Cutting through the Amazon financial jungle

Gary Lutin spearheads the effort to convince the giant e-tailer to provide clearer financial reporting to investors.

8 min read
Give Gary Lutin a break: Drop the "pro forma."

Adviser to a New York Society of Security Analysts forum that is examining how Amazon.com reports financial information, Lutin has been pressing the big e-tailer and its dot-com brethren to stick to the basics of financial reporting: clear, precise information.

If it were up to Lutin, there would be no more mention of "fantasy" figures such as traffic numbers, customer counts, or "pro forma" profits that exclude everything but the kitchen sink.

In the wake of a report by former Lehman Brothers analyst Ravi Suria that raised doubts about Amazon's viability, Lutin sent two highly publicized letters to Amazon requesting that company executives respond to questions arising from the report. Although Amazon executives initially participated in the forum, the company has not yet officially responded to Lutin's letters.

An investment banker who founded his own namesake investment house, Lutin has long had an interest in how corporations are governed and how they relate to their shareholders. Lutin spoke with CNET News.com's Troy Wolverton last week about the need for reality-based financial reports and Amazon's reporting practices.

Why did your forum focus on Amazon?
Amazon was considered an attractive case study partly because they illustrated the types of controversy prevalent among New Economy companies generally. There were disputes about the validity of particular metrics. There were questions about what pro forma numbers actually meant, so on and so forth.

Amazon and other dot-com companies need to understand that the fantasy phase is over. We have returned to reality now. And they need to deal in reality information. Amazon was in what I would consider to be the normal range of controversy; they were not extreme. There was no general view that they were crossing any lines beyond what was considered acceptable in that context a year ago.

We thought Amazon would make an ideal example and particularly as a participant in the program since they were considered a leader among New Economy companies and also because, unlike many (companies), they actually had what appeared to be a viable business.

What were the issues you wanted to address in the forum?
The whole issue of investor information, including audited reports and the reliability of them. But also the controversies in the dot-com area, which were not so much focused on the reliability of the financial statements as on the controversies relating to the definition of metrics and pro forma numbers.

There were lots of disputes about what was the relevant number and how was it being defined, how was it being measured. And nobody knew.

Companies were coming out with some measurement of eyeballs. Even if you accept the validity of eyeballs as a measurement that can somehow be used as a basis for valuing the company, there's no indication of how anybody was measuring eyeballs. So one company's measurement of eyeballs was different from another company's measurement of eyeballs.

Who is to blame for this confusing information?
At our first meeting in July, I actually started out the meeting reviewing the list of the people that might be considered to have some responsibility in this area.

Is it the treasurer, the chief executive officer, the audit committee, the auditors, the sell-side analyst, the journalist that reports what the sell-side analyst says, the buy-side analyst who accepts without review? Who is responsible for all this? That was the issue of the program: Who is responsible for investor information?

It's everybody. Everybody plays some role in it. A year ago everybody was accepting it. Whether you want to blame an investor for encouraging the fantasy or a company's management for accommodating, it is a worthy subject of debate for historians. What I was interested in then and am now is simply setting us on a path back to reality.

So how do we get back to that reality?
Well, I think that one of the major contributors to an appreciation of reality is the kind of disruption that's occurred in the last few months. Some people recognized that the emperor had no clothes; others began to accept it, and now everybody has to come to grips with that. So external conditions have essentially imposed reality on those who may or may not have wanted it.

Fantasy is not a sustainable basis for an economy. Reality is. I know a lot of people have been disappointed about the results of their investments, but allocations of capital have to be made on the basis of what kind of return can be generated. Investors provide reality dollars to companies that need reality returns on them. You can't deal with pro forma returns.

What's wrong with the pro forma figures that a company such as Amazon puts out?
Well, one of the problems is we don't know. They're not defined. That is what is wrong with them.

Pro forma numbers or any numbers that are used need to be defined so that you can understand what they are, you can relate them, you can figure out what the adjustments are between net income and a pro forma income. You need to be able to compare them not only with prior periods in the same company, but with other companies. Otherwise it's meaningless--it's a fantasy number. Investors can't base decisions on fantasy numbers.

Do we need government bodies to step in and set new rules for reporting?
I think you really have all of the rules and regulations that you need. I don't think adding more rules and regulations is necessary. I think adhering to the existing rules and regulations is important now as it always has been. What is more important, though, is a marketplace that focuses on reality rather than on fantasy. You can't blame the carnival barker for your having attended a sideshow that had fantasy exhibits.

How did we get to the point where we were accepting fantasy instead of reality?
I think history demonstrates that this is a very normal process.

Investors and analysts should never believe a 'trust me' number. Every time there's a major technology innovation, people get excited about it, whether it's cannons to knock down castle walls or whether it's printing presses or whether it's automobiles, whether it was trains or telegraph, steam engines--any of these things, people get irrationally exuberant. It always happens. People get excited about all the applications and they gradually test them out and refine it and begin to apply it. We're now in the process of returning from the exuberance phase to a more rational and practical reality-based applications phase, which is where all the money is.

I'm not saying that people should be less excited about the applications of a new technology and all of its truly wonderful opportunities, but what you'll see now is a much more practically-based focus on how to apply it: how to actually make money with it, how to make it easier for people to function in society.

Of the issues you've raised about Amazon in your forum, which are peculiar to Amazon and which apply more generally?
The original intent of the project or the case study for the Amazon Forum was to use Amazon as an illustration of a more general condition. There are obviously some specific elements or issues that are particular to Amazon, but I think, in general, the investment in most New Economy companies and the valuation of their stock was based entirely on fantasy.

This was not specific to Amazon. Yahoo and eBay, which are now huge companies that have good, solid foundations, were valued at levels which were unjustifiable by any rational standard. If they had achieved 100 percent of the markets that were conceivably available to them and had established above-average rates of returns in serving those markets, they could never have become worth what they were priced at a year ago.

How should investors realistically value New Economy companies?
Based on how much income they can produce from the capital that's been provided: The same way you evaluate Old Economy companies. These are businesses--they're enterprises. Whether it's an Old Economy company or a New Economy company, it's an enterprise community. The information technology innovations, the Internet, all these things will affect how an enterprise community is organized and how it functions and will have very dramatic effects on that. But it won't affect the general principles that have existed since at least the beginning of recorded history that an enterprise community organizes people to generate wealth.

What would you change about how Amazon reports its results to investors?
Well, I think Amazon in particular and other dot-com companies in general need to understand that the fantasy phase is over. We have returned to reality now. And they need to deal in reality information. Reality information is reporting real income, real cash flow--not pro forma income, pro forma cash flow, not eyeballs, not mind share. Investors provide management with real dollars. They do that in the expectation of management generating a return on invested capital measured in real dollars, not pro forma, not eyeballs.

When Amazon says that it will be profitable by the fourth quarter on a pro forma basis, should investors or analysts believe that number?
Investors and analysts should never believe a "trust me" number. If the number has any validity it should be explained and defined. Amazon is talking about pro forma profitability, so we're not sure exactly what they're measuring.

The fourth quarter is a seasonally aberrant quarter; that's the quarter when retailers do most of their annual business. Achieving profitability in the fourth quarter may not mean that they're profitable on an annualized basis. That's like saying that this 60-second period during which you're paying me $100 for these three books is a profitable period; however, the period during which I have to pay my supplier doesn't count.

You can't do things that way. They need to define how that relates to an annual operation--what they mean by profitability. All those things are undefined.

It's a meaningless statement and the problem with it is that it doesn't sound meaningless. It sounds like the company is going to be profitable.

What do you think of (former Lehman Brothers analyst) Ravi Suria's critique of Amazon?
Well, I'm not taking any position on that pro or con. It was a professionally prepared report by a qualified professional, reviewed by a firm that is very credible in this field. Whether you agree with it or disagree with it, the report itself was a professionally credible analysis. Keep in mind that (Merrill Lynch analyst) Henry Blodget, who disagrees with the conclusions, also confirms that the report was professionally credible. Amazon appeared to be the only one said that the report was chock full of errors and tried to dismiss it on that basis.

We brought in people who were authorities on the issue, and it was very clear that there was no foundation for Amazon's position. The only explanation that Amazon provided was shown to be lacking in substance. Analysts disagree and agree with Suria's conclusions. That's what is supposed to happen. The forum isn't advocating one side or the other. What concerns us is that Amazon's management makes public statements that the Suria report is chock full of errors and then refuses to explain what's wrong with it.

Jeff Bezos is a former investment banker. Does it bother you that a former investment banker is heading a company that is presenting information in the way that Amazon's been presenting it?
I think you would have to assume, given Mr. Bezos' background, that he knows what he's doing. His background as an investment banker suggests that he has not been overwhelmed himself by irrational exuberance or fantasy.