The Shape of a Profitable Amazon


It's beginning to look at lot like Christmas for Amazon. The company's stock climbed 28%, from $7 to $9 a share, on the U.S. Commerce Dept.'s report that retail sales were up a better-than-expected 7.1% in October. That tally was skewed toward auto sales, but Web audience-measurement service Nielsen/Netratings reported that for the week ending Nov. 11, the number of online shoppers increased 14%.

Investors are figuring, yet again, that it's another make-or-break holiday season for the online retail giant, which has promised that in the fourth quarter, it will finally attain "pro-forma" operating profitability. Focusing on holiday sales, though, may miss the point when it comes to the e-tailer's promises. The key to Amazon's profitability this quarter won't be top-line sales growth but revenues from its technology-service partnerships. CEO Jeff Bezos & Co. have taken over the Web stores and fulfillment activities of online operations for the likes of Target, Toys 'R' Us, Circuit City, and Borders.

GROWING SEGMENT. With gross margins of 60% and higher ?- more than double Amazon's total gross margins -- these deals will deliver the cash that could finally push the company into the black. Even more important, such margin-rich revenues address Amazon's perpetual profitability challenge. In 2001, technology-service deals will total about $200 million. That's only 7% of Amazon's $3 billion annual revenues, but the business accounts for 18% of its gross margins.

Numbers like this are why U.S. Bancorp Piper Jaffray analyst Safa Raschtchy expects service revenues could ?- and should -- double next year. Within five years, he believes they could make up more than 50% of Amazon revenues. What's more, Bezos may have no choice if he wants to please markets. "Investors want the driver of profitability to be a growing segment. That means the service division has to grow," says Raschtchy.

To some degree, Amazon has already acknowledged its transition from retail behemoth to provider of logistics, customer service, and technology for brick-and-mortar giants. In an e-mail sent on Nov. 14 to Amazon investors, the company announced that it would restructure itself into five segments with the goal of better focusing on technology services. "It's important to acknowledge who has what expertise. We have the expertise in online sales, fulfillment, and customer service. We can get to profitability sooner by playing off those skills," says Amazon spokesman Bill Curry.

SMALL SLICE. A picture of what Amazon could look like one day soon is a company called Global Sports (GSPT). The King of Prussia (Pa.) outsourcing company operates e-commerce businesses for 25 sports retailers including Sports Authority and The Athlete's Foot. Global Sports owns the merchandise and manages inventory, fulfillment, and customer service. Each retailer, in turn, receives a single-digit percentage cut of any revenues that come from its site. To consumers, it just looks like they're buying from their local retailer.

Global Sports' strategy is attractive to its retailing partners for two key reasons. First, it relieves them of the burden of building and maintaining costly e-commerce infrastructure. Moreover, because Global Sports bears all the costs, it allows a client's e-commerce operations to be profitable from day one. Global Sports, in turn, makes money because of the scale of its business. Moreover, Global Sports spends nothing on advertising and marketing. The retailers take care of that.

The outsourcing company has a different deal with retail giant Kmart. Here, Global Sports provides back-end services for a fee and takes a small percentage from any online sales. This minimizes Global Sports' risk because it doesn't have to deal with unused inventory. The Kmart deal, signed in August, is estimated to bring in $3 million to $5 million in revenues in the fourth quarter and an additional $10 million to $12 million in 2002, with margins that could be as high as 50% to 70%, according U.S. Bancorp Piper Jaffray.

VERTICAL BENEFITS. Like Amazon, Global Sports expects pro-forma operating profit in the fourth quarter and throughout 2002. But Global Sports' revenues are growing much faster than Amazon's -- though Amazon is clearly starting with a bigger base. Global Sports expects to bring in just over $100 million in revenues this year, up from $43 million in 2000, and $200 million next year. Compare that to just 10% growth for Amazon, which is estimated to have $3.3 billion in revenues for 2002.

Amazon needs more deals like the one it signed in September with Target to jump-start growth. The hip discount retail chain pays Amazon to run its Web site and gives Bezos & Co. a small percentage of any online sales. The revenues could easily run into the tens of millions this year from that relationship, as Target.com has become a leading online retailer.

Analysts say, though, that Amazon could get the most bang for its info-tech buck if it developed customers and expertise in vertical channels, just as Global Sports has. The consumer-electronics business would be a great start. Like sporting goods, there's a huge overlap in merchandise sold at stores around the country, which keeps cost and risk low.

LOTS OF LEVERAGE. Still, don't expect Amazon to abandon its retail business. Bezos' ability to sell the company as a technology-services provider relies heavily on its own retail success. "Retailers come to Amazon because it has a reputation as a great retailer," says Jupiter Media Metrix' Ken Cassar. Having a customer base of 23 million that can be directed to buy at Target.com, for example, helps persuade big partners to sign on.

However, Amazon must staunch the bleeding from poorly performing product lines incorporated as part of Bezos's failed online department-store strategy. Analysts expect that starting as early as the first quarter, the company will begin dumping money-losing items, such as tools, hardware, and kitchen equipment and focus exclusively on books, videos, and music. That's where its expertise lies.

Unfortunately, those are all low-margin businesses with limited growth prospects and big competition. "Amazon's core business just can't sustain growth. In order to move the needle, Amazon needs to stop wanting to be the biggest company and start partnering with them," says Shawn Milne, an analyst with the Soundview Technology Group. If you can't beat them, run their servers. By Jane Black in New York


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