazon--and for that matter, most e-tailers--is based may be flawed. Arguing that excessive debt and poor inventory management will make Amazon's operating cash-flow situation worse the more it sells, Suria suggested that cash was being devoured at such a rate that the company might eventually find it difficult to meet its obligations by the end of the first quarter next year.

This is scary stuff. After all, if Amazon can't make money in e-retailing, who can? Amazon was quick to scoff at the notion that its model is flawed, although it concedes execution could be improved as it ramps up from selling books and CDs to offering up everything from lawn chairs to power saws. Dismissing Suria's concerns as ''baloney,'' Bezos claims the company will have positive operating cash flow over the next three quarters. And even though the company acknowledges that it may be forced to dip into its cash stash again in the first quarter of 2001, Bezos insists that Amazon is on the road to profitability.

TICKING CLOCK. On the surface, the debate appears to focus on arcane accounting issues. But underlying them is a fundamental question: Can Amazon deliver profits--and how soon? The timing is crucial, because until now, Amazon hasn't had to generate cash or profits. Its growth, critics contend, has been almost entirely funded by investors and the debt market.

But the dot-com implosion means that Amazon's access to new capital will likely be cut off now, so the clock is ticking. It must begin to replenish its cash through its operations rather than constantly depleting it. Although many analysts think Suria is overly pessimistic and give Amazon closer to six quarters before its bankroll runs out, that is still not far off.

Suria's report got Wall Street's attention because it had the audacity to evaluate this icon of the New Economy as a traditional retailer. Up until Suria, Amazon was usually viewed under a rose-colored microscope that overlooked divergence by dot-coms from standard business measures. Suria's reasoning was simple: Because Amazon has built up a vast infrastructure of warehouse and distribution centers to house burgeoning inventories of product lines, relies on brand-name identification, and needs to spend relentlessly to attract each dollar of sales, it faces many of the same difficulties managing its business as old-line retailers do.

So Suria used the standard yardstick of retail success--the ability to generate a positive cash flow. And for retailers, traditional or otherwise, this often boils down to an ability to properly estimate the right amount of inventories needed to meet demand, at the right price, without overstocking. Simply put, stock up too much, and the costs of holding that inventory far outweigh the thin margins you make on whatever you sell.

This is hardly the most becoming angle from which to view Amazon--and that classic retail error, Suria argued, is exactly the mistake Amazon made in last year's Christmas season. That's why he focused on the results of the first quarter of this year, when gross operating cash flow nose-dived from a positive $31.5 million to a negative $320.5 million. This performance was far worse than any in the previous nine quarters, only four of which were in the black. ''As has been said before, cash is a fact, profit is an accounting opinion. And the company's inability to make hard cash per unit sold is clearly manifested in its weak balance sheet, poor working-capital management, and massive negative operating cash flow--the financial characteristics that have driven innumerable retailers to disaster throughout history,'' Suria wrote in the report.

DEBT TROUBLE. Ironically, a key contributor to this first-quarter debacle was Amazon's efforts to implement its strategy for growth. By adding product lines such as electronics and toys, and building distribution centers all over the country, the job of policing its inventories became much more difficult, particularly for a retailer that concedes it is lacking in retail experience. On $676 million in sales in the fourth quarter, Amazon was forced to take a $39 million writedown on inventory. The question now is whether Amazon will manage the process any better this year, with far higher sales and an ever-more complex product mix. ''They may have to settle for a little lower growth,'' says Bob Grandhi, manager of Monument Fund Group's Internet Fund, who sold all its e-tailing stocks including Amazon when he joined in April. ''We can't ask them to be profitable and also grow as fast as they have.''

Suria and other critics also point out that Amazon's ability to turn over its inventory rapidly enough has declined since the end of 1998; that, too, is a classic measure of poor retail management. Amazon's rate of inventory turnover plummeted from 8.5 times in the first quarter of 1998 to 2.9 times for the first quarter of this year. In 1999, when Amazon's sales grew 170% from the previous year, its inventories ballooned by 650%, Suria pointed out. ''When a company manages inventory properly, it should grow along with its sales-growth rate,'' he noted. When inventory grows faster than sales, ''it means simply that they're not selling as much as they're buying.''

Amazon's fast-growing debt load, which has risen to a staggering $2.1 billion, is also a source of concern. From 1997 through the latest quarter, the company may have reported as much as $2.9 billion in revenues, but it raised $2.8 billion to meet its cash needs--amounting to 95 cents for every $1 of merchandise sold, Suria noted. In the future, Amazon will be under far greater pressure to meet its obligations by generating its own cash. ''Bondholders are in effect being paid cash from money they lent the company,'' says Marie Menendez, Moody's senior corporate finance analyst of the interest payments of about $150 million a year.

Not surprisingly, Amazon vehemently disagrees with Suria's portrayal. Bezos insists that the company is getting a handle on its costs and generating new sources of revenue to take the place of market support. Bezos promises that Amazon will show positive operating cash flow for the last three quarters of this year, an assessment that equity analysts accept. He's not predicting what will happen in 2001's first quarter, however, when Amazon will have to pay suppliers for an expected $1 billion in holiday sales. But until then, he expects rising sales and greater efficiencies handling the company's vast, relatively new network of distribution centers to not only end the cash drain but also to produce cash flow.

Indeed, many analysts believe the Amazon of year 2000 is actually in better position than ever. Operating losses fell from 26% of sales in the fourth quarter to 17% in the first quarter. As a result, analysts expect operating losses to drop to a single-digit percentage of sales by yearend--when books, music, and video are expected to be profitable on their own--and they predict a companywide operating profit by the end of 2001. Says Merrill Lynch & Co. Internet analyst Henry Blodget: ''I'm not at all concerned about the cash side.''

Where Bezos and his band of Wall Street believers think Lehman's report went astray was in focusing on the one year of Amazon's greatest expansion and projecting those costs forward into the future. The costs came up front, but now, they argue, Amazon will exploit its ability to handle far higher volumes. ''For a company that's changing at this velocity, looking only back at finances can lead to misleading conclusions,'' says Amazon.com Treasurer Russ Grandinetti.

One controversy seems to be over the vast network of distribution centers that Amazon built over the past couple of years. While largely empty and unused, the centers gave Amazon a leg up on online and traditional rivals last Christmas: It could ship on time over the holidays, creating an intensely loyal customer base. In the first quarter, repeat orders constituted 76% of sales.

Suria's critics claim he was looking at these one-time capital costs and assuming that Amazon would have to keep spending at those levels. Now that the centers are built, Bezos says Amazon can work on making them more efficient. In fact, the costs of the construction are not in the operating cash-flow calculations upon which Suria bases his criticism.

There is early evidence that Amazon is beginning to manage its unwieldy portfolio of products better, moving customers more quickly to new products. For instance, it became the largest CD seller after only four months. And sales of children's products, mostly toys, hit $95 million in the fourth quarter, less than five months after Amazon's ''toy store'' opened. Customers are also ordering more every quarter: Annual sales per customer rose to $121 in March from $107 a year before.

Amazon is also developing new sources of revenues other than direct sales. It is trying to line up partners, particularly ones that can handle highly regulated or difficult-to-ship products such as sofas and drugs. In return for cash payments of up to $150 million apiece over three to five years, Amazon allows other e-merchants, such as Living.com and Drugstore.com (DSCM), to host stores on its site. While this on the whole is a strategic plus, the plan also leaves Amazon's revenue base vulnerable to the travails of its dot-com partners--some of which are already facing layoffs and difficulties raising capital.

Bezos and supporters also object to Amazon being lumped in with Old Economy giants like Wal-Mart (WMT), claiming that there are more differences than similarities. The argument: Amazon will not be forced to build new stores, stock shelves, or hire new people to generate sales. As Amazon's sales grow, analysts say it will require no more than a third of the investment of a brick-and-mortar retailer for the same amount of sales. Goldman, Sachs & Co., the company's original underwriter, estimates for the next year, Amazon's operating expenses will rise only 8% and marketing only 7% while driving a 59% jump in sales, to $4.5 billion. The ultimate result, says J.P. Morgan & Co. analyst Tom Wyman: ''Their operating margin will be twice that of brick-and-mortar retailers.''

BRAND POWER. Ultimately, Bezos contends, Amazon should be more profitable than conventional retailers, though he won't hazard by how much. Indeed, he implies that Amazon aims to produce not necessarily higher profit margins but higher profits overall--which he contends is more important to investors. His take: a company with $10 billion in sales and a 5% profit margin--that is, $500 million in profits--is much more valuable than a $1 billion company with 10% margins, which has $100 million in profits.

But whether Amazon is more or less like retailers, it certainly must contend with many of the same forces. Just like retailers, Amazon is highly dependent on brand recognition and identity to bring customers back to its site. And just like retailers that overextend themselves, some critics believe that Amazon's one-stop shopping mentality is a threat. Expanding beyond its signature items--books, CDs, and videos--could muddy the Amazon brand at a time in consumer history when success demands a clear image. ''The most powerful brands in the world stand for something simple,'' says Al Ries, brand management consultant and author of The 11 Immutable Laws of Internet Branding. ''Volvo stands for safety. Dell is a personal computer. Even Microsoft is software. Now Amazon is going to stand for books and charcoal grills. This makes no sense to me.''

Bezos argues Amazon stands for high-quality customer service over the Web--and that customers looking for that will return again and again. But the debate is far from academic. The power of the retail brand has been demonstrated repeatedly over the past decade. The most successful retail chains, from Gap (GPS) to Target Stores (TGT) to the mighty Wal-Mart, have unadulterated images that stick with consumers and keep them coming back. Retailers that have stumbled, from Tandy Corp. (TAN) to Kmart Corp. (KM), shared a common misstep: They failed to build a coherent theme for consumers by selling unrelated merchandise or not providing a consistent level of service.

Amazon and other e-tailers were fortunate in having been launched in a boom economy. But a consumer spending slowdown would endanger revenues at Amazon as much as at any other retailer.

Worse, Bezos is finding it necessary to cut prices on one of its newest lines: consumer electronics. True, low prices are what drew customers to the Web in the first place. But from the start, Amazon has tried to depend on a wide selection to be its strongest drawing card.

Ultimately, Amazon and those on Wall Street who still back it have made a giant bet that none of these factors will be enough to keep it from boosting sales enough to get to profitability. At base, it is a bet on Amazon's ability to outrace the financial squeeze that all money-losing e-businesses now face. But as the difficulties of beating the debt clock increase--and the questions multiply about how the numbers will ever add up--a growing number of investors and analysts are bailing out, no longer liking the odds. Who is right? Coming down on either side ultimately requires something of a leap of faith. The only certainty: In its short life as a public company, Amazon's experience has often set the rules under which e-commerce companies operate. Survive or stumble, that will continue to be the case.

By Robert Hof in San Mateo and Debra Sparks and Ellen Neuborne in New York, with Wendy Zellner in Dallas

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