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AmAzon.com in the YeAr 2000 On June 22, 2000, Ravi Suria, a credit analyst at Lehman Brothers, issued a report sounding an alarm about the convertible debt of Amazon.com. When he looked at the company's financials, he saw a \"weak balance sheet, poor working capital management, and massive negative operating cash flow.\" He regarded the debt as \"extremely weak and deteriorating\" and strongly advised investors to avoid it. Amazon.com was, he noted, \"the pioneering and best- established brand\" among Internet retailers. Nevertheless, he was convinced that the company was going to run out of cash in less than a year because of its poor operating performance, reflecting basic weaknesses in its business model. Amazon, he said, had really evolved from a \"virtual\" retailer to something more like a \"real world\" retailer, and was encountering the same kinds of cash flow problems and problems related to management of working capital that had spelled disaster for many retailers in the past. In February 1999 the company had issued $1.25 billion in convertible debt. A year later, it completed a second offering of convertible debt, this time for $680 million. As Suria saw things, however, the company was burning cash up fast, and if it was not able to start generating positive free cash flows soon, it would be in dire straits. \"The party is over,\" he said, \"and the February round of financing seems to have been the last call.\"1 In response to Suria's report, the price of Amazon's convertible debt dropped 15%, and its stock price dropped 19%, in one day after the report became public. Background2 Jeff BezosAmazon's founder, chairman, and CEO knew a good deal about the worlds of both technology and finance. After earning a degree in computer science and electrical engineering at Princeton, he worked for two years in commercial banking; then four years in investment banking in New York, managing a hedge fund. Then, fascinated by the possibilities of selling consumer goods over the Internet, he started Amazon.com. The company was founded in 1994, began selling books online in 1995, and went public in 1997. Bezos initially considered a number of possible retailing businesses for the Internet. He regarded book selling as especially attractive for several reasons: vThe number of products that customers might want was far larger than any physical store could carry. There were over a million books in printand many more that were out of print. (The largest physical book stores, so-called \"superstores,\" carried about 150,000 titles. Mall stores and small independent stores carried a small fraction of that.) vThe existing market was large. Annual retail sales of books were about $25 billion in the United States and about $80 billion worldwide. vThe book publishing and retailing industries were relatively fragmented. No book publisher controlled more than 15% of the U.S. market, and the two largest land-based book retailers, Barnes & Noble and Borders, controlled about 25% of the market. (Barnes & Noble and Borders, however, had been expanding significantly in recent years.) Bezos' decision to locate the company in Seattle, Washington was also deliberate. The Seattle area had a lot of computer-technical talent (e.g., Microsoft was located nearby); it was near one of the largest book wholesalers in the country; and it would provide, he felt, a time-zone advantage in making shipments to customers around the country.3 Evolution of Corporate Strategy As the company developed, it made two major changes in strategy: (1) it began doing more self-distributio AmAzon.com in the YeAr 2000 On June 22, 2000, Ravi Suria, a credit analyst at Lehman Brothers, issued a report sounding an alarm about the convertible debt of Amazon.com. When he looked at the company's financials, he saw a \"weak balance sheet, poor working capital management, and massive negative operating cash flow.\" He regarded the debt as \"extremely weak and deteriorating\" and strongly advised investors to avoid it. Amazon.com was, he noted, \"the pioneering and best- established brand\" among Internet retailers. Nevertheless, he was convinced that the company was going to run out of cash in less than a year because of its poor operating performance, reflecting basic weaknesses in its business model. Amazon, he said, had really evolved from a \"virtual\" retailer to something more like a \"real world\" retailer, and was encountering the same kinds of cash flow problems and problems related to management of working capital that had spelled disaster for many retailers in the past. In February 1999 the company had issued $1.25 billion in convertible debt. A year later, it completed a second offering of convertible debt, this time for $680 million. As Suria saw things, however, the company was burning cash up fast, and if it was not able to start generating positive free cash flows soon, it would be in dire straits. \"The party is over,\" he said, \"and the February round of financing seems to have been the last call.\"1 In response to Suria's report, the price of Amazon's convertible debt dropped 15%, and its stock price dropped 19%, in one day after the report became public. Background2 Jeff BezosAmazon's founder, chairman, and CEO knew a good deal about the worlds of both technology and finance. After earning a degree in computer science and electrical engineering at Princeton, he worked for two years in commercial banking; then four years in investment banking in New York, managing a hedge fund. Then, fascinated by the possibilities of selling consumer goods over the Internet, he started Amazon.com. The company was founded in 1994, began selling books online in 1995, and went public in 1997. Bezos initially considered a number of possible retailing businesses for the Internet. He regarded book selling as especially attractive for several reasons: vThe number of products that customers might want was far larger than any physical store could carry. There were over a million books in printand many more that were out of print. (The largest physical book stores, so-called \"superstores,\" carried about 150,000 titles. Mall stores and small independent stores carried a small fraction of that.) vThe existing market was large. Annual retail sales of books were about $25 billion in the United States and about $80 billion worldwide. vThe book publishing and retailing industries were relatively fragmented. No book publisher controlled more than 15% of the U.S. market, and the two largest land-based book retailers, Barnes & Noble and Borders, controlled about 25% of the market. (Barnes & Noble and Borders, however, had been expanding significantly in recent years.) Bezos' decision to locate the company in Seattle, Washington was also deliberate. The Seattle area had a lot of computer-technical talent (e.g., Microsoft was located nearby); it was near one of the largest book wholesalers in the country; and it would provide, he felt, a time-zone advantage in making shipments to customers around the country.3 Evolution of Corporate Strategy As the company developed, it made two major changes in strategy: (1) it began doing more self-distributio AmAzon.com in the YeAr 2000 On June 22, 2000, Ravi Suria, a credit analyst at Lehman Brothers, issued a report sounding an alarm about the convertible debt of Amazon.com. When he looked at the company's financials, he saw a \"weak balance sheet, poor working capital management, and massive negative operating cash flow.\" He regarded the debt as \"extremely weak and deteriorating\" and strongly advised investors to avoid it. Amazon.com was, he noted, \"the pioneering and best- established brand\" among Internet retailers. Nevertheless, he was convinced that the company was going to run out of cash in less than a year because of its poor operating performance, reflecting basic weaknesses in its business model. Amazon, he said, had really evolved from a \"virtual\" retailer to something more like a \"real world\" retailer, and was encountering the same kinds of cash flow problems and problems related to management of working capital that had spelled disaster for many retailers in the past. In February 1999 the company had issued $1.25 billion in convertible debt. A year later, it completed a second offering of convertible debt, this time for $680 million. As Suria saw things, however, the company was burning cash up fast, and if it was not able to start generating positive free cash flows soon, it would be in dire straits. \"The party is over,\" he said, \"and the February round of financing seems to have been the last call.\"1 In response to Suria's report, the price of Amazon's convertible debt dropped 15%, and its stock price dropped 19%, in one day after the report became public. Background2 Jeff BezosAmazon's founder, chairman, and CEO knew a good deal about the worlds of both technology and finance. After earning a degree in computer science and electrical engineering at Princeton, he worked for two years in commercial banking; then four years in investment banking in New York, managing a hedge fund. Then, fascinated by the possibilities of selling consumer goods over the Internet, he started Amazon.com. The company was founded in 1994, began selling books online in 1995, and went public in 1997. Bezos initially considered a number of possible retailing businesses for the Internet. He regarded book selling as especially attractive for several reasons: vThe number of products that customers might want was far larger than any physical store could carry. There were over a million books in printand many more that were out of print. (The largest physical book stores, so-called \"superstores,\" carried about 150,000 titles. Mall stores and small independent stores carried a small fraction of that.) vThe existing market was large. Annual retail sales of books were about $25 billion in the United States and about $80 billion worldwide. vThe book publishing and retailing industries were relatively fragmented. No book publisher controlled more than 15% of the U.S. market, and the two largest land-based book retailers, Barnes & Noble and Borders, controlled about 25% of the market. (Barnes & Noble and Borders, however, had been expanding significantly in recent years.) Bezos' decision to locate the company in Seattle, Washington was also deliberate. The Seattle area had a lot of computer-technical talent (e.g., Microsoft was located nearby); it was near one of the largest book wholesalers in the country; and it would provide, he felt, a time-zone advantage in making shipments to customers around the country.3 Evolution of Corporate Strategy As the company developed, it made two major changes in strategy: (1) it began doing more self-distributio distinct web sites and distribution facilities in England and Germany. Thus in mid-2000 Amazon was the largest Internet retailer in the world, with $1.9 billion in trailing twelve- month revenues and 20 million customers in over 150 countries. It claimed to offer for sale 18 million different products (SKUs). And its brand was very well known. Some observers, however, believed that Amazon was badly over-extending itself. In trying to be all things to all people, some people felt, the company was taking on more than it could handle. Al Ries, the author of a book on Internet branding, said, \"The most powerful brands in the world stand for something simple. Volvo stands for safety. Dell is a personal computer. Even Microsoft is software. Now Amazon is going to stand for books and charcoal grills. This makes no sense to me.\"13 Since the web was indifferent to distance and place, it was, in the view of some people, better suited to specialist retailers, to \"category killers,\" than to generalists. (For example, eToys specialized in selling toys; CDNow specialized in selling CDs, Outpost.com specialized in selling computers and other electronic products.) Specialist retailers would, in this view, know more about particular categories of products and would be better able to develop the merchandising skills necessary to make their particular businesses successful. Customer Service In Jeff Bezos' view, however, what Amazon.com \"stood for\" was highquality customer service. And part of the reason why it could provide that, he believed, was that people at Amazon knew more about e-commerce than anyone else. In 1998 the chairman of Putnam/Penguin, one of the largest book publishers in the world, said, \"When you talk to Amazon, you realize it's a technology company, not a merchant.\"14 Such was the sophistication of the company's software, Bezos claimed, that \"coming to Amazon will not be like entering the halls of a huge, soulless department store. It will be more like stopping by at a local shop where your every taste and preference is known.\"15 The company had in fact been developing many information-rich features for its web sitefor example, product reviews by both outside experts and other Amazon customers, the customer's own purchasing history, \"collaborative filtering\" software that aimed to provide a kind of electronic word-of-mouth among people with similar tastes, e-mails to alert customers to the release of new products they had asked about, an ability given to customers to track the shipment of products they had ordered. Pricing An academic study, published in April 2000, seemed to support Bezos' view of things.16 Amazon often engaged in aggressive pricing in order to attract customers, but the academic study found that pricing differences among Internet retail businesses, even for commodity-type products like books and CDs, were as pronounced as they were for conventional retailers and that Internet sites with the lowest prices didn't necessarily have the largest market shares. Amazon, for example, was the leader in online book and CD sales but, this study found, didn't necessarily have the lowest prices. The level of customer satisfaction and customer service it provided was evidently key to its ability to attract customers. Amazon itself, however, regarded the pricing issue as a threat. \"New and expanded web technologies,\" it said in its 1999 10-K, \"may increase the competitive pressures on online retailers. For example, 'shopping agent' technologies 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.\" A professor of operations and information management, Eric Clemons, writing in the Financial Times in June 2000 about particular kinds of risk in the e-commerce world, noted that Amazon, like most e-commerce businesses, was continuing to spend significant amounts of money to acquire new customers, but he wasn't at all sure that that made sense: It is too early to determine if consumers will remain loyal to these sites, allowing these retailers time to harvest profits and cover the costs of their acquisition, or whether the web's empowerment of consumer choice will mean that customers constantly migrate to the lowest-cost online seller. If the web is as liberating and empowering as most accounts have led us to believe, all business models based on paying to acquire share are flawed.Financing Strategy Amazon had started with private equity financing of about $1 million. It sold $8 million of convertible preferred in 1996 (which was converted to common the following year). The IPO in May 1997 brought in about $50 million. The company had also been receiving cash from employees when they exercised their stock options. The company had issued debt on three occasions: vIn May 1998 the company sold 10% senior discount notes due in 2008. They were sold for $326 million, but their value at maturity would be $530 million. They accreted interest until 2003 and paid cash interest after that. (During 1999 the company repurchased $266 million principal amount of this issue [representing $178 million accreted value]. Thus as of year-end 1999, the accreted amount outstanding was $191 million.) vIn February 1999 the company sold $1.25 billion par value of 4.75% convertible subordinated notes due in 2009. vIn February 2000 the company sold 690 ($680 million) par value of 6.875% euro-denominated convertible subordinated notes due in 2010. When this second set of convertibles was issued, observers noted the much-higher interest rate that Amazon had to offer compared to the 4.75% interest rate it offered on the convertibles it had sold just a year earlier. Some observers also suggested that Amazon had taken the offering to Europe because it had been a tough sell in the United States. The company denied this. It said that it sold this second set of convertibles in Europe because it wanted to broaden its market recognition there. It also said that it intended to use some of the proceeds from the issue to support growth in its European operations. Thus at the end of the first quarter of 2000, Amazon had $2.15 billion in debt outstanding (including some capital leases), of which about $1.9 billion consisted of the convertibles. The convertibles were rated triple C by both Standard & Poor's and Moody's. A summary of the terms of the two convertible issues is provided in Exhibit 5. Exhibit 6 shows the company's cash obligations, for interest and principal, for all of its debt securities over the next ten years