confesses its risks

Michael Perelman michael at
Wed Jan 5 20:03:03 PST 2000

Sounds like a buy recommendation to me.

Doug Henwood wrote:

> [Today's news that's losses widened along with holiday
> sales prompted me to look at their latest quarterly report
> <
> xt>. I love confessional prose like this. - Doug]
> In addition to the factors discussed in the "Liquidity and Capital
> Resources" sections of this "Management's Discussion and Analysis of Financial
> Condition and Results of Operations" and in the Company's Annual Report on Form
> 10-K for the year ended December 31, 1998, the following additional factors may
> affect the Company's future results:
> We Have a Limited Operating History
> We incorporated in July 1994 and began offering products for sale
> on our Web
> site in July 1995. Accordingly, we have a relatively short operating history
> upon which you can evaluate our business and prospects. You should consider our
> prospects in light of the risks, expenses and difficulties frequently
> encountered by online commerce companies. As an online commerce
> company, we have
> an evolving and unpredictable business model, we face intense competition, we
> must effectively manage our growth and we must respond quickly to rapid changes
> in customer demands and industry standards. We may not succeed in addressing
> these challenges and risks.
> We Have an Accumulated Deficit and Anticipate Further Losses
> We have incurred significant losses since we began doing business. As of
> Sept ember 30, 1999, we had an accumulated deficit of $558.8 million.
> To succeed we must invest heavily in marketing and promotion and in
> developing our product, technology and operating infrastructure. In
> addition, the expenses associated with our recent acquisitions, and
> interest expense related to our outstanding notes, will adversely
> affect our operating results. Our aggressive pricing programs have
> resulted in relatively low product gross margins, so we need to
> generate and sustain substantially higher revenues in order to become
> profitable. Although our revenues have grown, we cannot sustain our
> current rate of growth. Our percentage growth rate will decrease in
> the future. For these reasons we believe that we will continue to
> incur substantial operating losses for the foreseeable future, and
> these losses may be significantly higher than our current losses.
> Unpredictability of Future Revenues; Potential Fluctuations in Quarterly
> Operating Results; Seasonality; Consumer Trends
> Due to our limited operating history and the unpredictability of our
> industry, we cannot accurately forecast our revenues. We base our current and
> future expense levels on our investment plans and estimates of future revenues.
> Our expenses are to a large extent fixed. We may not be able to adjust our
> spending quickly if our revenues fall short of our expectations.
> Further, we may
> make pricing, purchasing, service, marketing, acquisition or
> financing decisions
> that could adversely affect our business results.
> Our quarterly operating results will fluctuate for many reasons, including:
> o our ability to retain existing customers, attract new customers and
> satisfy our customers' demands,
> o our ability to acquire merchandise, manage our inventory and fulfill
> orders,
> o changes in gross margins of our current and future products, services
> and markets,
> o purchases of large quantities of toys, electronics products, home
> improvement products and software particularly in advance of the
> holidays for which demand may not materialize,
> o introduction of our new sites, services and products or those of
> competitors,
> o changes in usage of the Internet and online services and consumer
> acceptance of the Internet and online commerce,
> o timing of upgrades and developments in our systems and infrastructure,
> o the level of traffic on our Web sites,
> o the effects of acquisitions and other business combinations,
> and related
> integration,
> o technical difficulties, system downtime or Internet brownouts,
> o introductions of popular books, music selections, videos, toys,
> electronics products, home improvement products, software and other
> products or services, and our ability to properly anticipate demand,
> o the mix of books, music, videos, toys, electronics products, home
> improvement products, software and other products sold by us,
> o our ability to prevent fraud perpetrated by third parties
> through credit
> card transactions, payments transactions, and auction and
> zShops transactions,
> o our level of merchandise returns, and
> o disruptions in service by common shipping carriers due to strikes or
> otherwise.
> The popularity of our auction and our zShops services, both of which permit
> anyone to offer merchandise for sale at, and of certain
> items offered
> through our auction and zShops services may vary over time due to perceived
> scarcity, subjective value, "fads" and consumer trends in general. If the
> popularity of our auction and zShops services or the items that are listed for
> sale declines, our revenues from these services will fall.
> Both seasonal fluctuations in Internet usage and traditional retail
> seasonality may affect our business. Internet usage generally declines during
> the summer. Sales in the traditional retail book, music, toy, electronics and
> home improvement industries usually increase significantly in the fourth
> calendar quarter of each year. The fourth quarter seasonal impact may be even
> more pronounced in our toys and electronics businesses.
> For these reasons, you should not rely on period-to-period comparisons of
> our financial results to forecast our future performance. Our future operating
> results may fall below the expectations of securities analysts or investors,
> which would likely cause the trading price of our common stock to decline.
> Intense Competition
> The online commerce market is new, rapidly evolving and intensely
> competitive. In addition, the retail book, music, video, toy, electronics, home
> improvement and software industries are intensely competitive. Our current or
> potential competitors include:
> o online vendors of books, music, video, toys, electronics, home
> improvement products and software,
> o a number of indirect competitors, including Web portals and Web search
> engines, such as Yahoo! Inc. and America Online, Inc., that
> are involved
> in online commerce, either directly or in collaboration with other
> retailers,
> o online auction services, including eBay, Inc. and Yahoo!
> Auctions run by
> Yahoo!,
> o publishers, distributors and retail vendors of books, music, video and
> other products, including Barnes & Noble, Inc., Bertelsmann
> AG and other
> large specialty booksellers and media corporations, many of which
> possess significant brand awareness, sales volume and customer bases,
> o major store-based retailers of toys, other children's products and
> electronics,
> o major store-based retailers of home improvement products,
> o major store-based retailers of software and
> o traditional retailers and manufacturers who currently sell, or who may
> sell, products or services through the Internet, mail order or direct
> marketing.
> We believe that the principal competitive factors in our market are brand
> recognition, selection, personalized services, convenience, price,
> accessibility, customer service, quality of search tools, quality of editorial
> and other site content, and reliability and speed of fulfillment.
> Many of our current and potential competitors have longer operating
> histories, larger customer bases, greater brand recognition and significantly
> greater financial, marketing and other resources than we have. They may be able
> to secure merchandise from vendors on more favorable terms and may be able to
> adopt more aggressive pricing or inventory policies. They also can devote more
> resources to technology development and marketing than we can. We
> also expect to
> experience increased competition from online commerce sites that provide goods
> and services at or near cost, relying on advertising revenues to achieve
> profitability.
> As the online commerce market continues to grow, other companies may enter
> into business combinations or alliances that strengthen their competitive
> positions. For example, (1) Bertelsmann purchased a significant interest in
> Barnes & Noble's online venture, inc., and has launched
> online stores in several countries, and (2) CDNow, Inc. agreed to merge with
> Columbia House, the jointly owned music retail arm of Sony and Time Warner. We
> may not be able to compete successfully against these and future competitors.
> Competition in the Internet and online commerce markets probably will
> intensify. As various Internet market segments obtain large, loyal customer
> bases, participants in those segments may use their market power to expand into
> the markets in which we operate. In addition, new and expanded Web technologies
> may increase the competitive pressures on online retailers. For example,
> "shopping agent" technologies, including our own "shopping agent" technology,
> All Products Search, permit customers to quickly compare our prices with those
> of our competitors. This increased competition may reduce our
> operating margins,
> diminish our market share or impair the value of our brand.
> System Risks
> Customer access to our Web sites directly affects the volume of orders we
> fulfill and thus affects our revenues. We experience occasional system
> interruptions that make our Web sites unavailable or prevent us from
> efficiently
> fulfilling orders, which may reduce the volume of goods we sell and the
> attractiveness of our products and services. These interruptions will continue.
> We need to add additional software and hardware and upgrade our systems and
> network infrastructure to accommodate increased traffic on our Web sites,
> increased sales volume and fully integrate our systems. Without these upgrades,
> we may face additional system interruptions, slower response times, diminished
> customer service, impaired quality and speed of order fulfillment,
> and delays in
> our financial reporting. In addition, our inventory management systems
> are not fully integrated with our financial reporting systems, and a
> significant
> amount of manual effort may be necessary to reconcile our inventory and other
> financial accounts.
> [glitch in original]
> accurately project the rate or timing of any increases in traffic or sales
> volume on our Web sites and, therefore, the integration and timing of these
> upgrades are uncertain.
> We maintain substantially all of our computer and communications
> hardware at
> a single leased facility in Seattle, Washington. Our systems and operations
> could be damaged or interrupted by fire, flood, power loss, telecommunications
> failure, break-ins, earthquake and similar events. We do not have
> backup systems
> or a formal disaster recovery plan and we may not have sufficient business
> interruption insurance to compensate us for losses from a major interruption.
> Computer viruses, physical or electronic break-ins and similar
> disruptions could
> cause system interruptions, delays, and loss of critical data and could prevent
> us from providing services and accepting and fulfilling customer orders.
> We May Have Difficulty Managing Our Growth
> We have rapidly and significantly expanded our operations and will further
> expand our operations to address potential growth of our product and service
> offerings and customer base. We will expand our product and service offerings
> and our international operations and will pursue other market opportunities. We
> need to successfully execute our announced distribution center expansion plan
> and continue to improve our transaction-processing, operational and financial
> systems, procedures and controls. This expansion will continue to place a
> significant strain on our management, operational and financial resources. Our
> distribution center expansion plan may not be completed in time to meet the
> increase in demand expected for the holiday season in the fourth quarter.
> Because it is difficult to predict sales increases and lead times for
> developing
> distribution centers are long, we may over-expand our facilities, which may
> result in excess inventory, warehousing, fulfillment and distribution capacity.
> We will also need to retain flexibility within our distribution and logistics
> network, including the ability to manage the operational challenges of shipping
> non-uniform and sometimes heavy products as part of the fulfillment of toy,
> electronics and home improvement orders. We also need to expand, train and
> manage our employee base. Our current and planned personnel, systems,
> procedures
> and controls may not be adequate to support and effectively manage our future
> operations. We may not be able to hire, train, retain, motivate and manage
> required personnel or to successfully identify, manage and exploit market
> opportunities, which may limit our growth.
> Risk of Entering New Business Areas
> We intend to expand our operations by promoting new or complementary
> products, services or sales formats and by expanding our product or service
> offerings. This will require significant additional expense and could
> strain our
> management, financial and operational resources. We cannot expect to benefit in
> these new markets from the first-to-market advantage that we experienced in the
> online book market. Our gross margins in these new business areas may be lower
> than our existing business activities. We may not be able to expand our
> operations in a cost-effective or timely manner. Any new business that our
> customers do not receive favorably could damage our reputation and the
> brand.
> Risk of Distribution Center Expansion
> We are in the process of implementing our previously announced distribution
> center expansion plan. During the nine-month period ended September
> 30, 1999, we
> opened distribution centers in Nevada, Georgia, Kentucky, Kansas and North
> Dakota and announced plans to open new distribution centers in
> Kentucky, Germany
> and the United Kingdom. These distribution centers are or will be highly
> automated and we have no previous experience with automated distribution
> centers, as the two distribution centers in operation prior to 1999, in
> Washington and Delaware, were manually operated. The new distribution centers
> may fail to operate properly to ensure that customer demand is met,
> particularly
> during the fourth quarter of 1999.
> If we do not successfully expand our distribution operations to accommodate
> peak volumes or if distribution centers fail to operate properly, it could
> significantly limit our ability to meet customer demand. Our
> distribution center
> expansion may cause disruptions in our business. We are not experienced in
> coordinating and managing distribution operations in geographically distant
> locations.
> Risks Related to the Fourth Quarter
> Because we expect a disproportionate amount of the our net sales to be
> realized during the holiday season in the fourth quarter of our fiscal year, we
> face significant risks in the fourth quarter. We may fail to accurately predict
> the optimal inventory levels at our distribution centers for the
> fourth quarter.
> If we do not sufficiently stock popular products during the fourth quarter and
> fail to meet customer demand, it could significantly impact our
> revenue. Because
> we have significantly increased inventory levels in anticipation of the fourth
> quarter, if we overstock products that are not popular with consumers we may be
> required to take significant inventory markdowns, most likely in the first
> quarter, which could reduce gross margins. A failure to optimize inventory at
> our distribution centers will negatively impact our shipping margins by
> requiring us to make partial shipments from two or more locations. In addition,
> we anticipate a negative impact on our shipping margins due to complimentary
> upgrades and split-shipments necessary to ensure timely delivery for
> the holiday
> season. Furthermore, if too many customers access our Web sites within a short
> period of time due to increased holiday demand, we may experience system
> interruptions that make our Web sites unavailable or prevent us from
> efficiently
> fulfilling orders, which may reduce the volume of goods we sell and the
> attractiveness of our products and services. Finally, our new automated
> distribution centers may fail to operate properly to ensure customer demand is
> met in the fourth quarter.
> Risk of International Expansion
> We plan to expand our presence in foreign markets. We have
> relatively little
> experience in purchasing, marketing and distributing products or services for
> these markets and may not benefit from any first-to-market advantages. It will
> be costly to establish international facilities and operations, promote our
> brand internationally, and develop localized Web sites and stores and other
> systems. We may not succeed in our efforts in these countries. If revenues from
> international activities do not offset the expense of establishing and
> maintaining foreign operations, our business, prospects, financial
> condition and
> operating results will suffer.
> As the international online commerce market continues to grow, competition
> in this market will likely intensify. In addition, governments in foreign
> jurisdictions may regulate Internet or other online services in such areas as
> content, privacy, network security, encryption or distribution. This may affect
> our ability to conduct business internationally.
> Risks of Business Combinations and Strategic Alliances
> We plan to continue to expand our operations and market presence
> by entering
> into business combinations, investments, joint ventures or other strategic
> alliances with other companies. These transactions create risks such as:
> o difficulty assimilating the operations, technology and personnel of the
> combined companies,
> o disruption of our ongoing business,
> o problems retaining key technical and managerial personnel,
> o expenses associated with amortization of goodwill and other purchased
> intangible assets,
> o additional operating losses and expenses of acquired businesses, and
> o impairment of relationships with existing employees, customers and
> business partners.
> We may not succeed in addressing these risks. In addition, the
> businesses we
> have acquired, and in the future may acquire, may incur operating losses.
> Rapid Technological Change
> Technology in the online commerce industry changes rapidly. Customer
> functionality requirements and preferences also change. Competitors often
> introduce new products and services with new technologies. These
> changes and the
> emergence of new industry standards and practices could render our existing Web
> sites and proprietary technology obsolete. To succeed we must enhance our Web
> site responsiveness, functionality and features, acquire and license leading
> technologies, enhance our existing services, develop new services and
> technology
> and respond to technological advances and emerging industry standards and
> practices on a cost-effective and timely basis. We may not be able to adapt
> quickly enough to changing customer requirements and industry standards.
> We Depend on Key Personnel
> We depend on the continued services and performance of our senior
> management
> and other key personnel, particularly Jeffrey P. Bezos, our chief executive
> officer and chairman of the board. We do not have "key person" life
> insurance policies. The loss of any of our executive officers or other key
> employees could harm our business.
> We Rely on a Small Number of Suppliers
> We purchase a majority of our book, music, and video titles from
> three major
> vendors, Ingram Book Group, Baker & Taylor, Inc. and Valley Media,
> Inc. Although
> we increased our direct purchasing from manufacturers during 1999, we continue
> to purchase a majority of our book, music, and video titles from these three
> suppliers. We do not have long-term contracts or arrangements with most of our
> vendors to guarantee the availability of merchandise, particular payment terms
> or the extension of credit limits. Our current vendors may stop selling
> merchandise to us on acceptable terms. We may not be able to acquire
> merchandise
> from other suppliers in a timely and efficient manner and on acceptable terms.
> We Face Inventory and Forecasting Risk with our Toy, Electronics, Home
> Improvement and Software Businesses
> The toy, electronics, home improvement and software businesses
> are difficult
> to manage and have inherent complexities that differ from those encountered in
> the book, music, and video businesses. Because we are a new
> participant in these
> markets, we do not yet have a basis to forecast product demand. Further, the
> acquisition of many of the toy, electronics, home improvement and software
> products that we offer involves a significant lead-time and up-front financial
> commitment.
> We will be exposed to significant inventory risks as a result of
> seasonality
> and rapid changes in product cycles, consumer tastes and "fads" in the market
> for such products. In order to achieve success in our toy, electronics, home
> improvement and software sales categories, we must seek to predict these trends
> and attempt neither to overstock unpopular nor understock popular products. The
> demand for products can change between the time they are ordered and
> the date of
> eventual sale. We will be particularly exposed to this risk in the
> first year of
> operations in our toy, electronics, home improvement and software businesses,
> particularly in anticipation of the holiday selling season.
> Our ability to negotiate satisfactory terms with manufacturers or suppliers
> so that we might stock certain "preferred" products or brands in the toy,
> electronics, home improvement and software businesses may be affected by our
> time of entry in such lines of business and the competitive positions of other
> physical stores and catalog and online retailers.
> In order to provide customers with a high quality experience and
> minimize the risk of stocking-out, we will carry a broad selection
> and significant inventory levels of toy, electronics, home
> improvement and software products. In the event that one or more of
> these products do not sell through in sufficient quantities to
> consumers at anticipated prices or during anticipated selling
> seasons, we may be required to markdown some of our prices or write
> down inventory, which will reduce our revenues and gross margins.
> We Are Highly Leveraged
> We have significant indebtedness. As of September 30, 1999, we had
> indebtedness under senior discount notes, convertible subordinated notes,
> capitalized lease obligations and other asset financing totaling approximately
> $1.5 billion. We may incur substantial additional debt in the future. Our
> indebtedness could:
> o make it difficult to make principal and interest payments on the
> convertible subordinated notes and the senior discount notes,
> o make it difficult to obtain necessary financing for working capital,
> capital expenditures, debt service requirements or other purposes,
> o limit our flexibility in planning for, or reacting to, changes in our
> business and competition, and
> o make it more difficult for us to react in the event of an economic
> downturn.
> We may not be able to meet our debt service obligations. If our
> cash flow is
> inadequate to meet our obligations, we may face substantial liquidity problems.
> If we are unable to generate sufficient cash flow or obtain funds for required
> payments, or if we fail to comply with other covenants in our indebtedness, we
> will be in default. This would permit our creditors to accelerate the maturity
> of our indebtedness.
> Risks Associated With Domain Names
> We hold rights to various Web domain names, including ","
> "," "" and "" Governmental agencies typically
> regulate domain names. These regulations are subject to change. We may not be
> able to acquire or maintain appropriate domain names in all countries in which
> we do business. Furthermore, regulations governing domain names may not protect
> our trademarks and similar proprietary rights. We may be unable to
> prevent third
> parties from acquiring domain names that are similar to, infringe upon or
> diminish the value of our trademarks and other proprietary rights.
> Governmental Regulation and Legal Uncertainties
> At this time, we face general business regulations and laws or regulations
> regarding taxation and access to online commerce. For example, expanding our
> distribution center network or other aspects of our business may result in
> additional sales and other tax obligations. Regulatory authorities may adopt
> specific laws and regulations governing the Internet or online commerce. These
> regulations may cover taxation, user privacy, pricing, content, copyrights,
> distribution, electronic contracts and characteristics and quality of products
> and services. Changes in consumer protection laws also may impose additional
> burdens on companies conducting business online. In addition, many states
> currently regulate "auctions" and "auctioneers" in conducting auctions and may
> regulate online auction services. These laws or regulations may impede the
> growth of the Internet or other online services. States may also regulate
> consumer to consumer fixed price online markets, like zShops. This could, in
> turn, diminish the demand for our products and services and increase
> our cost of
> doing business. Moreover, it is not clear how existing laws governing issues
> such as property ownership, sales and other taxes, libel and personal privacy
> apply to the Internet and online commerce. Unfavorable resolution of these
> issues may harm our business.
> Risks Related to Auction and zShops Services
> We may be unable to prevent users of our auction and zShops
> services from selling unlawful goods, or from selling goods in an
> unlawful manner. We may face civil or criminal liability for unlawful
> and fraudulent activities by our auction and zShops users. Any costs
> we incur as a result of liability relating to the sale of unlawful
> goods, the unlawful sale of goods, the fraudulent receipt of goods or
> the fraudulent collection of payments, could harm our business.
> In running our auction and zShops services, we rely on sellers of goods to
> make accurate representations and provide reliable delivery and on
> buyers to pay
> the agreed purchase price. For our auction and zShops services, we do not take
> responsibility for delivery of payment or goods to any users of our services.
> While we can suspend or terminate the accounts of users of auctions or zShops
> who fail to fulfill their delivery obligations to other users, we
> cannot require
> users to make payments or deliver goods. We do not compensate users who believe
> they have been defrauded by other users except through our guarantee
> program. In
> addition, we are aware that governmental agencies are currently investigating
> the conduct of online auctions.
> Risks Related to Fraud and Payments
> Although we have developed systems and processes to mitigate fraudulent
> credit card transactions, failure to prevent such fraud may impact our
> financial results. In addition, fraudulent activities by our auction and zShops
> users, such as the fraudulent receipt of goods and the fraudulent collection of
> payments, may create liability for us through our guarantee program. We
> guarantee payments made through Payments for both buyers and sellers
> and we may be unable to prevent users of Payments from fraudulently
> receiving goods when no payment will be made to a seller or fraudulently
> collecting payments when no goods will be shipped to a buyer. The law relating
> to the liability of providers of online payment services is currently
> unsettled. Our liability risk will increase as we encourage or require sellers
> to use Payments. Any costs we incur as a result of liability because
> of our guarantee of payments made through Payments could harm our
> business. In addition, the functionality of Payments depends on
> certain third-party vendors delivering services. If these vendors are unable or
> unwilling to provide services, Payments will not be viable (and our
> businesses that use Payments may not be viable).
> Risk of Uncertain Protection of Intellectual Property
> Third parties that license our proprietary rights, such as trademarks,
> patented technology or copyrighted material, may take actions that diminish the
> value of our proprietary rights or reputation. In addition, the steps
> we take to
> protect our proprietary rights may not be adequate and third parties may
> infringe or misappropriate our copyrights, trademarks, trade dress, patents and
> similar proprietary rights. Other parties may claim that we infringed their
> proprietary rights. We have been subject to claims, and expect to
> continue to be
> subject to legal proceedings and claims, regarding alleged infringement by our
> licensees and us of the trademarks and other intellectual property rights of
> third parties. Such claims, whether or not meritorious, may result in the
> expenditure of significant financial and managerial resources.
> Risks of Year 2000 Noncompliance
> [...]
> Our Stock Price Is Highly Volatile
> The trading price of our common stock fluctuates significantly.
> For example,
> during the 52-week period ended September 30, 1999 (as adjusted for the 3-for-1
> split of our common stock on January 4, 1999 and the 2-for-1 split of
> our common
> stock on September 1, 1999), the reported closing price of our common stock on
> the NASDAQ National Market was as high as $105.0625 and as low as $42.75 per
> share. Trading prices of our common stock may fluctuate in response to a number
> of events and factors, such as:
> o quarterly variations in operating results,
> o announcements of innovations,
> o new products, services and strategic developments by us or our
> competitors, or business combinations and investments by us or our
> competitors,
> o changes in our operating expense levels or losses,
> o changes in financial estimates and recommendations by securities
> analysts,
> o performance by other online commerce companies, and
> o news reports relating to trends in the Internet, book, music, video,
> toys, electronics, home improvement products, software, auctions,
> consumer to consumer fixed price online markets, or other product or
> service industries.
> Any of these events may cause our stock price to fall, which may adversely
> affect our business and financing opportunities. In addition, the stock market
> in general and the market prices for Internet-related companies in particular
> have experienced significant volatility that often has been unrelated to such
> companies' operating performance. These broad market and industry fluctuations
> may adversely affect the trading price of our common stock regardless of our
> operating performance.


Michael Perelman Economics Department California State University michael at Chico, CA 95929 530-898-5321 fax 530-898-5901

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