FW: ATC Wire: Initiating Coverage on Amazon.com

Dan Kohn (dan@teledesic.com)
Tue, 10 Jun 1997 18:21:40 -0700

When it rains, it pours. NetMarket was the company I started and sold=20
to CUC in '94. They have a deal with AOL today, and Bill Gurley has=20
an interesting piece on them at the bottom.

- dan

** CUC to pay AOL $50 million for distribution

CUC International signed a Web commerce pact with America Online
under which it will pay AOL $50 million to distribute its shopping,
travel and other services online, the two companies said Tuesday.
CUC offerings will appear throughout various channels within the
AOL network, "including anchor tenancies in the all-new AOL
Shopping Channel and other AOL promotional services," a statement
from the companies said. CUC also operates its own online retail
venture, called NetMarket, which will be linked to AOL. Shares of
AOL closed up 3 1/8, or 5.4 percent, to 60 1/2 on news of the
agreement. Bob Pittman, President and Chief Executive Officer of
AOL Networks, said, "Our agreement with CUC demonstrates the
enormous value of our member base to sophisticated marketing and
consumer service providers." CUC's stock gained 1/2 to 24 1/8.

-----Original Message-----
From: Bill Gurley [SMTP:bgurley@abovethecrowd.com]
Sent: Tuesday, June 10, 1997 6:01 AM
To: atcwire@abovethecrowd.com
Subject: ATC Wire: Initiating Coverage on Amazon.com

ATC Wire: Initiating Coverage on Amazon.com
(AMZN#@, $19.88) BUY
Deutsche Morgan Grenfell Technology Group
J. William Gurley
June 9, 1997

Earnings Per Share
FY 1996A 1997E 1998E
1Q (0.02) (0.13) (0.32)
2Q (0.03) (0.32) (0.26)
3Q (0.10) (0.37) (0.21)
4Q (0.10) (0.38) (0.12)
Total (0.25) (1.20) (0.90)
PE: nm nm
Current Book Value/Shrs: $2.02
Shares Outstanding: (M) 23.9
Market Cap: (M) $475.1
97E Revenues: (M) $100.8
Fiscal Year Ends: Dec. 31

Major Report Summary:

(The following summarizes a 46-page report titled,
"Amazon.com: The Quintessential Wave Rider." Please contact
your DMG salesperson to receive a copy).

=B7 The book market is huge-$26 billion in the United States
alone and more than $82 billion worldwide.

=B7 On-line book selling is a compelling alternative for
customers, who favor the enhanced shopping experience, and
for publishers, who are looking to alleviate their current
economic pain.

=B7 Although competition in the on-line book retail market is
increasing, Amazon.com's operational flexibility and first-
mover advantages should ensure long-term success.

=B7 Leveraging its capital-efficient business model,
Amazon.com should evolve into a profitable and stable player
in the retail book industry.

=B7 We are initiating coverage of Amazon.com with a BUY rating
and a 12-month forward price target of $26 per share.


We have a fundamental belief that, all things being equal,
companies that leverage the Internet are superior
investments to those that seek to define it. These
companies, which we classify as "Wave Riders," use the
Internet as a competitive weapon to steal market share in
large existent markets. From an investment perspective,
these companies are aided by a calculable and well-defined
market, the lack of excess baggage that hinders the
flexibility of their established competitors, and the scale
advantage of being the first mover in Web-based business.
Amazon.com, the Internet retailing pioneer, has all of the
above characteristics and is clearly the quintessential Wave
Rider. To further appreciate Amazon.com's value to
customers, suppliers and investors, the following summary of
our report outlines (1) the advantages of on-line commerce,
(2) the present state of the book market, (3) the Amazon.com
advantage, (4) the competitive landscape, and (5)
Amazon.com's financials and valuation.

The Advantages of Electronic Commerce:

Electronic commerce has evolved from a niche supply-chain
tool to an ubiquitous method of communication available to
companies of all sizes and industries. Driving this
expansion is the more efficient exchange of information
between suppliers, manufacturers, distributors, retailers,
and customers. The Internet's universal connectivity and
address-ability are the primary forces behind this business
process evolution, and are having particular impact on
changing the way goods are sold to customers. Products
selling particularly well on the Internet generally have
high distribution costs, high degrees of personalization,
Internet-enabled customers (obviously), significant
electronic cost-savings potential and intensive, data-
oriented purchasing decisions. Companies that embrace the
advantages of the new medium to sell products and that match
the above criteria can enjoy significant structural
advantages over traditional competitors.

The Current State of the Book Market:

With regard to the book market, there are three
characteristics that should be particularly appealing to
Amazon.com's investors. First, the market is very large on
both a domestic and global basis. Domestic book sales
topped $26 billion in 1996, and global sales were
approximately $82 billion. Needless to say, even small
shares of this huge market are significant. Second, the
industry is fragmented at both the reseller level and the
publisher level, which should allow for easier market entry.
Last, publishers are feeling tremendous economic pressure,
due in part to unlimited returns policies meant to aid book
sales. Resellers presently lack the incentive not to abuse
publishers' unlimited return policy, and have driven returns
over the last 10 years up from the 15%-25% range to 35%-50%.
Publishers, as well as the popular press, have targeted the
superstores as the worst return offenders. In addition to
returns, the book industry's troubles are further amplified
by the increased price competition among publishers to sign
popular authors. Fatter contracts have to be spread across
more books, magnifying the risk if the book fails. We
believe that the enhanced information available in the on-
line model will help bring down returns as well as gauge new-
title demand. The book industry is ripe for a change and
the on-line model is a compelling alternative.

The Amazon.com Advantage:

Given the business advantages to being on-line and the
overall state of the book market, Amazon.com's founder Jeff
Bezos realized that books could be the first, best consumer
on-line product. The Web-based book store offers customers
the ability to search, browse, learn, interact, and order in
ways unique to the on-line environment. The customer, who
is simply browsing can begin with the "book of the day" or
wander through Amazon.com's "miles of aisles" where books
are grouped by subject. The browsing function is enhanced
by the Internet's "hot links," and at the click of a mouse a
user can move from researching a particular subject to
reviewing a certain author's bibliography to reading
critiques from either established reviewers or other
customers. Users can also perform simple searches by
author, title, subject and ISBN number. Once a book is
found, the site offers a significant amount of content,
which can be used to evaluate the individual title.
Available content includes book jacket images, synopses,
reviews and customer testimonials. When the decision is
made to purchase, the user places the book in a virtual
shopping cart and moves on to the next area of interest.
When finished, the customer advances to the ordering section
where payment method, shipping address and other details are

Amazon.com's success in providing the services described
above is evident in its accomplishments. First, the company
recorded first-quarter sales of $16 million, exceeding
1996's yearly sales of $15.7 million. This growth and
volume makes Amazon.com the undisputed leader in on-line
book retailing. Second, Amazon.com has generated a list of
more than 340,000 unique customer accounts, complete with
customer profiles, which include not only former purchases
but previous searches and considerations as well. Third,
over 40% of the company's sales come from repeat customers,
an impressive statistic considering Amazon.com's rapid
growth. Fourth, Amazon.com has the largest on-line catalog
of books, including 1.5 million "in-print" books as well as
1 million "out-of-print" books. Fifth, the company has
volumes (300,000 summaries) of related content to assist
customers in making book-buying decisions. Sixth,
Amazon.com operates as the fulfillment arm to more than
8,500 "Associates," who sell books to niche-interest
communities on the Internet. These partners expand
Amazon.com's reach on the Internet and attract customers to
its site. Seventh and last, Amazon.com's success is not
limited to the U.S. domestic market, as more than 28% of
1Q97's sales have been to international customers. This
statistic implies that Amazon's positive word-of-mouth must
be strong as the company has not actively marketed to non-
U.S. customers. Going forward we expect Amazon.com to
continue to innovate in the Web-retailing space with an ever-
expanding array of content, the use of collaborative
filtering, the establishment of focused "storefronts" and,
eventually, technology that will allow each user to have a
unique shopping experience.

Amazon.com's accomplishments, listed above, have clearly
made the company a success in the eyes of the customer.
Publishers and investors, however, should also favor the
Amazon.com business model. Publishers are attracted to
Amazon.com's return rates (which consistently have been
below 2%) over traditional booksellers' rates (which
consistently have been at least 30%). Amazon.com is looking
to steer the industry to where return rights are removed
from the cost of the book, which would lower Amazon.com's
per-book cost and put pressure on traditional booksellers,
if publishers were to expand such a policy across all of its
products. Publishers also benefit from on-line's ability to
obtain valuable customer information. By tracking
customers' past buying and browsing behavior, better
forecasts can be generated to plan first-print book runs and
launch promotions to specific readers, who are more likely
to respond in a positive fashion. The combination of better
information and lower-return rates should help alleviate the
pain publishers are experiencing under the current economic

Not only customers and publishers, but shareholders should
also find the Amazon.com on-line model attractive, given its
much more efficient use of capital versus its traditional
land-based competitors. The land-based competitor must
invest in real estate, stores, and multiple copies of its
inventory. The on-line model meanwhile experiences
infrastructure and working capital advantages of a factor of
3-10 times. Take, for instance, inventory turns. The land-
based player, aided by return rights, turns its inventory a
meager three to four times a year. Amazon.com, on the other
hand, is currently turning its inventory approximately 50-60
times a year. Interestingly, Amazon.com's capital usage is
so efficient that its ROIC is in fact incalculable, as the
company's current liabilities are greater than its
receivables, inventory, and fixed asset base combined. As
such, the company currently has a negative net capital
position. This means that the company would be a net
producer of cash as it grows, even if its long-term
operating margins were zero. We believe that Amazon.com's
capital utilization advantages will eventually lead to
market success and an above-average valuation. Admittedly,
the company is currently losing money, so its operating
losses result in cash depletion as opposed to accretion.
However, as the company achieves scale, we believe it will
be in a superior financial position vis-=E0-vis its
competitors, who must struggle with cannibalization across a
much more capital-intensive business model.

Amazon.com's Competitive Position:

We believe that Amazon.com has a number of competitive
advantages due to the fact the company pioneered on-line
bookselling. First, Amazon.com has already penetrated the
international market, where its principal competitors have
much less brand recognition. Second, the company has built a
Web site that can service more than 80,000 customers a day.
Third, the company has engineered a reliable and scalable e-
mail customer support system, which is simply not available
"off the shelf." Fourth, Amazon.com has established an
expertise in book sourcing, building a database of titles of
1.5 million "in-print" books and 1 million "out-of-print"
books. Keep in mind that prior to the launch of its own Web
site, Barnes & Noble's (NYSE - BKS - $42 1/8) sourcing needs
were limited by the size of its largest store (175,000
titles). Fifth, the company has built a sophisticated
distribution system exclusively dedicated to delivering books
on a per-customer basis, a different competency than
distributing books in bulk to physical stores. "Build-to-
inventory" is not the same as "build-to-order," and
Amazon.com has an advantage in scaling this direct business,
which is already twice the size of Barnes & Noble's catalog
business. Sixth, Amazon.com's head start in acquiring book
content appears to be paying off. In a recent comparison
between Amazon.com and Barnes & Noble, the WebWeek reviewer
noted, "The big difference between the two...is Amazon's vast
amount of review material , written by its staff, culled from
various publications, or supplied by its customers," and
"...overall, Amazon does a much better job of telling me about
books." A seventh and related advantage is Amazon.com's head
start in acquiring customer and author testimonials. The
more customers who leave testimonials, the more compelling
the Amazon.com site. The more compelling the site, the more
customers who will visit and leave testimonials. Eighth and
last, Amazon.com has first-mover advantages in Web-unique
areas such as bookmarks. With a two-year head start,
Amazon.com is well-entrenched in the browsers of its top

Keeping Amazon.com's numerous advantages in mind, we
currently believe that the number of Amazon.com rivals is
primarily limited to the two land-based leaders, Barnes &
Noble and Borders (NYSE-BGP-$23 1/8), and the member-based
BookStacks Unlimited, which is owned by CUC International
(NYSE-CU-$23 1/8). We think the door is closing in terms of
competition outside of the four aforementioned players. At
this point, the resources necessary to establish publisher
relationships, build an on-line content base, and build a
nationally-recognized brand appear too great to allow for
new entrants. Amazon.com and CUC squeezed through a very
small window and at the time when first movers were given
the benefit of the doubt, pricing was less aggressive, and
competition was minimal.

Relative to the land-based leaders, we believe Amazon.com
has the benefit of multiple relative degrees of
freedom-including everything from the lack of a capital-
intensive store base to the freedom afforded by convincing
the investment community that it makes sense to invest early
for scale purposes. We are particularly drawn to Amazon's
potential for superior Return on Invested Capital (ROIC)
versus that of Barnes & Noble and Borders, both of which
have struggled to create value for their shareholders above
their cost of capital. One of the key reasons for this is
the capital requirements that are necessary to support a
large store base. Both companies have used off-balance-
sheet operating leases to finance the majority of their
stores. Leading valuation methodologies, however, consider
operating leases to be a kind of permanent financing and
recommend that "minimum rents for operating leases should be
discounted to present value and treated as a debt and an
asset equivalent." As such, we have chosen to re-capitalize
these leases for the purpose of our ROIC analysis. The
resulting leverage increase puts Borders and Barnes &
Noble's debt to total market capitalization in the 55%-70%
range. The combination of leverage and poor ROIC makes it
difficult for Amazon.com's land-based competitors to lower
their prices in an attempt to put the company out of

In addition to ROIC superiority, we believe that Amazon.com
has additional degrees of freedom versus land-based
competition when it comes to the evolution of the on-line
bookselling industry. First, as we mentioned earlier,
Amazon.com's cash requirements are very little versus
traditional bookstores. Second, the company has few fixed
commitments while Barnes & Noble has already committed
itself to spending 11% of sales on leases and debt coverage.
Third, like it or not, Amazon.com has convinced the
investment community that it is acceptable to operate with
operating losses over the next two fiscal years. Barnes &
Noble and Borders do not have this same liberty. Fourth,
Amazon.com has no potential pricing conflicts with
traditional stores. Barnes & Noble's store managers will
not take kindly to the customers who inadvertently say,
"I'll just buy it on-line" after strolling through the
aisles and utilizing store resources. Also, keep in mind
that if Barnes & Noble's physical stores came close to
matching its Web site on price, they would be horribly
unprofitable. Fifth, Amazon.com's near-term marketing
budget is substantial ($66 million for the next two years),
while similar on-line marketing expenditures would
drastically alter Barnes & Noble's and Border's operating
plan. Sixth, Amazon.com has four times the absolute cash
level ($50 million versus $12 million) reported by Barnes &
Noble in their year-end 1996 financial documents. Once
again, we believe this highlights the fragility and leverage
of the Barnes & Noble model. Seventh and last, nexus tax
laws require corporations that have a physical presence in a
state to collect sales tax in that state. For example,
Amazon.com collects sales tax in Washington. In order to
avoid tax collection on a nationwide basis, Barnes & Noble
and Borders will have to keep their land-based operations
totally separate from their on-line operations. This means
no URL listings in the store, no returns at the stores, and
no co-promotion between the stores and the Web site. This
should significantly limit the advantages of the store
presence and the brand.

As stated above, Amazon.com will rely on degrees of freedom
and greater capital efficiency to compete against
traditional land-based bookstores. CUC, however, is on-line
only and brings a unique approach to on-line bookselling.
In addressing CUC, we think it is important to address two
issues. The first issue is whether or not CUC's membership
model will be successful. The second issue is whether or
not CUC's NetMarket will be successful and what impact will
this have on the rest of the market. First, we see no
reason why the membership model will not be successful with
regard to on-line bookselling. Membership models are much
easier to implement on-line, where retailers keep track of
all customers anyway. Moreover, membership models may help
to obscure pricing in a market where price comparisons are
fairly simple to conduct. However, investors should focus
on three things. First, in the traditional world,
membership models have not worked very well. Walden Books
has had very mediocre success with this concept. Second,
selling books at cost and making money on membership fees is
no feat. Why would customers or investors care where the
margin is situated as long as the margin is collected?
Lastly, CUC talks as if it has a patent on membership
models. What is to prevent Amazon.com from launching a
membership model of its own? Absolutely nothing.

CUC has also proposed that it will launch a service called
NetMarket that will offer its members discounts on a wide
variety of products and services, from books to insurance.
We are not convinced that this model will be successful, as
on-line malls, a similar concept, have been disasters.
However, even if this concept works, we believe that
NetMarket may steal a large number of dollars from a very
small number of Web shoppers. Just as with Sam's Club,
certain people prefer to buy everything from one source at
discounted prices under a membership plan. However, the
existence of Sam's Club is not the death knell for K-mart
(NYSE - KM - $13 1/8), Target (NYSE - DH - $52 3/4), or Wal-
Mart (NYSE - WMT - $31 3/8), because these stores sell to a
much broader audience. In this light, we do not suspect
that NetMarket, in and of itself, will dictate that
BookStacks Unlimited will be successful. Instead, we
believe that the company that focuses on providing the best
affinity area for each Internet commerce product category is
more likely to control the lion's share of the revenues.
This issue of focus becomes even more important in light of
CUC's recent announcement to acquire HFS Inc. In just how
many different product categories can one company compete?

Financials and Valuation:

Our report concludes with a financial review of Amazon.com
and begins with revenue projections based on a top-down
market share analysis. First, we conservatively estimate on-
line penetration of the worldwide book market to rise from
less than 0.5% in 1997 to 2.8% in 2001, with slightly higher
penetration rates in the United States. Next, we assume
Amazon.com's on-line market share will drop from 90% in 1997
to 25% in 2001, to reflect our belief that over time
multiple players will compete in the market. Our resulting
revenue estimates slope gradually downward from 540% in 1997
to 32% in 2001, a trend we believe is realistic. Moving on
to margins, our estimates reflect management's commitment to
growth over near-term profitability, a strategy we believe
will ultimately enable Amazon.com to lock in its on-line
leadership status, negotiate better terms with suppliers,
and put itself in a powerful position in the event that the
industry consolidates. As a result, we project Amazon.com
to post losses in 1997-1998 before turning profitable in

With respect to valuation, our methodology is based on
discounted forward P/E multiples. We start with our EPS
estimate for 2001 of $1.54, although this number is not
"fully-taxed" due to the expected NOL (net operating loss)
carry forward. To adjust for this, we simply apply a full-
tax rate and arrive at an adjusted EPS estimate of $1.36.
We then apply a P/E multiple range of 25x-30x to arrive at
an estimated mid-2000 stock price range of $34.12-$40.95.
We feel comfortable with our P/E multiple estimates, which
are slightly lower than our projected 2001 growth rate of
32% and slightly higher than the current average of the
leading book retailers of 19x. The 30%-60% premium to
Barnes & Noble and Borders is based on the fact that
Amazon.com's business model should be less capital-intensive
and therefore should have higher cash flow characteristics
relative to earnings. We see a similar business model
premium for Dell Computer# (OTC - DELL - $112 1/8), which
currently trades at 24x the 1998 DMG EPS estimate versus a
comparable figure of 17x for Compaq (NYSE - CPQ - $103 1/8).
We would also point out that our projected growth rate for
Amazon.com is much higher than even the current revenue
growth rates at Barnes & Noble or Borders. After calculating
our projected mid-2000 stock price range, we then discount
the values back two years at a 20% discount rate to arrive
at a mid-1998 range of $23.70-$28.43. We choose as our price
target the midpoint of this range ($26.07), which represents
a percentage return to investors of 38% from June 6 th close
of $19.88. As our return estimate exceeds our 20% cost of
capital, we initiate coverage of Amazon.com with a BUY rating.

# Deutsche Morgan Grenfell Inc. makes a market in this
security. @ Deutsche Morgan Grenfell Inc. Or one of its
affiliates managed or co-managed a public offering of
securities for this company within the last three years.
Stock priced 6/6/97.

Deutsche Morgan Grenfell 31 W. 52nd Street
New York, NY 10019-6118 Tel. (212) 468-5000/Fax (212) 468-5490

Copyright (c) Deutsche Morgan Grenfell Inc. 1997. All
rights reserved. The information contained herein has been
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