Amazon: Ponzi Scheme or Wal-Mart of the Web?

Shares in rose better than 10 percent today, for no apparent reason, unless investors were able (I wasn’t) to glean some information of relevance from the earnings report of, which came out today. Amazon’s shares are now back to the recent high they hit last week after the company announced its earnings–that is, losses–for the fourth quarter.

That earnings report occasioned a response in the press and the financial community that was completely predictable. At this point, there appears to be almost no one who’s ambivalent about Amazon. The bulls think Jeff Bezos is building the Wal-Mart of the Web, and that the losses the company is piling up now represent sound investments in the future, analogous perhaps to all the money cable companies spent for decades in order to build out their infrastructures. The bears think Amazon is at best a complete sham and at worst an explicit fraud, carefully managing its stock price, living on borrowed money, and spinning every earnings report in a manner so blatant that even James Carville would blush.

There was a wonderful illustration of this dichotomy on the front page of the New York Times’ business section on Thursday. The headline above the article on Amazon read “Amazon Loss Soared 543% in 4th Quarter.” But the subhead read, “But Total Sales Surged, And Books Made Profit.” You could almost imagine the argument in the newsroom, with the skeptic winning and getting to put the bad news in large-point type, but with the true believer at least getting the chance to toss in his two cents.

The schism in sentiment about Amazon is real. But it’s a mistake to think that both sides have equally strong cases. It’s perfectly appropriate to question Amazon’s current stock-market valuation, which is around $28 billion, although the fact that that valuation has been fairly steady for a while now does make the “smoke and mirror” hypothesis seem rather flimsy. (You can fool investors for a while, but you can’t fool them for very long, and you especially can’t fool them when a stock price is holding steady, as opposed to rising sharply and therefore feeding on itself.) But the conventional critique of Amazon’s business strategy is looking increasingly facile, and is peculiarly inattentive to the cash-flow dynamics of Amazon’s business.

The essence of that critique is that Amazon is just buying customers, and that once it runs out of the money to do so the Ponzi scheme will collapse. Of course, Amazon is buying customers, just as all companies do. Some companies do it by dumping money into advertising, some by offering discounts. Amazon does both. The only important question is whether Amazon is spending too much on those customers, and the answer seems pretty clearly to be no. In its latest quarter, Amazon added 3.8 million new customers, and spent an average of $19 to acquire them. When you consider that better than 60 percent of Amazon’s sales come from repeat customers–which implies that they’re loyal–and that the average customer spent $116 in 1999 (10 percent more than in 1998), $19 seems like something of a bargain.

Then there are the raw numbers, which are staggering. Take, to begin with, the 3.8 million new customers, and try to imagine how much money Barnes & Noble would have to spend offline to get that many customers. Amazon grew its revenues 167 percent over a year ago, grossing $676 million in the quarter. That means that by the end of 2000, Amazon will be a $3 billion company. Four years ago, it did not exist. This is not a growth rate that companies this size typically enjoy.

It’s of course true that Amazon is losing lots of money. But there are a few things to keep in mind here. First is that the reported losses–in this case, $543 million–are much larger than Amazon’s actual losses, since the $543 million includes a host of non-cash charges (and when it comes to evaluating a business, all that matters is the cash it puts into and takes out of its operations). Second is that even after all of the investment in warehouses and inventory that Amazon made in 1999, the company is able to run itself with relatively little invested capital, compared with brick-and-mortar retailers. Finally, Amazon has done an excellent job of investing in smaller companies at rock-bottom prices and of getting Wall Street to lend it money whenever it needs it. The company’s critics see this as further evidence of how deluded investors are. But they should probably see it as evidence that the risk-to-reward ratio for Amazon is good.

Finally, what all this boils down to is that Amazon doesn’t really have a choice. It’s possible that Bezos is wrong about the company’s future ability to retain customers, and that the barriers to entry on the Web will always be so low that attaining Wal-Mart-like dominance will be impossible. But the strategy he’s pursuing is the only way to find out if he’s wrong. If he doesn’t invest now, when customer acquisition is still relatively cheap and the Web, for all its explosion, is still relatively empty ground, then he won’t have the chance to invest later. And in the end, if he fails, the whole thing will have cost less in terms of actual capital than most big companies spend on R&D in a single year. Given the potential rewards, that seems like a worthwhile tradeoff.