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Amazon Finally Clicks

Ten years old and profitable at last, it offers a textbook lesson on how to be both focused and flexible.
Russ Banham, CFO IT
March 15, 2004

The foosball tables are still there, as are the desks made from sawhorses, plywood, and old doors. And no one wears a tie, not even CFO Thomas J. Szkutak. But if some E-commerce trappings are alive and well at Amazon.com headquarters, others are not. Red ink, for example, has disappeared—at least for now. The company posted its first indisputably (that is, GAAP-based) profitable year in 2003, propelled by strong holiday sales and a weakened dollar, which boosted overseas results.

That has prompted plenty of backslapping in the halls of Amazon's headquarters, a former hospital with an improbable Art Deco design and a postcard view of downtown Seattle and Puget Sound. As it prepares to celebrate its 10th anniversary, Amazon.com is a very different company from the so-called E-tailer that, at the time of its initial public offering in 1997, had to caution would-be investors not to confuse it with Amazon Natural Treasures, a retailer and E-tailer of rain-forest products.

Few would make that mistake today. While still sometimes referred to as an online bookstore, Amazon now boasts a product line that staggers the imagination, from apparel, sporting goods, and jewelry to new services including a feature that lets customers make "1-Click" Presidential campaign contributions.

Behind Amazon's breadth of products and services are myriad business arrangements: some products the company owns, inventories, sells, and ships; others it sells on behalf of third-party retailers. Some of these third-party products Amazon ships and fulfills; others are shipped and fulfilled by the third parties themselves. Among those third parties are thousands of mom-and-pop E-tailers that collectively make Amazon's Marketplace division a perpetual online garage sale surpassed only by E-bay.

With 39 million active customer accounts (based on the number of E-mail addresses from which orders originated in 2003), Amazon seems to be making good on its promise to offer the "Earth's biggest selection of products," or as Szkutak puts it, "to build a place where people can find, discover, and buy anything they want online." To do that, he says, the company has learned—sometimes the hard way—to "start with the customer and work backward."

Working backward has changed Amazon from an online retailer to an E-commerce platform. Today, it is not a store so much as a channel, a place where brand-name third-party retailers, smaller businesses, and just plain folks can hawk their goods to a worldwide clientele. This past holiday season, shoppers traipsed through Amazon to buy products from Gap, Toys "R" Us, True Value Hardware, and Kitchen Etc.—and maybe some kid in Idaho who was trying to unload his slightly dog-eared Harry Potter library. Assembling such a vast collection of partners and building the systems that allow customers to buy from an individual as easily as they buy from a retail giant has not been easy, and analysts praise Amazon's achievements. "Amazon has knocked 10 steps down to 1," says Adam Sarner, a research analyst at Stamford, Connecticut-based technology research firm Gartner Inc. "This is what they mean by 'customer convenience.'"

Jonathan Gaw, a research manager at technology research firm IDC, says, "No one else has this kind of expertise, because no one else has invested the capital to build this kind of infrastructure."

Amazon.com was once viewed as a leading member of the E-commerce vanguard, but most of the followers have fallen by the wayside. True, the survivors—E-bay, MSN, AOL, Yahoo, and Google—have become household names, but success remains precarious and depends on, among other things, the ability to be nimble. Amazon built its brand initially on low-priced books and waited for customers to come bargain-hunting. Today it pulls out all the stops to get people to visit, from "never-before-seen" Bruce Springsteen concert footage to a "secret message" from Madonna. If that sounds like the sort of pop-culture gimmickry one might expect from, say, AOL, there's good reason: the E-commerce giants are out to eat one another's lunch. When Google, for example, announced Froogle, a new service that allows users to search for a product name and be directed only to sites that sell that product, Amazon launched a new subsidiary, A9, devoted to Web searching, and even located its offices close to Google in Silicon Valley. Similarly, the boundaries between the business models of E-bay, Yahoo, and even Microsoft can be hard to discern, as all of these companies seek to protect themselves and to copy whatever seems to work.

Little wonder why Erik Brynjolfsson, a professor at MIT's Sloan School of Management and director of its Center for eBusiness, calls Amazon "the world's largest consumer laboratory." Indeed, the reason Amazon survived for nine years without an annual profit is that it had a long-term vision for building its technology infrastructure, a research-and-development strategy more like a pharmaceutical company. "Our technology and content expenses were $156 million and $167 million for the nine months ending September 30, 2003, and 2002, respectively, representing 5 percent and 7 percent of net sales," Szkutak notes. He says those expenditures will continue, but not at the expense of profitability. "Do I expect us to someday sustain year-over-year profitability? I wouldn't be here if I didn't," he says.


For all its diversification, however, Amazon still derives three-quarters of its revenue from products that it inventories, sells, ships, and fulfills via its own supply chain, which includes six warehouses in the United States and four overseas. Those who have followed the brief history of E-commerce know it wasn't supposed to be that way: Amazon's original vision posited the company as a much more virtual entity, an electronic middleman light on capital assets. Instead, centralized distribution driven by technology—everything from inventory systems to real-time logistics analysis—has proved a potent combination.

To leverage those capabilities, a CFO needs to think in terms of inventory velocity. "Say both Amazon and a physical store are selling a digital camera for $300," Szkutak says. "The physical store's inventory turns are 7.5 times a year and ours are 20 times a year. The hypothetical value of the camera one year later, due to obsolescence, is, say, $210, an obsolescence loss per week of $1.70. However, since the camera is in inventory an average of 7 weeks at the physical store and only 2.6 weeks at Amazon, the obsolescence cost per unit works out to $12 for the store and $4.50 for Amazon. As a percent of sales, that's 4 percent for the physical store and 1.5 percent for Amazon. In short, our inventory velocity translates to margin benefit."

Got that? Amazon's annual gross margins of 25 percent (for its North American segment) and nearly 20 inventory turns, important twin metrics in the retailing sphere, compare very well against traditional retailers like Wal-Mart Stores (22 percent gross margins and 7 inventory turns) and Costco (13 percent and 11 turns), according to the Securities and Exchange Commission filings of these companies. But Amazon's extensive array of products surpasses even that of the superstores, a factor even more important to the company's financial viability than low-priced merchandise, according to an MIT study. "Amazon carries [several million] book titles, whereas conventional bookstores carry on average about 40,000 titles," Brynjolfsson says. "Previous research indicated that consumers on average saved 8 percent by buying books online. However, our newest study found that greater product selection and convenience were far greater contributors to total consumer value. The extra choice creates value because consumers can find products that are a better fit for their particular interests and needs," he explains. "The value can be calculated in dollar terms. Consumers at Amazon gained more than $1 billion of additional consumer value due to the extra product variety for the year 2000. This was about seven times more than the extra value consumers received from the 8 percent lower prices. Clearly, product selection and convenience, not lower prices, are the biggest areas of consumer benefit."

Live Free or Die?
Having reported its first billion-dollar quarter (Q3) and posted its first yearly profit, Amazon seems to have benefited from its decision to expand its product offerings; cut prices on books and other items; and offer free shipping on orders over $25. Free cash flow in Q4 was $346 million, up from $135 million in the same period a year earlier, an achievement that has analysts smiling. "Profits as defined by GAAP are not as relevant as return on free cash flow," says Anthony Noto, a managing director for Goldman Sachs. "Economic value is created more by free cash flow than by GAAP earnings. At the end of the day, it is free cash flow that companies are rated on."

That free cash isn't just in the form of dead Presidents. As Amazon continues to sprout tributaries around the world, from Japan to Europe, it expects its current international sales, which already account for 40 percent of the total, to play an ever-larger role in its success. "We are examining other country sites, which I'm not able to discuss," Szkutak says. "I can say that our international revenue is up some 71 percent from third-quarter 2002 to third-quarter 2003, from $973 million to $1.6 billion."

The good news has not escaped Wall Street; indeed, investors seemed to anticipate it. Amazon's stock value tripled in 2003, but took a dive just as the company was announcing its positive annual results, a correction that most saw as sensible. On February 10, Standard & Poor's put Amazon on "credit watch positive," but didn't actually raise its rating. Szkutak downplays any and all tribulations, saying, "We're still the same high-tech company...focused on fulfilling Jeff's dream of building a place where people can find anything online."

No Time to Rest
Jeff, of course, is Jeff Bezos, Amazon's founder, chairman, and CEO, and Time magazine's "Person of the Year" in 1999. Lauded by the magazine as the "King of the Internet," Bezos had a legendary epiphany in May 1994, when he spied an Internet site that measured Net usage; it was growing at an astonishing 2,300 percent a year. He quickly grasped an, if not the, essential value proposition of the Net: the ability to sell nearly anything to anyone with maximum convenience and minimum overhead. Books were a perfect start, since a catalog of all books available for sale would be the size of a New York City phone book—that is, too big, unwieldy, and expensive to mail out. Amazon.com was founded that year, and its Website was launched in July 1995, billed as the "Earth's Biggest Bookstore." And it was also its most innovative, with a host of customer-friendly enhancements rolled out almost monthly. "The only reason left for a customer to go to an actual physical store," Szkutak says, "is because he or she needs something right now, this minute."


Some analysts say that providing that kind of instant gratification is something Amazon should consider. Thomas Underwood, a principal in equity research in the Manassas, Virginia, office of global financial adviser Legg Mason Wood Walker, says, "They're putting all their eggs in one basket by being a pure-play online retailer. Very few companies will be successful doing that. Traditional retailers found out they can't ply just one distribution channel. Look at J. Crew, which sells apparel online, through stores and catalogs. Amazon can be successful doing things the way they do now, and I applaud its efforts to be the undisputed leader in the online channel, but eventually it will need to go multichannel."

Gartner's Sarner agrees. "Statistics indicate that someone who goes to J.Crew.com is 27 times more likely to visit a J. Crew store afterward," he says. "This is major. Only 5 percent of retail sales are online. Ultimately, retailers like J. Crew that had pretty poor Websites will catch up to the Amazon customer experience. When they do, they'll have an advantage Amazon doesn't—a store to get what you need as soon as you want it."

But Szkutak has a different perspective: "I wouldn't expect us to go multichannel, in the traditional sense, with our own physical stores." But, he adds, partnerships may come into play. Already, ties with Borders Books and Circuit City allow customers to buy a book or TV online and then do an in-store pickup. Brynjolfsson concurs: "I don't see them needing to have a brick-and-mortar presence, although I do see them partnering with such firms extensively. Why invest in brick and mortar when there are other ways to offer an offline presence?"

"Other ways" would, in fact, make for an apt slogan for Amazon. "Back in 2000, everyone assumed Amazon would open distribution centers for every product it sold," says Goldman Sachs's Noto. "Now we know that in some businesses it wants to be the principal capturing all the reward, and in others it wants to be the agent getting a smaller piece of the pie." In apparel, for example, Amazon found a way to sell other companies' apparel using its technology infrastructure and the partner's supply chain.

Beyond the third-party deals are other new concepts, like the Amazon Services subsidiary, which sells a turnkey, outsourced E-commerce product incorporating Amazon's recognized shopping features and technology. "I think it's brilliant actually," says Patti Freeman Evans, an analyst at Jupitermedia Corp. "They realize that there are hundreds of thousands of independent small businesses out there that don't have the technology or resources to launch their own E-commerce platforms."

But for every brilliant move Amazon makes, observers point to something in its current business model that causes concern. Will tax policies change and chill the growing ardor for online shopping? Can Amazon continue to provide free shipping plus low prices? What about its slow acquisition pace, or the brand impact of allowing virtually anybody to sell almost anything (other than pornography, offensive material, and guns) through Amazon Marketplace?

As Amazon begins its second decade, few observers doubt that it will continue its online dominance in the categories that spawned it: books, CDs, and videos. And even those analysts who have concerns readily admit that the company has made history. "I can go up to any person in the street and ask if they've heard of Amazon.com," Underwood says, "and they'll almost certainly say yes. That's incredible. Amazon did in a decade what Macy's did in a century." But, he adds, "Amazon is in a very competitive battle with these other major sites, and it is way too soon to declare a winner."

Russ Banham is a Seattle-based writer.

All Things 'R' US

Veteran Web shoppers may have noticed something odd: visit Toysrus.com, Target.com, or Borders.com and you'll see a site that looks an awful lot like Amazon.com. The resemblance varies from one retailer to another, but no matter how you slice it, Amazon.com is a ubiquitous if ghostly presence. The reason stems from what Mark Stabingas, Amazon's vice president of worldwide business development, dubs a "change of mind-set" circa 2000, when the company began offering its technology service and E-commerce expertise to third parties.

First, the company accommodated third parties such as used-book sellers. Then, in a well-publicized move, it stepped in when Toy "R" Us had problems with its homegrown E-tail effort and provided the company with an E-commerce backbone. The next milestone came in October 2001, when Amazon provided department store Target with a similar backbone but allowed Target to entirely control the look and feel of its Website.

The Target deal is a high-profile success for Amazon's Amazon Services subsidiary, a $1 billion effort that essentially falls into two categories: Merchants@amazon.com and Merchant.com. "Merchants@amazon is a merchandising relationship designed to open up an incremental sales channel to retailers that want to access our tens of millions of customers," explains Stabingas. "A good example is Gap or Nordstrom. You can click on either one in our apparel section and buy online from these stores. They are the seller of record handling the fulfillment, and we earn a commission on each sale."

Target falls into the other category, Merchant.com, in which the retailer controls the look and feel of the site while letting Amazon handle technology services, fulfillment, and customer service. The revenue model also is different. "Suffice it to say we have a variable revenue model for Merchant.com, in which the revenue varies depending on the sales recorded," says Stabingas.


Amazon won't disclose revenue from either model or even supply the number of seller relationships. "What I can say," Stabingas says, "is that at the end of the day, what we're selling is the same, whatever the model, and that is the Amazon customer experience."

E-Business: They Wrote the Book

Amazon.com's 10-year climb to profitability offers lessons that many companies should take to heart, including:

Focus on the long term. "One of the things that was striking on my visits to Amazon was the attention their management paid to long-term value," says Erik Brynjolfsson, a professor at MIT's Sloan School of Management. "There were a number of options they had which would have boosted short-term profits, such as raising prices slightly or modifying their logistics, or not 'investing' in new product categories, but that would hurt their long-term efforts. In numerous separate conversations with different managers, they consistently were interested in the long term, not just making next quarter's numbers. That's something I don't often see at other companies I visit, and clearly it comes from the top."

Truly understand your customer. Much lip-service is paid to customer service and related disciplines, but Amazon builds customer commitment into everything it does. CFO Thomas Szkutak says Amazon has consistently begun with the customer experience in mind and worked backward to create the infrastructure needed to satisfy customer demands.

Balance focus with flexibility. Amazon hasn't gotten everything right, but it's been quick to identify mistakes and capitalize on changing market opportunities. As a result, it evolved from a store to a mall to a virtual construction company—or, more accurately, a hybrid of those. More changes are in store as E-business competition intensifies, but all of Amazon's course corrections have been made with a single guiding vision in mind: providing customers with easy access to anything and (almost) everything online.




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