The Case for Amazon, Part 3: The Bottom Line of Legg Mason's Analysis

First we heard from Legg Mason analyst Randy Befumo on the five key issues currently facing Amazon.com (AMZN Quote). Then we heard him counter the Lehman Brothers report that suggests Amazon is getting close to running out of cash. Now, in this final installment of "Legg Mason and Amazon: The Movie," Randy tells us why he thinks Amazon is a great investment. Randy:

Over the past four years, Amazon has created a remarkable asset -- the company routinely aggregates 14 million-plus customers on a monthly basis. As history has taught us through radio, TV and the initial consumer development of the Internet, a large aggregated audience in and of itself has tremendous value. America Online (AOL Quote) and Yahoo! (YHOO Quote) are the most recent examples of the power of aggregation and the amount of value a large mass of aggregated customers can create. While the evidence to date on what sort of economic model Amazon will ultimately have is mixed, as long as this aggregation exists it represents significant value to a large number of buyers.

As to what economic model Amazon will ultimately have, speculation rules the day. What I do know is that Amazon's management has consistently put off profitability in favor of rapidly building new verticals to increase the lifetime value of customers. For the company, profitability is a decision governed by considering how fast they want to grow and how many verticals they ultimately want to operate. Despite the fact that building customer value through adding new verticals and acquiring new customers creates enduring value, the operating investment to build these new verticals is run through the profit-and-loss immediately. If Amazon were building factories instead of new product categories, it could capitalize these investments and depreciate them over the years. Instead, it pays the operating piper on a daily basis for building value that is more than instantaneous.

Despite the high level of operating loss from this accounting treatment, the cumulative operating cash flow for the company is only $61 million. This remarkable fact is never mentioned by those who argue the model is heading toward bankruptcy. Suppliers, not the capital markets, are funding the operating losses. As long as Amazon can continue to grow and pay its suppliers in a reasonable amount of time, there is no reason to believe that this will stop.

Further, Amazon has completed a one-time acceleration of the buildout of its distribution capacity and far from seeing capital expenditure increase in 2000, the actual data from the first quarter support management's contention that capital expenditure will decrease significantly year-over-year and roughly equal depreciation. Stripping out losses from emerging businesses, Amazon has seen its gross margin recover overall despite the fact that shipping has gone from a mid-teens gross margin in 1998 to breakeven in the first quarter of 2000. This change is due to the company's decision to split shipments to maintain customer satisfaction.

Gross margins are actually increasing in spite of decreasing gross margins in shipping over the same period, a strong indication that operating performance is actually pretty good. Yes, there are some definitional problems with what should go into gross margin, but far from the unanimity that those who are negative on the company suggest, there appears to be a great deal of turmoil with the Financial Accounting Standards Board as to setting definitions for gross margins as it appears online retailers have a wide diversity of practice as well.

Ultimately, the important story occurs on the operating line. Based on our analysis of the operating dynamics, in conjunction with management's guidance, we believe that shrinking operating losses through the year are quite possible in spite of high levels of operating investment in new verticals.

The Lehman piece [see Part 2] holds an old analytical error. "Therefore, we would become a lot more comfortable with the credit if we see the company generating positive operating cash flows during the next shopping season..." Well, if the company actually performs in the next holiday season, the stock will perfectly reflect this information and will have gone up a lot in the interim. This may not matter very much to the bondholders, but the belief that the equity holders can wait until after positive information hits the tape and then invest is a little silly. You actually have to own the stock in advance of confirmation of the economic model to make the big money. Buying at higher prices for "more certainty" is code for systematic underperformance. This, in my analysis, is one of the principal reasons that professional money managers systematically underperform -- the certainty tax.

As for Amazon "fac[ing] a significant operational challenge to change [operational inefficiencies] this year amidst a period of much higher growth, much higher competition, new product lines and new distribution centers," I take a different point of view.

The year 2000 is looking a lot better every day than 1999. Destructive competition from other e-tailers is drying up as the most egregious abusers of the capital markets are going belly up and venture capitalists are content to lick their wounds. As for traditional retailers having a stronger presence in Christmas 2000, given the long-term trend they have been collectively exhibiting (protecting the bottom line from e-commerce losses) it seems unlikely they will be price-aggressive either. Growth in terms of percentage year-over-year growth is actually slowing and the number of new categories being ramped for a first holiday season is actually lower, meaning the cost of developing new verticals and the inefficiencies that arise from "hypergrowth" should diminish. Finally, the "new" distribution centers will be more than 12 months old at a minimum and are likely to be better run at better utilizations as they mature. The hand-wringing over next Christmas being worse than the last one just doesn't bear up to any scrutiny.

Consequently, with pessimism near its apex, the price of Amazon for those who can maintain a long-term horizon gets more attractive every day. While we will likely see turbulence until Q4 results start to manifest and Amazon actually achieves the single-digit operating margin loss it has forecast, I believe that it is clear from the actual results that the model actually works and that Amazon is building the highest long-term value possible at the expense of short-term results. Although the in-between times are likely to be choppy, should Amazon work it will perform admirably from current levels. The best information I have to date suggests that it should work splendidly.

Thanks, Randy. And to the rest of you: Don't say you don't have enough information from the longs and the shorts to make an informed decision.

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