Markets & Finance

Amazon: High Hopes -- and Cold Reality


By Scott Kessler Last week, I attended Amazon.com's (AMZN) analyst meeting in Seattle. Nearly a dozen executives, including former Time "Man of the Year" and current Chairman and CEO Jeff Bezos, presented their vision of the company's past, present and future.

I left the day-long meeting definitely better informed about the progress the company has made, but somewhat uncertain about its long-term prospects as an equity investment.

SEEKING GROWTH. The key to Amazon's success is growth -- through additional product and service offerings both domestically and internationally. Despite achieving fantastic success over the last five full calendar years, during which the company's revenues increased from $500,000 to $2.8 billion, 2001 is shaping up to be a difficult year.

The maturation of its core Books, Video and Music segment and the reality of the "law of large numbers," coupled with the dot-com crash and economic slowdown, have made growth tougher to come by than ever before. However, during its analyst meeting the company announced some new initiatives intended to jump-start what has understandably been decelerating growth.

"Customer Relationship Merchandising" is what Amazon calls its personalized direct marketing efforts. Specifically, the company has been using its extensive customer, clickstream, and purchasing data to develop and deploy sophisticated promotional strategies. These programs are being used to increase the number of purchases from first-year buyers, spending of existing customers, and strength of relationships with purchasers.

Although book-selling is a $23 billion business, only 58% of these revenues are generated from the consumer market. The remainder comes from larger customers, which Amazon plans to pursue with its institutional book sales program that will serve bulk buyers such as libraries. The institutional sales program is expected to launch in the second half of 2001 and achieve $150 million in sales over the next two years.

Amazon also hopes to open its PC store later this year. Computers have high average-selling prices and dollar contribution per unit. In addition, they provide for significant add-on opportunities. Also, and perhaps most importantly, Amazon plans on carrying no PC inventory, but rather having the manufacturers ship the product directly to purchasers. We expect potential partners to include companies that have been less successful at selling online, such as Compaq, Hewlett-Packard and IBM.

For the past several months, Amazon has also been serving as a platform for the sale of used items. Recently, Used@Amazon.com offered over 10 million products listed by members of the Amazon community, including many small businesses. This store enables the company to deepen its relationships with customers while generating significant growth and high-margin revenues.

GLOBAL REACH. Amazon.com is not only the top player in domestic consumer e-commerce, but also internationally. The company has country-specific websites focused on four international markets, the United Kingdom, Germany, France and Japan that have been widely successful. In fact, the market segment positions (in terms of reach) of the company's international and U.S. websites (respectively) in each of these countries are as follows:

U.K.: #1 and #2

Germany: #1 and #5

France: #3 and #7

Japan: #1 and #4

The company's websites are in markets that account for 92% of the world's business-to-consumer e-commerce revenues. As a result, over the near-term Amazon expects to focus on its existing international operations by continuing to expand into additional product categories and drive toward profitability. In fact, we expect the U.K. and German sites to achieve pro forma operating profits this year.

Despite new and anticipated product and services offerings and its significant international opportunities, perhaps Amazon's greatest potential for growth lies in its e-commerce services segment.

The company has spent years perfecting its e-commerce platform, which has been singled out as one of the best on the Internet. Starting last year, Amazon began to pursue the outsourcing of its e-commerce platform and services as a separate business. Now the company has such several agreements in place, with the likes of Toys "R" Us, Borders and Babies "R" Us, whereby it derives significant high-margin revenues.

Amazon is actively engaged in discussions to strike additional e-commerce services agreements. We expect any consummated deals to be announced by September, so that the new websites can be deployed in time for the holiday selling season.

COST CONTROLS. Although there are some questions about Amazon's growth prospects because the company has never made any money despite achieving fantastic increases in revenues, the bulk of the issues surrounding the company are associated with cost of goods and operational expenses. Amazon has clearly made significant progress in this area.

Of paramount importance to reducing cost of goods is the company's relationships with vendors. Amazon is focused on securing the best possible prices from manufacturers and wholesalers, as well as receiving items in the most efficient manner. Amazon is also very focused on managing its inventory effectively, and employs sophisticated forecasting techniques.

From an operational perspective, the company is achieving improvements within its supply chain and fulfillment centers. Specifically, Amazon has implemented process changes to reduce product defects and variation and added capacity via drop-ship (direct shipment from manufacturers and wholesalers) and partnerships. In addition, despite offering well-regarded customer service, the company's contacts per order have been declining due to increased website ease of use, customer access to information, and self-service options. The customer service segment has also been a key element of the company's customer merchandising efforts, in particular regarding pre-sales advice and order-taking.

As for technology and infrastructure expenditures, Amazon spent heavily in this area from 1997 to 2000, and has begun to leverage and scale these investments quite effectively.

BIG IDEAS. Amazon likes to say that it has the "Earth's Biggest Selection" of products. It's also the world's most popular and successful online retailer. Remember years ago when Wal-Mart was asked when it would supplant Amazon.com? They said, "Wal-Mart plans to be the Wal-Mart of the Internet." Well, Walmart.com is at best an also-ran to Amazon and I think it fair to say that Amazon.com has ostensibly become the Wal-Mart of the Internet.

But does Amazon have loftier aspirations?

During the company's first quarter conference call, Jeff Bezos concluded the presentations by executives with a discussion about Amazon -- the platform. The company had already announced a few major deals in this area, and Bezos made it quite clear that Amazon is squarely focused on its opportunity as an e-commerce platform provider. Right now, the company is the Internet's leading retailer, but some (myself excluded) believe that its future is to become more of an outsourcer of e-commerce services.

This distinction -- e-tailer vs. services provider -- is extremely important. If Amazon is satisfied with being the Wal-Mart of the Internet, the company will most likely continue to be successful, but with the operational characteristics of a retailer, with relatively low long-term growth and margins.

If the company aims to become more of a technology outsourcer, Amazon.com has the potential to achieve the fundamentals of a software company (perhaps like its colossal Seattle neighbor), with greater revenue and profit opportunity. Generally, better business models contribute to better equity performance.

TOO HIGH A BAR? However, often there is a notable disconnect between the performance of a company's stock and the achievements of the company itself. Amazon is a great example of this distinction. Users rave about its easy-to-use website, expansive product selection, and wonderful customer service. Revenues have been growing significantly, as the company has moved into new product categories and geographies. Costs and expenses have been declining as a percentage of revenues. Competitors have been going out of business.

So why are the shares down so sharply from their all-time and 52-week highs?

Because the company understandably has not been able to achieve the unreasonably high expectations many once had for it. The shares were simply overvalued. The stock was priced not to perfection, but to the fantasy-type levels typified by the Internet mania of the late 1990's. Fundamentally, Amazon.com is a retailer that does business on the Internet. Its growth is decelerating. It's losing a lot of money. It has billions of dollars in debt. Its future is uncertain.

So, even though the company is making great strides and has wonderful potential, the significant risk warrants my recommendation of 3 STARS, or hold, which has been in place since I took over coverage of the company in March 2000. Kessler is an Internet industry analyst for Standard & Poor's


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