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In the world of nationwide retailing, where billions of dollars change hands daily, $9 million is an afterthought. But that figure was the key to a divergence of opinion in late April between two analysts over whether to recommend that their clients either buy or sell Amazon.com (AMZN) stock.
On Apr. 27, the day after Amazon reported its first-quarter results, Mark Rowen of Prudential Securities upgraded Amazon from hold to strong buy, while David Trossman of First Union Securities downgraded it from buy to hold.
How two analysts can look at the same information -- in this case Amazon's first-quarter earnings report -- and come away with opposite reactions is a case study for investors interested in understanding the thinking behind an analyst's recommendation. In Amazon's case, the split decision has all to do with the previously mentioned $9 million. Every Amazon shareholder has to look at that $9 million and make up their own minds about what it means for the company. Because even though both analysts based their recommendations on well-reasoned arguments, in the end only one will be right.
ONE PERCENT.
The $9 million I'm referring to was the difference between Amazon's fulfillment costs in 2000's first quarter and in 1999's fourth quarter. In this year's first quarter, the company spent $99 million to fulfill orders for $574 million in sales. In last year's fourth quarter, Amazon spent $108 million to fulfill orders for $676 million in sales. In percentage terms, the company spent 16% of its revenue in the fourth quarter on fulfillment, while it spent 17% in the first quarter.
That one percentage point change in fulfillment costs as a portion of revenue goes to the heart of the essential argument about Amazon's future. "Nobody can reasonably say that Amazon isn't going to be a huge success," says Trossman. "The argument is about how much money they have to spend in order to be a success. The next few quarters' results will end that argument."
While Amazon has pretty much won the war to become the preeminent online retailer, its stock has yet to win its war to be recognized as the next Wal-Mart Stores (WMT) -- a stock that will outperform its peers for a generation. That's because Amazon has yet to prove that it can make higher-than-average profit margins as a mature business. The company admits that it's at least three quarters, and maybe many more, away from hitting profitability. But plenty of tea leaves are here now that can hint at how Amazon will do once it gets there.
GOOD HINT.
A crucial factor to consider is gross margins, and that number provided good news to Rowen. The company declared gross margins of 22.3% in the first quarter, whereas Rowen had expected gross margins of 19.5%. In last year's fourth quarter, Amazon's gross margins fell to 12%.
More important to Rowen was the figure he calculated for Amazon's so-called variable profit margin, which is the gross profit minus the cost of fulfillment. Amazon's variable profit margin, which Rowen considers to be a good hint at uncovering future operating profits, rose to 5.1% in the first quarter of this year from a slightly negative figure in the fourth quarter of last year. That negative number was due mainly to write-downs of some expensive items that didn't sell as expected in the Christmas rush. "Amazon's economic model appears to be back on track," Rowen says. "When I saw that gross margins were near 23%, I thought that management had a much better chance of meeting its goals [of lowering costs and becoming profitable] for the fourth quarter."
Most of the news headlines about the quarterly results agreed with Rowen's analysis. Gross margins, after all, had increased from the fourth quarter and were back in a more desirable position. Wal-Mart, by comparison, makes a gross margin of 21.4% and an operating margin of around 5%.
NO SURPRISE.
But David Trossman fixated on the change in fulfillment costs as a percentage of revenues, that worrisome one percentage point increase. That $9 million. The 1999 Christmas season had, as expected, produced far greater revenues than 2000's first quarter did, so it wasn't surprising that the fulfillment costs would be lower in the first quarter. But Trossman had expected the difference to be a lot greater than $9 million. So, he figured, something was going wrong with Amazon's ability to take in orders and efficiently send out merchandise, or else fulfillment costs should have been considerably smaller.
On the surface, it may seem silly to focus on one quarter's fulfillment costs, especially when you take into account the huge revenues that everyone expects Amazon to make in the future. Four billion dollars is a conservative sales estimate for 2001, and the growth curve probably won't have begun to flatten even at that point.
But remember, it's not just about how much money is coming in. It's about how much money Amazon is spending. "The cash spending going out the door is greater than we expected," says Trossman. "Other people are concentrating on the gross margin and what's above that [i.e., the increase in revenues] in the income statement. I'm looking at the gross margin and what's below that [i.e. the costs for the company] on the income statement."
Which analyst is right? We probably won't know for sure until this time next year when Amazon is expected to report its first profitable quarter. Only then would investors get to see how much the company can make in real profits. But investors have to make up their minds up about the stock before then. Before you buy or sell Amazon, you have to decide how important that $9 million is.
Jaffe writes about the markets for Business Week Online Which analyst do you think is right? Let us know at our Ask Sam Jaffe Forum
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