August 27, 2008, 12:00 AM

Advantage: Amazon

How long can Amazon continue to deliver a winning strategy? And what can competitors do to counter it?

Amazon.com Inc., already the dominant online retailer with more than double the 2007 web sales of its nearest competitor, is widening its lead. Its sales last year grew at nearly double the rate of U.S. e-commerce-38% vs. 22%-and in the first half of this year Amazon’s North American web sales grew by 33% while online retail as a whole grew by only 12%, according to comScore Inc.

Several factors drive this growth. They include Amazon expanding into new categories beyond books and music-more than a dozen in the past year. The e-retailer’s free shipping offers and low prices encourage frequent purchases by 81 million active Amazon shoppers. And thousands of other retailers are helping expand Amazon’s selection by selling on Amazon-even though it means paying a commission and handing over customer data to a competing e-retailer.

“They are a formidable competitor,” says Mark Carson, president and co-founder of Fat Brain Toys, which generates 30% of sales through Amazon. But, he adds, “They realized several years ago that it was impractical for them to sell everything to everyone. So instead of trying to mine all the gold themselves, they decided to sell a few picks and shovels.”

Those picks and shovels include a variety of services Amazon offers partner retailers, such as handling payment and fulfillment. But the biggest lure is the opportunity to reach Amazon’s massive customer base.

The risk to these partner retailers, though, is that Amazon becomes more powerful with each retailer that adds its stock to the Amazon platform, and with each new customer attracted to make a purchase through a retailer selling on Amazon. Those customers become Amazon customers, as retailers selling on Amazon agree that only Amazon can send follow-up marketing e-mails to customers who make purchases at Amazon.com, even if it’s a third-party retailer fulfilling the order.

In short, Amazon has created its own virtuous circle: more customers coming to Amazon make it a more attractive platform for other merchants, while more merchants selling on Amazon lead more consumers to start their shopping at Amazon.com.

Add in Amazon’s low prices, personalized recommendations, free shipping and strong reputation among consumers and it’s easy to see why Deutsche Bank analysts Jeetil Patel and Herman Leung recently concluded that Amazon “has built highly defensible elements into its business model.”

That poses a tough question for other online retailers: Do they recognize Amazon’s growing strength and sell through Amazon, even at the expense of paying a commission-typically 12% to 15%-and missing a chance to add to their customer mailing lists? Or do they try to differentiate themselves from Amazon, and, if so, how?

There are ways to compete with Amazon, observers say, although they may not be cheap or easy. What’s more, one of Amazon founder Jeff Bezos’s central precepts is to have “a bias for action,” and Amazon is moving aggressively to shore up any weaknesses with acquisitions and new technology.

A position of strength

For now, it is Amazon that is on the offensive, moving into new categories rapidly with cut-rate prices. “Our pricing strategy is very simple,” chief financial officer Thomas J. Szkutak told analysts earlier this year. “We are going to make sure we have great low prices for customers.” A spot check by Internet Retailer of three products-a best-selling book, a kitchen appliance and a computer printer-showed Amazon was cheaper than major online competitors in each case, by from 3.7% to 31.9%.

That low price strategy doesn’t always sit well with investment analysts, who often question Amazon executives about why they don’t raise prices to boost profit margins. But Amazon clearly is bent on attracting customers with low prices, even if it means forgoing some profit for now, says Colin Sebastian, a stock analyst who covers Amazon for Lazard Capital Markets.

“They’ve chosen volume growth instead of better financial leverage and operating margins,” Sebastian says. “And long-term that may turn out to be the right strategy.”

With Amazon’s sales growing faster than e-commerce as a whole, Amazon made up more than 10% of U.S. online sales in the first half of the year, compared with 8.9% last year and 7.9% in 2006. Analysts often compare Amazon’s growth to that of eBay, because both are increasingly shopping platforms for other merchants. While Amazon’s sales grew 33% in the first half of this year, the dollar value of merchandise sold on eBay rose only 10%.

Free shipping

Amazon’s free shipping offers are a big part of the company’s success, some analysts believe. The company’s Amazon Prime program, which offers consumers free two-day shipping on every order for $79 per year, has been an “overwhelming success,” say Patel and Leung of Deutsche Bank.

While Amazon, which has a reputation among analysts for revealing as little data as possible, has not said how many consumers have signed up for Amazon Prime since it was launched three years ago, there are clues in the company’s financial reports.

Amazon’s spending on shipping-which includes shipping to Amazon Prime customers, Amazon’s Super Saver offer of free standard shipping on any order of $25 or more, and its Fulfillment by Amazon program of shipping on behalf of merchants that sell on Amazon-went up 38% in the second quarter of 2008 compared with the same period a year ago. And shipping income, which includes Amazon Prime membership fees and merchant payments for Fulfillment by Amazon services, was up 22%.

Patel and Leung say the fact that unit sales growth, 32% in the second quarter, outpaced customer growth, which was 18%, means customers are shopping more often at Amazon. In short, the Deutsche Bank analysts argue, the shipping programs are changing how consumers shop, causing many to go to Amazon more frequently than before.

Loyal customers

There is other evidence that consumers are shopping at Amazon more frequently than at other major e-commerce sites. 54.3% of visitors to Amazon in June had also visited in May, compared with 41.8% for eBay, 40.7% for WalMart.com and 39.5% for Target.com, according to Nielsen Online. And the typical visitor to Amazon.com visited 3.4 times in June, versus an average of 2.6 times for the top 25 online retailing sites, says comScore.

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