Case Study: Amazon.com

By Mary E. Behr  |  Posted 11-01-2003

Case Study: Amazon.com

It was a statement unusual in its candor. Cornell Williams, Vice President and Chief Technology Officer for Gap Inc. Direct, the online division of apparel retailer Gap Inc., was at an e-tailers conference in mid-2003 when he was asked about his company's decision a year earlier to sell clothing through Amazon.com while maintaining its own retail Web site. "When I go to Amazon, I'm not looking for apparel," Williams told attendees. "Right now, the Amazon relationship does not have a primary revenue impact [on the Gap]."

Odds are, that's the last thing Amazon.com Inc. management wants to hear. The company that debuted eight years ago as an online bookseller and became the Web's paradigmatic retailer is in the midst of a difficult transition that has gone mostly unnoticed. With its book and CD sales beginning to slow and international expansion peaking, Amazon is quietly trying to transform itself into a technology company, a portal and infrastructure provider for would-be e-tailers.

It's a difficult gambit that represents an intriguing disconnect between a central tenet of Amazon's growth strategy and the general view of Amazon that has driven its stock this year to levels unseen since the dot-com crash. While Amazon's top executives, led by CEO and president Jeffrey Bezos, contend that Amazon's future depends on signing up more and more third-party retailers to sell products through Amazon.com, most analysts have ignored this plank of Amazon's platform. Instead, they've staked their buy ratings on the notion that Amazon is still a sexy, fast-growth e-tailer, even without third-party partners. Whether Amazon will be able to live up to either the internal or external expectations is an open question, but the attempt will go a long way toward finally addressing a larger issue: What does it take to make money online?

"Amazon's having an identity crisis," says Carrie Johnson, senior analyst at Forrester Research Inc. "Which is not to say that they won't overcome it. What they look like is up in the air."

A close examination of Amazon's numbers hints at how tough it is to sustain profitability as a pure-play e-tailer and why the company is taking a different course. While Amazon had operating earnings of $52 million in the third quarter of 2003—its first operating profit in a quarter that doesn't include the holiday season—it was a muted accomplishment. Once interest payments of $30 million on a $2-billion-plus junk bond offering at the height of the dot-com boom are subtracted, Amazon is left with just $22 million in profits on revenues of $1.1 billion. And even those slim earnings required that Amazon stifle spending on marketing, technology and content, setting budgets in these essential categories at virtually the same levels as the previous year. Some of this was easier to swallow because of smart cost- containment decisions: A couple of years ago, Amazon switched to Linux as its primary architecture. Since then, Amazon has lowered technology expenses by about 20 percent, according to a report by Forrester's Johnson. But many of the cost cuts that Amazon has undertaken to ensure profitability are not choices an expanding business usually makes.

"Online retailers have had to cut back their spending appetites in order to find a way to sustained profitability," says David Fry, president and CEO of Fry Inc., which designs and manages e-tailer Web sites. "That means they can't do everything they once thought they could do when budgets seemed limitless."

When did Amazon's earnings ever have much to do with its share price? To view chart click here

page 2


To buoy third-quarter sales, Amazon discounted product prices significantly and continued to offer free shipping for orders exceeding $25, a program begun in August 2002. But free shipping comes at a high price for Amazon: In the third quarter, the company paid out $27 million on delivery, more than 2 percent of sales, compared to $10 million in delivery fee charges it took in from customers, about 1 percent of sales, in the same period a year earlier, when it offered free shipping for orders of $49 or more for two months of the quarter. The more generous free shipping program could become a millstone if revenue growth slows, as now appears to be the case. Worldwide sales of books, videos and CDs rose only 28 percent in the third quarter, compared to 34 percent in the quarter a year earlier. And while sales outside the U.S., which accounts for about one-third of Amazon's revenues, grew 61 percent, that's a far cry from the 91 percent increase the year before—an indication that big gains from Amazon's expansion into the U.K., Germany, Japan and France may have crested. In recognition of this, Amazon has cut sales growth estimates for 2004 to just 16 percent.

"We're cautiously optimistic about the future," said Tom Szkutak, Amazon's senior vice president and chief financial officer.

This mixed performance and conservative tone surprised some of Amazon's most bullish analysts, who had helped the e-tailer's stock run up 200 percent during the first nine months of 2003, to a market valuation of more than $20 billion, or ten times that of Barnes & Noble Inc., Amazon's much more successful bricks-and-mortar rival. A day after the third-quarter earnings announcement, The Goldman Sachs Group Inc.'s Anthony Noto—who maintained his buy rating on Amazon throughout a 70 percent fall in the company's stock in 2000—advised his clients to sell and take profits. Noto warned that from 2005 on, Amazon could expect annual earnings growth of 20 percent, a slimmed-down estimate that suggests a much lower stock price.

Sounds like a replay of words heard around the time the dot-com bubble popped. Currently, Amazon has no meaningful price-to-earnings ratio; but its current price, about $56 a share as we went to press, gives it a multiple of price-to-forward 12-months estimated earnings of 65. WalMart's is only 25. "Amazon is No. 1 in brand recognition and No. 1 in customer service," says Safa Rashtchy, senior research analyst at U.S. Bancorp Piper Jaffray Inc. "People like them. If a company is doing well, people ignore valuation."

But, as history has taught us, that only lasts so long. And that's why Amazon is remaking itself. The key to the makeover is this past June's launch of Amazon Services Inc., a subsidiary whose ambitious goal is to sign up other retailers willing to outsource their Web operations to Amazon and sell their products at Amazon.com. (Although Amazon will also manage Web sites for companies not doing business on Amazon, that is a much less potentially profitable aspect of its new strategy.) For a fee estimated by analysts of 10 percent or more of retail revenue, Amazon Services will set up the e-tail site and handle fulfillment and customer service. Initial Amazon Services clients include Toys "R" Us Inc. and Target Corp., both of which were selling products online exclusively at Amazon even before the debut of Amazon Services. Other Amazon Services e-tailing partners—the Gap, Office Depot Inc., Nordstrom Inc., Circuit City Stores Inc., Eddie Bauer Inc. and Lands' End Inc. among them—sell products at Amazon.com as well as at their own Web sites.

"Being a retailer would not have put [Amazon] over the top, so it is evolving into a tech company," says Lauren Freedman, president of the e-tailing group inc., a Chicago-based research and strategy firm.

There's already been some payoff. In the third quarter, sales from third-party companies grew to 22 percent of Amazon's worldwide units, compared with 17 percent the year before. Forrester's Johnson estimates that by 2008, Amazon's revenue from services could reach 50 percent of sales, but only if Amazon undertakes improvements to its Web site that make it more desirable to e-tailing partners. If this forecast pans out, third-party revenue could more than make up for the slowdown in sales in Amazon's traditional businesses. What's more, the commissions on Amazon third-party sales are mostly profit, because expenses for Amazon's fulfillment and customer service systems are already included as costs in Amazon's overall retail operations. As a result, Amazon Services could provide a steady and lucrative earnings stream when no other aspect of Amazon's operations has yet shown to be so potentially rewarding and consistent.

"We're driving a lot of demand for third-party sellers," says Bezos. "We need to continue expanding into new product categories and increasing the depth of selection of those that we are already in."

Amazon Faces Intense Competition For Growth. To view chart click here

page 3


But Amazon's new strategy is anything but a cinch. There are significant obstacles that Amazon must overcome first, beginning with its discomfortingly crowded Web site. Shoppers are drowning in a sea of links as more and more partners parade their products there, says Forrester's Johnson, an experience that's much less pleasant and convenient for the consumer. The sheer overload of products has made Amazon's store messy—as much a turn-off to shoppers in cyberspace as it is in the real world. To get a sense of Amazon's clutter, try searching for Bill Gates. Besides the 32,000 results in books, you can thumb through 34 in video, including Hoop Dreams (William Gates is the name of a basketball player in the movie) and nearly a dozen completely irrelevant items in medical supplies, lifestyle and gifts, and scientific supplies. In perhaps the strangest result, the Microsoft Corp. chairman's name is linked to the menu of the Flytrap Restaurant in San Francisco, because the words Bill of Fare and Golden Gate appear on the page.

Conditions like these spook potential partners too. While Amazon management boasts about the ever-increasing number of third-party sellers on its site—its recently opened apparel shop, for instance, contains more than two dozen retailers—even companies that are already doing business with Amazon are complaining about the terms of the arrangement. Echoing Gap's Williams, some say that the sales are negligible. Others, according to Forrester's Johnson, go further and say that revenue is disappointing. In fact, the apparel shop, which Amazon executives point to as a model for the future in which the site will shelter numerous retailers under one category umbrella, has been a lightning rod for discontent among Amazon's partners. Two key complaints: Amazon's technology sometimes makes it difficult to upload content to the Web site, and Amazon lacks the expertise in the apparel business to provide adequate account management.

"With the venture into the world of online apparel sales, Amazon.com may be overreaching," said Geri Spieler, a Gartner Inc. retail services analyst, in a report.

For a company that is built on technology, ironically, Amazon is no shoo-in to win over retail customers that want to outsource their Web sites. It's competing against some heavy-hitters, including GSI Commerce Inc., IBM Corp. and Microsoft, all of which have a head start on Amazon and the advantage of being independent and not a rival retailer. And in the portal business, Amazon is just as vulnerable. Other big online names, including MSN, Yahoo! and Google, have similar growth strategies and excellent technology. In time, they'll likely precipitate a bidding war over retailers for their sites.

Amazon management declined to discuss specific retail partner complaints or the performance of Amazon Services. But in past interviews, Amazon executives have pointed to a weapon that, they say, trumps any concerns about the company's ability to succeed at its new strategy: 35 million active customers who, according to Forrester, spend 10 percent more online than the average of all online shoppers. That's a powerful card to play, because it gives partners an instant audience for their products, with no significant promotional efforts on their part, Bezos claims. "Amazon Services offers retailers the opportunity to tap into our industry-leading shopping experience," Amazon's chief says. "These retailers can grow their online businesses faster and less expensively by taking advantage of what we've learned."

As for the somewhat skittish relationships with retailers, Amazon executives dismiss the problems as growing pains. "It's in the early stages of development," says Owen Van Natta, Amazon's vice president of worldwide business development. "We've proven that we get successful over time."

He and Bezos point to the continuous introduction of new technologies—from 1-click checkouts and personalized recommendations to the recently launched Search Inside the Book, an option that lets people search for books by phrases or words contained in them—as Amazon's greatest skill. That focus on new technologies and innovation, says Bezos, "drives customer experience" and ultimately is the competitive advantage that ensures its success.

Forrester's Johnson recommends that Amazon clean up the shopping experience in 2004 by limiting the amount of content that consumers see and hiring account managers with expertise in retailing sectors like apparel and sporting goods to help mend fences with antsy third-party partners. After that, she says, Amazon should focus on adding about 20 new partners a year and providing reasonable commission terms and excellent service. If Amazon does this while continuing to squeeze the most out of its books, media and electronics businesses and applying its technological expertise to develop cross-selling programs among all the items on its site, the retailer's annual revenues could skyrocket to nearly $16 billion by 2008, more than four times last year's sales.

But if Amazon fails to fix relationships with its partners, Johnson warns, its annual revenue in four years could dip below $8 billion, with diminishing sales from third-party retailers.

Few companies ever stand at such a distinct crossroads as Amazon does now. Outwardly, the company seems to be poised within easy grasp of its goals as it embarks on its strategy of transformation, carrying the same Bezos-inspired "can't fail" confidence that has driven the e-tailer for eight years. Amazon, like the performance of its shares, has always required a suspension of disbelief. But shifting from a retailer to a portal, from a bookseller to a technology services company, is the biggest trick that Amazon has yet attempted—and perhaps the one that ultimately will determine whether Amazon survives. It could take a lot more than tall tales and devoted followers for Amazon to pull it off.

Mary E. Behr writes about business and technology issues.


Resources


Resources


Articles

  • "The Future of Amazon.com" By Carrie A. Johnson
    Forrester Research Inc., Sept. 2003
    www.forrester.com/ER/Research/Report/Summary/0,1338,16873,FF.html

  • "In Latest Strategy Shift, Amazon Is Offering a Home to Retailers" By Nick Wingfield
    The Wall Street Journal, Sept. 24, 2003

    Web Sites

    www.frymulti.com
    Fry Inc.