TSC Net Stock Summit Transcript: Part 5

TheStreet.com held its Net Stock Summit last Friday in its lower Manhattan offices. This is the fifth installment of the edited transcript of the Summit, which TSC is publishing throughout the week. (Click for Part 1, 2, 3 and 4.) This segment asks the question "Will Amazon.com ever make a profit?" An archived audio version of the Summit is available here.

Dave Kansas: Let's go on to question five here so we can be sure to get to everyone's stock picks. Question five was -- we said "Amazon.com (AMZN) will never make a profit." Twenty-six percent agreed -- that's pretty amazing -- and 73% disagreed, meaning that they thought they would make a profit. Now I would like to know if people think Amazon.com will make a profit, but how long will it take if you say yes, not just, 'Yes, sometime in eternity'? You just wrote about them today, Henry. What do you think?

Henry Blodget: We think they will make a profit. We think the management team has made a decision and it's been a great strategy thus far, which is to build for shareholder value in year four, five and six, not year one, two. And we really believe that the company actually could show a profit right now if they wanted to, if that was the goal. And unfortunately, if they did, what that would mean is that the shareholder value in year four and five would be much lower than it will be if they continue to do what they're doing, which is investing for a much larger future.

You obviously have to have a lot of faith to buy into that, and part of my faith in Amazon is having spent time with the management team. I think they're brilliant, I think they're motivated by a lot more than money, and I think they're doing the right thing. And I would just point to an America Online (AOL), which for years was the joke of the Street because they couldn't make any money, and Steve Case was always saying, 'We're not running the company for Wall Street. We're running it for market share.' And now it's the blue-chip of the Internet, and they are huge. And I think Amazon has the same potential.

I think there is risk that the bear story on the margins is right, and they will have trouble making the kind of profit they were looking for. But at this point, we're still comfortable with the long-term strategy, which is build for long-term shareholder value.

Kansas: So year seven or eight of their history, you see profitability?

Blodget: I see profitability with them when it makes sense. They have convinced the Street, and I think they've done a great job of it, that they are a very disciplined management team. They have the tools necessary to make the right financial decisions for long-term value, and when those tools tell them that it's time to start cranking back on the expense leverage and starting to show a profit, I think they'll do it.

Herb Greenberg: Well, Henry, how do they keep those profit margins nice and fat when shopping.com is advertising in The Wall Street Journal its books at some low price and everybody's undercutting them -- very, very steeply undercutting them? And on the software side, you have the same thing. How are they gonna overcome that hurdle?

Blodget: I think there are two main points on price. One, I think for a big percentage of the online shopping population, Amazon's value proposition is a lot more than price. Price is a big component, but you also have service, ease of use, reputation, end-to-end delivery -- and basically your confidence in the brand. There is clearly a segment of the online population that will always shop on price. They will try to buy the lowest price at any time. Amazon, I would argue, doesn't want those shoppers as customers. Leave them to buy.com or shopping.com. That's the first thing. "I think for a big percentage of the online shopping population, Amazon's value proposition is a lot more than price. Price is a big component, but you also have service, ease of use, reputation, end-to-end delivery -- and basically your confidence in the brand." -- Henry Blodget

Second thing, if any company is positioned well to compete on price, it is the volume leader, and Amazon is the volume leader in the sectors in which it competes. And I think they will extend that lead over time. What Jeff Bezos has always argued is that the winner in this space will have the lowest prices and the highest profit margin. I agree with that, and I would look at a Dell (DELL) as an example of a company that, simply because they are out ahead of the competition -- and again, Dell's value proposition is not that they make better computers. It's that they are much better at the direct model than anybody else.

Look at the difference in their profitability vs. Gateway (GTW), which isn't all that far behind, and it's doing the same thing. Dell's much more profitable. It's because their whole value proposition is better, cheaper, faster, and they do it better than anybody.

So I think pricing is an issue. I think, however, now that Amazon has raised a billion and a half dollars, if buy.com or anybody else wants to go public on the value proposition of 10% off Amazon.com, they are now in a position where Amazon could conceivably burn $250 million a year for five years -- in order to price 10% under them, if that's the value proposition. So again, I think it's a long-term equation. I think there's more to it than purely price, and I think they are positioned to compete on price, if anybody is.

Kansas: Brian, do you guys own Amazon?

Brian Salerno: Yeah, we own Amazon. It's a very small position in the fund right now, mostly for valuation reasons. We think, for the most part, people have reflected their enthusiasm for the stock -- and Amazon's success. But what we're looking at right now, before we're willing to raise the position, we want to know that they can do more than just distribute books in a convenient manner to consumers. That's already priced into the stock, we think. And basically, it's just a retailer. Profits are never going to be fat doing that, never. I mean, if you're just selling books, you're not gonna have fat profits.

What we're looking at is: Can they grow that to be such a huge business with books, CDs, tapes, other things in there that they have millions and millions of loyal users that come back? Leverage that into being a shopping agent for other vendors, where they're not taking inventory, and that's where you get fat profits. And then it's worth a heck of a lot more. We're waiting to see, is there any evidence that they can do that? We're not sure right now.

Kansas: Ryan ... do you guys own Amazon as well?

Ryan Jacob: Oh, we have a fairly small position. Mainly it's not that we think Amazon's gonna blow up anytime soon. It's just that we think it's fully valued and there are some better opportunities elsewhere. But, that being said, basically, if you bought Amazon and hoping that just by selling books it would be a profitable enterprise, you probably took the wrong approach. And the same way with America Online. If you had bought that early on thinking it -- you know, 20 bucks a month, they'd be able to turn a profit, well, they wouldn't.

The question is really: What kind of asset are they building? And at America Online it's 16 million subscribers. How can they leverage that off into other revenue streams? And with Amazon, it's the customers that they've been acquiring, that brand-building. It's that trust they've built along the way with Internet users. Amazon really -- it's their game to lose. They can become the e-commerce destination point on the Web. So, I mean, on that hand it's very exciting, and going forward, I would agree with Brian to some extent that they will dish off in areas where they don't have particular expertise to other merchants, and that's a much higher-margin type of business.

They will eventually take advertising on their site, which is a much higher-margin business. Even though they may have margin compression on selling commodity products like books, videos and CDs, there are higher-margin opportunities for them in the future, which still means that their prospects still look pretty bright. And now with this billion and a quarter in new cash, that doesn't hurt either. I think a lot of the offline retailers had the opportunity to kind of sweep Amazon under the rug a couple years ago, but I think they blew it. And now it's Amazon's game to lose. "I think a lot of the offline retailers had the opportunity to kind of sweep Amazon under the rug a couple years ago, but I think they blew it. And now it's Amazon's game to lose." -- Ryan Jacob

Kansas: Recurring theme, ignoring the Internet, it seems.

Nick Moore: Well, no. Let's look at that business elementally 'cause it's very instructive about the Internet. And the long story short, they can be profitable anytime they want to, OK? They've won that battle. You can't have the hyper growth and profits today. When the hyper growth winds down, they can be profitable, but I wouldn't be surprised if they did a profitable quarter at the end of this year if they had the same sort of sequential uptick, but maybe that's next year.

Let's look at that business 'cause if they were just books -- right? -- $18 billion market in the U.S. They had had 2% or 3% in net-profit-on-the-dollar sales, right? So that's -- what? -- $500 million if you add the whole thing. And pare that down 'cause they won't get it all. You'll still buy books in the airport and so on. Maybe they'll go into that. The...

Kansas: Three percent net or gross?

Moore: Net profits, 'cause they have 22%, 23% gross margins, just like a disk-drive company, right? The thing is they only have -- today they're generating 200 and -- what? -- 20 million run rate in gross margin dollars. That's their value added economically. They've only deployed $60 million into the business, right? There's $29 million in inventories, $29 million in property plant equipment, no accounts receivable. They don't even break it out of the line item because it's all by Visa. One-day-one-day collections. So there's no capital in that business. So we can compare them to merchants and say this is a much higher-ROE business. If they wanted to kick over that 3% net profit now, you'd have a 50% ROE, right? Just like that. And you want to invest in companies with a 50% cash ROE, right? It's a huge business model.

The other thing is: What is Amazon, really? This is consumer software. There aren't gonna be very many players. You could talk price all day. You have to learn Amazon's site, you know. Are you really gonna go learn barnesandnoble to save 20 cents on a book? No, not particularly, when you're gonna sooner or later discover garden.com. You're gonna be going to CNN or TheStreet.com for news. You're gonna be less and less tolerant of switching sites, just like we've always been with every other form of software. So they can defend their turf, I think, without spending a billion dollars on promotions. You know, there will be some things that go on here and there, but I think mostly the people who come in to compete on price are gonna miss the point.

Every low-priced software company in history has failed. You can look at all the software companies named Platinum, companies like The Learning Company (TLC) have all been -- Borland -- have all been splattered, every single one, 'cause the value of learning how to navigate a piece of software is invariably too high.

Kansas: All right.

Jim Cramer: These always seem like it's never happened before, but when I was a broker at Goldman in the '80s, there were guys who were pushing TCOMA. And I looked at it, and I said, you know, 'TCOMA -- they'll never make a profit.' And then Malone came to town, and he talked about how he would never make a profit, but no one else would ever come in the business and, therefore, you would have a monopoly someday. And I laughed at him, and I left billions on the table.

McCaw came to town, and McCaw revealed a business model to me, which was a nightmare 'cause I thought of myself as McCaw. I said, 'Well, what -- you know, here's a guy who's willing to lose billions of dollars.' And both McCaw and TCOMA were great investments. So, I mean, the way the question's framed, I think, is very interesting 'cause I think a lot of people have been taught that profitability is always at suit for -- but I know from Malone and I know from McCaw that they were not charlatans and they were not snake charmers. They had a vision and it just didn't include profitability.

And I wanted to shoehorn them into what I regarded as being the only effective business model, which is one where you have a certain amount of revenue, and then you generate a certain amount of profit and then you show it. It did not mean that there aren't a lot of businesses out there that are never gonna make money, but making money and not making money was not how Malone looked at it and it's not how McCaw looked at it. And they were two great success stories that I left on the table.

Next: The panelists' stock picks.

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