Amazon on My Mind
The Motley Fool - May 05, 1998 18:13
AMZN KTEL WMT HD KR FMY COST DH CCI SCH DELL CPQ BRK.A BRK.B NOB AXP BGP KMT MCD CCI V%MFOOL
P%TMF
May 5,
1998/FOOLWIRE/ -- Rather than waiting a few months to talk about Amazon.com
(Nasdaq: AMZN) after discussing it last Friday, I thought there would be no
harm in talking about the company again today. This is obviously a
controversial stock, judging by some of the intense emails I received. I
think there are a few reasons for the intensity that people feel about the
company's stock.
If It goes up quickly, its value isn't real. If you don't know a situation
well, then you tend to be skeptical of a explosive rise in the stock price.
Take K-tel International (Nasdaq: KTEL), for instance. I am guilty of being
skeptical of the value of this stock, especially when the only analyst
coverage out there capitalizes revenues that have nothing to do with the
Internet, compares that valuation to the valuations of pure-play Internet
companies, and then proclaims it as undervalued. K-tel might be a great
company and could cash in huge on the Internet, but just hanging a shingle
up on the Internet is not a guarantee of a darn thing. But K-tel's run
shouldn't mean that an a priori judgment should be made that it's selling
above intrinsic value. If one had perfect foresight on its future cash
flows, then one could make a highly informed judgment on that.
Amazon.com sells a commodity. The reasoning that a company needs patent
protection or high-margin products to do well is fallacious. Here's a list
of names of companies selling commodity items that make their money from
service and efficient capital management: Wal-Mart (NYSE: WMT), Home Depot
(NYSE: HD), Kroger (NYSE: KR), Fred Meyer (NYSE: FMY), Costco (Nasdaq:
COST), Dayton Hudson (NYSE: DH), Citibank (NYSE: CCI), Charles Schwab (NYSE:
SCH), Dell (Nasdaq: DELL), Compaq (NYSE: CPQ), and GEICO, a subsidiary of
Berkshire Hathaway (NYSE: BRK.A and BRK.B), all built brand names and
shareholder returns not by selling proprietary things but by selling
non-proprietary things better and cheaper than anyone else. Amazon.com
doesn't need huge margins and huge barriers to entry to succeed.
This can be borne out in the most basic capital efficiency model, the DuPont
ROE formula:
Leverage * asset turnover * net margins = ROE
Expressed mathematically, assets/equity * revenues/assets * net
income/revenues. Canceling out the common numerators and denominators, this
equation turns back into the familiar net income/shareholders' equity ratio
that goes by the name "return on equity" (ROE). However, it is instructive
to work through the various elements to see that asset turnover is many
times more important than margins. Asset turnover is due to operating
acumen, not inheriting killer intellectual property from previous management
or operating a natural monopoly with lots of pricing power.
If you look at a bank such as Norwest (NYSE: NOB), its net margin is lower
than other big banks and it carries lower leverage than the average large
bank or financial services company. Its ability to generate super-normal
returns on equity capital comes from its asset turnover, which is a good 35%
higher than average. American Express (NYSE: AXP), despite having a great
brand name, operates in a similar way. Its margins are extremely low
compared to other financial services companies, and its leverage is low,
too. But its ridiculously high asset turnover ratio allows it to generate
extraordinary returns on equity capital.
Amazon.com is modeling itself this way. Its bricks-and-mortar competitors
may be able to underprice them in the short run, but that would put their
land-locked businesses in trouble, since the bricks and mortar part of
Borders (NYSE: BGP) isn't a cash cow that can feed a cutthroat Internet
price leader indefinitely. Borders, the mature company that people like to
point to as a reasonable investment in comparison to Amazon, only turned
free cash flow positive (considering working capital changes) last year,
with approximately $3 million in free cash flow in 1996 and $34 million in
free cash flow in 1997.
No one should be under the illusion that the bookselling business is
attractive. It's not. No commodity business is an inherently attractive
business. Neither is selling grills and duct tape, a la Wal-Mart, nor milk
and rice, a la Kroger. There will always be room for very good operators,
though, which is where people make a mistake on Amazon. This is taken as a
ceterus paribus assumption by the Amazon.com bears out there, which is
crazy. Strength in execution of a business plan on a daily basis can be the
deciding factor in an investment. Wal-Mart kicked the daylights out of Kmart
(NYSE: KMT) on this count, and McDonald's (NYSE: MCD) Ray Kroc pounded all
the other quick-serve restaurants in its growth phase. When you get to a
mature size, the growth slows, sure, but if an investor been around for the
ride to maturity, he can do well, especially if the company has been able to
finance its growth internally or without excessive equity issuance.
The one part of my column the other day that rubbed a few people wrong was
my use of "new age" accounting where I capitalized marketing outlays and
charged off the capitalized asset over five years. The reason why this was
done was not simply to show profits. Economic profits are in many cases
distorted by Generally Accepted Accounting Principles anyway. The goal of
the exercise was to look at the company's marketing expenditures as if they
were capital expenditures. Since the company's capital expenditure needs are
minimal by design, its capital allocation efforts elsewhere in the business
are necessarily effected. While the company is in its immature hypergrowth
phase, its marketing spending will naturally outstrip earnings. When and if
it gets to maturity, its marketing spending will be oriented to maintaining
its brand name presence.
In the interim, whether you want to expense all marketing immediately or
capitalize those expenditures and charge them off over five years, the net
free cash flow of the company doesn't change. The amortization expenses will
be non-cash and the marketing spending would be looked at as capital
expenditures. This should have been implicit in what I was saying, but
assumptions can pave the road to hell when good intentions are taking the
day off. In addition, the tangible shareholders' equity of the company would
not change by capitalizing the marketing spending. The asset resulting from
the capitalization would be totally intangible. Looking at economic profits
as I spelled them out is not supposed to be an exercise in delusion and it's
not supposed to mask real cash flow needs, it's supposed to be a management
decision-making tool and a tool an investor can use to look at the progress
of a hypergrowth company. Too many people get hung up on earnings as the
final arbiter of a company's value.
Earnings are meant to portray the economics of a business and to represent a
return to capital. However, earnings become distorted by various subjective
management and GAAP adjustments. Cash flows hardly ever lie. So, only a
delusional management would ignore cash flows and take as the only indicator
of return to capital the methodology that I described the other day. The
management that wants to think in a number of different ways about the
economics of their business could step outside the box for a moment and look
at their business in such a way and not be bothered by the hobgoblins of
foolish (small "f") consistency and devotion to GAAP.
-- by Dale Wettlaufer |
