Amazon looks to diversification in drive for profit

Will diversification into new markets finally turn a profit for before the dotcom godfather burns through the last of...

Will diversification into new markets finally turn a profit for before the dotcom godfather burns through the last of its savings? Stephen Phillips reports

In five years has built the world's biggest online store. However, despite generating expected $1bn (£0.67bn) sales from the Christmas retail season alone, profit has proved elusive. Despite its profligate sales, business-to-consumer e-commerce's pre-eminent player is not expected to enter the black until year-end, according to financial analysts' most-optimistic forecasts. Meanwhile, a cost-intensive diversification strategy casts doubt on the prospect of the company ever turning a profit, according to a growing chorus of company-watchers.

Since spotting the Web's potential as a medium for commerce in 1995, just months after the first browser prised open the Internet for consumers, Amazon has remorselessly driven home its first-mover advantage. The trail-blazing Web merchant has carved out a dominant share of the online book, music and video-retailing market by leading rivals in delivery speed and reliability and offering a ground-breaking interface (anchored by its patented 1-Click online purchase technology), that enables customers to enter payment details just once for all sales transactions.

If the story ended here there might be a happy-ending in sight. On its own, this part of Amazon's business recently entered profit for the first time, with US sales alone worth $1bn (£0.67bn) a year. However, instead of resting on such laurels, Amazon CEO and founder Jeff Bezos is eyeing the ultimate spoils of building the Web's one-stop shop.

To this end, the e-tailer is relentlessly colonising new markets using pacts with established vendors such as Toys 'R' Us to gain instant brand cachet and supply chain access. So far Amazon has diversified into toys, tools, electronics and kitchenware and its ambition shows no sign of flagging.

With the land grab for Internet retail markets in full flow, the e-tailer does not have the luxury of being able to wait for profitability as a platform for expansion, according to Amazon commentator and venture capitalist Steve Jurvetson, managing director of Silicon Valley's Draper Fisher Jurvetson. If it digs, rivals will sew up coveted customers and its "future opportunity is truncated", he says.

To underpin its bid to become the Web's most pervasive retailer, Amazon has plunged "hundreds of millions of dollars", says David Risher, senior vice-president and general manager, US Stores, into assembling a formidable logistics operation. This spans seven US warehouses to serve its largest national market, offering storage space ranging from 200,000 to 800,000 square feet; a 500,000 square feet warehouse near Milton Keynes to cater for UK customers; plus facilities in Germany, alongside operations in France and Japan - its newest national markets.

The company is banking on harnessing the traction it has developed in its established markets to conquer new ones. The crown jewel in its quest, according to Jurvetson, is an unparalleled customer database providing the most-comprehensive glimpse into consumer buying habits enjoyed by any retailer (online or physical), opening up multifarious cross-selling opportunities.

However, away from the risk-friendly culture of Silicon Valley, the financial community takes a decidedly less bullish stance on the prospects of Amazon pulling off what Jurvetson dubs its "monopolist's gamble". Many Amazon-watchers believe diversification will saddle the company with an unsustainable cost burden. "There is an incompatibility between its brand proposition of offering a dominant breadth of assortment and achieving profitability," says Lauren Cooks Levitan, managing director, research at San Francisco investment bank, Robertson Stephens.

What could prove Amazon's undoing are so-called split shipments - multiple deliveries to fulfil a single customer order - says Levitan. This is a keenly-felt problem in the US, the source of two-thirds of the company's revenue, where far-flung population centres necessitate a network of distribution centres for product shipments. By extending its product range, Amazon will have to source items in a single order from multiple locations, according to Levitan, ratcheting up costs from postage and labour to picking and dispatching goods. Meanwhile, the alternative of stocking every product at all distribution centres is financially prohibitive.

Recent anecdotal research by Robertson Stephens found that Amazon took an average 3.67 shipments to fulfil each order. The e-tailer says orders placed by the bank were atypical and denies split shipments are a function of diversification.

Nevertheless, Risher admits Amazon will lose money on shipments if split deliveries become "a major problem". To avoid this outcome Amazon is working to match inventory distribution to geographical demand patterns, he says.

To ease such fulfillment headaches, Jurvetson proposes uncoupling Amazon's logistics operation from its Web storefront. The company should spin out its distribution arm as a separate money-spinner, he advises, while farming out fulfillment to a specialist to shed costs and focus on selling. Outsourced e-fulfillment - spanning warehousing and dispatch of items ordered online - is expected to be worth £5bn ($7.15bn) a year in the UK alone by 2008, according to research from consultant E-Insight.

However, Amazon has shown no inclination to relinquish internal control over operations. As a legacy of its first-mover status, the firm has historically developed its software in-house, reflecting the absence of external products when it started out. Even though suppliers have since sprung up to service the burgeoning online retail market, Amazon has stuck to a proprietary approach that seems increasingly like an expensive anachronism.

Another challenge of diversification is the higher marketing costs attached to many of the new offerings, which unlike books need to be 'sold'. Last summer, investment bank Lehman Brothers ascribed Amazon's second-quarter sales shortfall to what it calculated as a reduction in marketing costs as a proportion of sales to 7.3% from 12.3% during the first half of 2000.

"To us this is an indication that new categories do not just sell themselves to existing customers and that without stores to drive traffic or catalogues to remind shoppers, pure-play online retailers like Amazon may need consistently higher marketing support," concludes a Lehman's research note.

As well as needing more merchandising, many of the new items are bulkier than books, CDs and videos, carrying correspondingly higher storage overheads. Meanwhile, the consumer electronics market is currently gripped by punishing price competition as new entrants such as grocery stores aggressively undercut established players, leading to crimped profit margins.

Share-price plunge

Amazon shows no sign of scaling back its ambition. However, its focus on 'sales before profit' is distinctly out of step with prevailing investor priorities in the wake of last year's dotcom downturn - raising implications for its continued ability to raise funds to bankroll its capital-intensive strategy.

Amazon's expansion was funded by a public investment market that eagerly snapped up its shares in endorsement of its singular pursuit of market share. But the estimated 16% failure rate of US dotcoms since last spring has left chastened investors demanding a clearly-plotted path to black ink as an assurance of return on investment. Shaky confidence in Amazon's ability to deliver the goods has seen the e-tailer's share price plunge 75% since the turn of 2000, before December's retail bonanza dealt a customary fillip to its stock.

As of last November, Amazon was reckoned to have $830m (£556m) in ready cash, a sum expected to sustain operations until late this year at present rates of consumption. However, unforeseen events or the failure of profit to materialise as expected may force Amazon to go cap in hand to a hostile market in order to stay afloat.

Despite his support for Amazon's expansion strategy, Jurvetson acknowledges that the company is treading a tightrope as it bids to generate cash from operations before burning through its savings. "The ideal way to run Amazon is to turn cash-flow positive when you run out of money and people are no longer prepared to give it to you cheaply," according to Jurvetson. He concedes, however, that no firm enjoys such foresight.

Meanwhile, there are a number of clouds on the horizon. The allow-ability of part of what Amazon counts as revenue is under question. The company's practice of accepting part-payment in stock for advertising space on its website, under its Amazon Commerce Network (ACN), is the subject of an unofficial probe by US public company watchdog, the Securities and Exchange Commission (SEC).

Amazon's November filing with the SEC revealed that 64% of the $166m (£111m) it received from ACN partners for the nine months ended 30 September was stock-based. The firm claimed $94.8m (£63.5m) of this as revenue, within $1.8bn (£1.2bn) total revenue for the period.

This is entirely in accordance with generally accepted accounting principles (GAAP), while accepting equity for services is long-standing US corporate practice. However, its use has become a bone of contention for loss-making Internet businesses such as Amazon, whose shares are valued as a multiple of revenue not profit. At issue is the 'quality' of such revenue - crystallised in the plunging stock valuations of many of the dotcoms paying to advertise on Amazon's site.

Much of what the e-tailer booked as revenue from ACN partners last year, based on their share price when the deal was struck, was subsequently wiped out amid the dotcom downturn. When stock recorded as revenue changes in value Amazon is not required to restate previously-reported figures. While the firm vows it will insist on a greater hard cash component to future ACN deals, the ability of struggling dotcoms to cough up currency is also in doubt.

Clouds on the horizon

While the threat from dotcom upstarts has receded with their reduced ability to raise funds on the investment market, the challenge from bricks and mortar retailers adding online stores is getting fiercer. As well as wielding generous Internet war chests from established profitability, physical retailers will benefit from a maturation of the online market, says Ken Cassar, senior retail analyst for Internet market watcher Jupiter Research.

This can be seen in a change in the demographics of online shopping from early adopters - typically wealthy, IT-literate young males who tended to surf exclusively pure-play dotcom websites - toward a customer base more representative of the population at large. "They will have a proclivity toward the stores they do business with in the real world," predicts Cassar.

The advent of digital wallets poses another potential threat to Amazon's ascendancy. By dispensing with onerous online form filling, the online payment system would eliminate one of the barriers to consumers' browsing smaller, less-sophisticated e-tailers' wares.

In the run-up to Christmas, Amazon senior executives convened daily summit meetings to micro-manage operations during its busiest season, and dispatching 450 head office staff from Seattle to swell the ranks of over-worked warehouse staff. The e-tailer will need to summon every ounce of this vigilance to rise to the challenges it can expect to face during the coming year.

Risky Business: Amazon's one-stop web shop

Amazon's vision of a one-stop Web shop faces the following reality checks:

  • Spiraling costs from split shipments of single orders
  • Increasing marketing demands of new wares, which unlike books need to be 'sold'
  • Investment market hostility to its sales-before-profit business model could make it hard to raise funds if the e-tailer burns through savings
  • Stiffer competition from well-heeled bricks-and-mortar retailers adding online stores

    Vital Stats:

  • Headquarters: Seattle, USA
  • Headcount: 8,700
  • Sales (1999): $1.64bn; $4bn expected for 2001
  • Net loss (1999): $720m
  • Sales (2000):2000 figures unavailable at time of publication

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