The Case for Amazon, Part 1: Why Legg Mason's Bill Miller Has Been Buying

Comments critical of Amazon.com's (AMZN Quote) business model aren't new to regular readers of this space. The column has gone out of the way to let short-sellers explain why they're betting against Amazon. But there is another side to the story; after all, somebody was buying all of the shares being sold in recent days. Among those buyers: the Legg Mason Value Fund, run by the revered Bill Miller, which is believed to be Amazon's second-largest mutual fund holder behind Janus Funds. Miller is perhaps best known for giving new meaning to "value," with his purchases of such highfliers America Online (AOL Quote) and Amazon. America Online turned out to be a brilliant call.

What makes him so sure with Amazon, especially with a bond analyst from Lehman Brothers questioning whether the company has enough cash to last the year? Well, I didn't try Miller. He tends to be press-shy. Instead, I went straight to Randy Befumo, one of his analysts who, along with Legg Mason research chief Lisa Rapuano, has been responsible for handling most of the research on Amazon. In three separate installments Wednesday I'll turn over my column to Befumo, a former journalist for the Motley Fool. He wrote this in response to my question: Why do you still like Amazon? At the very least, you won't be able to say you didn't get both sides of the story. I give you Randy Befumo:

Investors over the past few days have reacted to five key issues with Amazon:

The first: sequential revenue growth. Both Henry Blodget (Merrill) and Mary Meeker (Morgan Stanley) have expressed concern with Amazon's ability to grow revenue 5% sequentially in the second quarter. Assuming June is in line with May, traffic as measured by unique visitors (via Media Metrix (MMXI Quote)) will be down about 6% sequentially in the second quarter of 2000.

By contrast, in the second quarter of 1999, traffic actually rose about 10% sequentially, contributing in part to a revenue increase of 7% sequentially. Of course, increased uniques are not the only way to grow revenue. As with any retailer, there are three factors: How much traffic did you get? What percentage of that traffic was converted into actual buyers? How much did the basket of goods bought by one customer increase? It is thus clearly not fait accompli that a sequential decrease in uniques means that there will be a sequential decrease in revenue.

Instead, growth in revenue will have more to do with Amazon's ability to increase the value of its customers rather than simply add new customers. All things being equal, with a decrease in uniques it is less likely that Amazon can achieve the forecast level of growth. The key clarifications are to determine how much less likely is it and what kind of growth is possible. I believe currently that Amazon will show some sequential growth based on higher rate of converting its traffic into paying customers and an increasing basket of goods bought.

However, a small decrease in sequential velocity today magnifies into the future, so the exact size of it is critical, even if it is only a percent or two today. A percent or two compounded over 20 years quarterly is an awfully big number, and it is not surprising that investors are more uncertain than they previously were. I believe a big reason for this deceleration is not a fundamental deterioration, but increasing seasonality, which brings us to the second issue ...

Seasonality. I believe that the reason for Amazon's decreasing ability to grow in the second quarter is pretty straightforward -- seasonality. As Amazon takes a larger share of mature markets, seasonal shifts in that market will have a greater demand. Investors are accustomed to solid sequential growth in all quarters for e-tailers. With Amazon now holding about 5% share of the U.S. book market, the company is no longer able to take enough share on one quarter to offset the impacts of seasonality. Also, the release schedule begins to work against the company ... the second quarter is typically not the prime time to release new books. Thus, while Amazon should continue to show remarkable year-over-year growth well into the 80%+ range, I believe that in the future we will probably not see revenue grow sequentially in the second quarter. Barnes & Noble (BKS Quote) and Border's (BGP Quote) are pretty flat sequentially from first quarter to second quarter (and from second quarter to third quarter) and there is no reason to believe that Amazon will be any different as long as books, music and video (BMV) are such a massive portion of the total revenue. Simply put, I don't think investors have adjusted to the reality of an increasing market share and the convergence between the company and the market as this occurs.

Third issue: proxy. Amazon, for better or worse, is a proxy for e-commerce. The company is the largest, most liquid, pure e-commerce vendor. When an institution wants e-commerce exposure, Amazon is one of the first names that appear on the list of potential candidates. Unfortunately, during a period where we are seeing incredibly negative news flow as marginal one-category e-tailers fold, this hurts Amazon. Even, as I believe, if it benefits Amazon long term. Especially now, if there is no actual evidence to support an argument, the stock will not react to that argument. Thus the failure of Barbeque.com, an idiotic concept that failed to recognize that putting a small business on the Web does not transform it into a large business overnight, weighs on the shares of Amazon. The problems at eToys (ETYS Quote) -- a company that has stupidly locked itself with its very name into one pretty sluggishly growing vertical market despite protestations to the contrary -- weighs on Amazon. Until Amazon starts to show evidence that it is actually benefiting from this in the form of increasing market share or better financial results, people are not going to believe in this. This is because of a shifting evidentiary threshold, which, not coincidentally, is issue four ...

Evidentiary Threshold. This is one of the most critical aspects of the recent activity in Amazon from my perspective, although it is completely a behavioral finance issue. The evidentiary threshold is a measure of how much evidence is required to make you believe something. In a time period where the incremental news flow is negative, the evidentiary threshold is increased, meaning that it takes more positive information to arrive at the same level of belief. If you imagine evidence as a continuum, with positive evidence on one end and negative evidence on the other, as the threshold shifts, ambiguous information in the middle is treated differently. Twelve months ago the market would have laughed off the equity analysis of a bond analyst. Now people want to believe that it is this analysis that is primarily responsible for the decrease in the last few days. (One-to-one relationships between information and stock price movements are notoriously hard to prove, despite the conceits of the financial press.) Amazon has been in a stage, since the March 10 crack in the Nasdaq, where people's interpretation of ambiguous information has been becoming more and more negative and this culminated on Friday.

Issue No. 5: Time Horizon. Concomitant with a rising evidentiary threshold is a shrinking time horizon. Twelve months ago, people were looking five or more years in the future. Today, the focus on Amazon that everyone is keying off of is actually two months in the past -- the first quarter results, printed in April. Given that Amazon's economic model is assumed to improve over time (as a base case for owning the equity), the shrinking time horizon kills the stock. Using the language of modern financial theory, all of Amazon's value is far in the future. Focusing on the recent past alone gives you no reason to be positive on the stock.

Coming up ... Part 2: What Befumo thinks of the Lehman report.

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