The New Wal-Mart?

With a critical mass of customers, a powerful brand and a knack for leveraging web technology, Amazon is making good on its early promises.

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When Amazon.com Inc. was born on the web in 1995, selling books out of Jeff Bezos’s garage, its name was decidedly out of proportion to its size. But it reflected Bezos’s ambitions for the company and today, nine years later, few dispute that Amazon is living up to its namesake river. It accomplished in eight years what it took Wal-Mart Stores Inc. 20 years to achieve—$5 billion in annual sales—and its future is nothing but up, analysts and consultants say.

To Amazon’s management team, though, the company is just getting started. “We want to be the biggest mass merchant on the web,” asserts Jason Goldberger, who as senior category manager plays a lead role in building out Amazon’s retail strategy.

Amazon already is the biggest, with well over 10 million SKUs at Amazon.com and sister sites around the world, 38 million unique visitors every month and $5.3 billion in 2003 net sales, up 36% from 2002 net sales of $3.9 billion. It is nearly double the No. 2 Dell Inc., which sells $2.8 billion worth of computers and equipment via its web site, and more than twice the size of No. 3 Office Depot Inc. with $2.6 billion But that’s not enough. “We want to be even bigger,” Goldberger says.

Amazon plans to continue its growth through a number of initiatives. It’s offering more products of its own with more special sections dedicated to such diverse categories as sports equipment, jewelry and gourmet food. It continues to build and improve its merchant associates or affiliate program, through which 900,000 web sites send leads to Amazon. It is expanding its relationships with other retailers, hosting products from thousands of other merchants, including more than 500 in its Gourmet Foods section alone. It provides the online operating platform for major retailers including Toys R Us Inc., Borders Group Inc. and Target Corp. And it’s encouraging free use of its web services development kit to help retailers and other web site operators link to Amazon and analyze its customer transaction data.

These multiple strategies, retailers and analysts say, are bringing Amazon hordes of shoppers and incremental sales. “America is shopping at Amazon.com,” says Sam Taylor, vice president of e-commerce for apparel retailer Lands’ End, a division of Sears, Roebuck and Co. which has a presence at Amazon. “At Lands’ End, we want to be wherever customers shop.”

And it isn’t only America that’s shopping Amazon. The company’s sharpest growth is coming from its four sites outside of North America, which serve the U.K., Germany, France and Japan. Combined net sales at those four sites grew 71% last year to $2 billion, up from $1.17 billion in 2002. That growth amounted to nearly four times the 18% increase in U.S. and Canadian sales, which rose to $3.3 billion last year from $2.8 billion in 2002, and will provide Amazon with an important source of revenue to help maintain its competitive strategies in the U.S., analysts say.

But analysts point out that Amazon faces challenges as it continues to grow. As it adds products and categories to move further beyond its initial core of books, music and videos, for example, it faces higher operating costs in such areas as fulfillment and marketing. It faces growing competition from web portals and shopping comparison sites as a source of online selling space. Although its platform services business is growing revenues and producing solid margins, its development in this area depends on the success of the merchandising skills of its client merchants. And as it works with thousands of outside developers who are using its technology to link retailers to it, Amazon must absorb growing expenses related to maintaining a base of computer scientists and merchandise experts.

Amazon lists in its financial statements filed with the Securities and Exchange Commission 24 “significant” wholly-owned subsidiaries, including foreign-based web sites, fulfillment services, e-commerce platform services for other retailers and a movie database. “Our biggest concern is that management might invest in too many new businesses—and that one or more of them might flop,” says Joseph Beaulieu, senior stock analyst at investment research firm Morningstar Inc., in a recent report on Amazon.

So far, Amazon hasn’t stumbled, analysts say. It just completed its first year of net profits, a trend analysts expect to continue. It posted net profit of $35 million on net sales of $5.3 billion for the year ended Dec. 31, 2003, compared to a net loss of $149 million in the prior year. Amazon’s operating expenses grew 6% to $986.6 million last year from $928.5 million in 2002, led by a 21% increase in fulfillment costs. Expenses related to marketing and technology infrastructure declined slightly, while expenses rose related to general administration and stock-based compensation. Amazon says it expects to continue investing more in personnel, including computer scientists, which may offset savings in technology and other costs.

It finished last year with a surge in financial performance, as Q4 net income rose year-over-year to $73 million from $3 million, on a 36% rise in net sales, to $1.9 billion from $1.4 billion.

Still, reaching Amazon’s full potential—whatever that may be—will require a lot of work, analysts say. For all of Amazon’s success so far in expanding its product lines through direct sales as well as through alliances and servicing deals with other retailers, the online behemoth has taken a relatively small step beyond its initial roots of selling media products.

The majority of Amazon’s direct sales are within its initial category of books, music and videos, where Amazon reports sales of $4 billion, 77% of all worldwide revenue. “Amazon is still working on changing its image from just a place where customers can buy media,” says Safa Rashtchy, stock analyst who follows Amazon for Piper Jaffray & Co. “Certainly it has succeeded somewhat, but it still has a long way to go.”

When Amazon launched in the summer of 1995, Bezos and company started out modestly with a single product category, books and CDs, which were easy to get consumers to buy online since they weren’t high-touch products and because their small size made them easy products to fulfill. Such a beginning afforded Amazon the opportunity to build up its expertise in fulfillment before taking on more complicated product categories like sporting goods and consumer electronics.

Dozens of categories

That start-small approach gets good reviews from analysts who say it gave Amazon the time to build up its expertise and brand. “Amazon did things right and kept building its brand, while it managed to not disappoint customers too often,” says Paula Rosenblum, director of retail research for research and consulting firm Aberdeen Group Inc. “Now they have a huge base of customers and top-of-mind awareness.”

She notes that Amazon has shown consistency in providing a solid online shopping experience through personalized cross-selling, customer service and low prices. In fact, Amazon ranks as No. 1 in the American Customer Satisfaction Index for retailers created by ForeSee Results Inc., with a score of 88 of 100. E-retail in general earns an 84 in the index.

With a strong brand and equally strong reputation for customer service, Amazon has put itself in a position to build out more product categories, analysts say. And that’s exactly what it’s been doing. It now features dozens of category-focused online stores, including Apparel, Toys, Books, Electronics and Jewelry and Watches, along with some still in beta test mode, Sports & Outdoors, Gourmet Food, and Health & Personal Care. Its Sports & Outdoors category alone offers 3,000 brands covering 50 sports.

Amazon keeps its plans for rolling out new categories close to its vest and it reports revenues only for broad category segments. Yet it is moving beyond its initial strategy of selling categories that have been relatively easy to source and fulfill, such as its media category. Although media accounted for 70% of North American net sales last year, it grew at half the rate of other category segments for which Amazon reports sales—14% for media sales vs. 29% for its “electronics and other general merchandise” segment.

The data snowball

Beaulieu of Morningstar notes that Amazon’s strategy for launching new product categories appears to be based on a desire to sell as many products as possible. “There must be a method there, though it’s possible they’re just moving down a laundry list of categories,” he says. “They still want to find more categories to continue driving growth.”

Amazon acknowledges that it wants to find more categories. “Our merchandising plan this year is a combination of giving our customers the widest selection of products possible at the lowest cost,” Goldberger says. But the company also asserts that it is going about this in a methodical way, using its own records of consumer shopping preferences to expand its product categories. “Customer choice and shopping behavior will help drive future category expansion,” says Glenn Cunningham, Amazon’s director of Home & Garden, which includes the new Gourmet Foods store.

In addition, the wider the variety of customer purchases, the more Amazon will make recommendations based on past shopping activity, he says. “Each customer visit and purchase improves the ability of our software to make the next customer experience that much more relevant for our customers,” Cunningham says. “For example, the addition of gourmet foods to our mix has allowed us to recommend food with the appropriate cooking vessel or cookbook.”

But as Amazon moves into new product categories, it will need to reconsider its need for promotional marketing campaigns, Rashtchy says. “They’ve been cutting back on marketing because they figured there was enough buzz about them in the market, and so their idea was to spend their revenue on free shipping for orders of $25 and over,” he says. “But they probably need to ramp up their marketing again, especially as they add categories they’re not known for.”

In its financial statement for last year, Amazon says it has willingly absorbed larger shipping costs as a form of marketing-based customer service. Although shipping revenue grew slightly last year to $372 million from $364.8 million in 2002, it declined as a percentage of sales, to 7% from 9.3%. As a result, its net cost of shipping expanded to $136.5 million from $96.9 million.

Conventional marketing expenditures, meanwhile, traveled in the opposite direction, declining to $123 million, or 2% of net sales, in 2003, from $138 million, or 4% of net sales, in 2001. “These free shipping offers reduce shipping revenue as a percentage of sales and reduce gross margins on retail sales,” Amazon says in its financial reports. But it adds: “We view these shipping offers as an effective marketing tool and intend to continue offering them.”

Adding partners

Rashtchy adds that he’s confident Amazon can hike its marketing costs and remain profitable, thanks to overall efficiencies it has implemented through its operations as well as steadily increasing sales. Despite the free shipping offers, for instance, Amazon has reduced fulfillment costs as a percentage of net sales over the past three years to 9% from 10% in 2002 and 12% in 2003, even as fulfillment net costs rose to $477 million last year, up from $392 million and $374 million, respectively, in the two prior years.

In addition to expanding its own product categories, Amazon’s long-term focus is to add partners, both to its affiliate network and to its roster of retailers who sell through Amazon’s specialized sites, such as apparel or sporting goods. Those partners will generate traffic that in turn will lure other partners, Beaulieu says. “The traffic makes Amazon.com more attractive to new partners, and more partners drive even more traffic to the site,” he says. About 10% of Amazon’s traffic comes through its 900,000 associates, or affiliate web sites, Rashtchy estimates.

A dual strategy

While Amazon creates more distance between itself and other retailers in its efficiencies as well as its scope of retail operations, it’s also working hard to build closer ties with those same merchants—a dual strategy that sets Amazon apart as both a super-sized merchant and a provider of services to other retailers—and puts it in a situation of promoting its own growth while helping its services customers and alliance partners.

So far, the dual strategy seems to be working for both Amazon and its retail clients, analysts say. When Lands’ End became one of the first retailers to open its own section within Amazon’s apparel category in the fall of 2002, its goal was to bring new customers to the Lands’ End brand and reactivate former customers. “That’s exactly what we’re seeing,” Taylor says. “About half of Lands’ End customers on Amazon are either brand new to us or reactivated Lands’ End customers.”

When Amazon launched its apparel section, some experts doubted it could succeed as a marketplace for established brands, especially since returns policies for products sold at Amazon often are different from the returns policies at the retailer’s own web site. In addition, Amazon handles order processing and customer service for many of those retailers, taking control of those crucial customer service functions out of retailers’ hands.

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But so far, the experts have been proven wrong, and many are eating their words. “I thought it was a statement of defeat when apparel retailers signed up at Amazon, but it has turned out to be a winner for all,” Rosenblum says. “Retailers are getting incremental customers, and I haven’t heard any complaints.”

Indeed, apparel retailers are getting more than just incremental sales, Taylor says, they’re getting new online marketing and merchandising ideas. He notes that Amazon has been helpful in discussing new ideas for increasing Lands’ End sales on Amazon.com, for example, studying consumer reviews of different brands at Amazon and analyzing the mix of products in Amazon shopping baskets. “Our merchants use this data to see the most popular brands among Amazon’s customers,” he says. Although he declines to specify how sales have increased on Amazon, Taylor says they’re trending at or better than expected. “We’re very pleased with the results we’re seeing,” he says.

Amazon was also helpful in providing clear instructions to Lands’ End’s IT staff on how to quickly link product and order data feeds between Amazon and Lands’ End, which handles its own customer service and fulfillment for orders placed through Amazon, Taylor says.

Amazon is also winning over smaller retailers. T-ShirtKing.com LLC, which has maintained a boutique on Amazon since the late 1990s, has found it to be a bargain for tapping into a broad customer base, says Bill Broadbent, founder and CEO, noting that a small retailer can expect to pay under $40 per month to merchandise products on Amazon. “You could spend $10,000 and not get a better shopping cart,” he says.

Cross-selling opportunities

Broadbent says a big advantage of listing products on Amazon is the cross-merchandising opportunities with related hot-selling products. Because T-ShirtKing’s products include T-shirts adorned with rock music groups, for example, they can experience higher sales when Amazon lists new music CDs from the same groups. He says that T-ShirtKing gets more than half of its Amazon sales through in-site searches conducted by shoppers, a process he leverages by making sure his products are linked from sections of Amazon with complementary products.

Amazon isn’t only offering real estate to other retailers, however. It is also offering its technical expertise. Its other revenue—which includes revenue from hosting other retailers’ web sites and selling its technical expertise in other ways—reached $110 million in the U.S. last year, up from $85 million the previous year. That revenue stream represents a diversification from retail because Amazon realizes the revenue, even if the retailer itself isn’t making money.

ToysRUs.com, which Amazon has operated as the toy category on Amazon.com since 2000, posted an operating loss of $18 million on $376 million in net sales last year, following a loss the prior year of $37 million on $340 million in net sales. But analysts say they don’t hold Toys R Us as a mark against Amazon’s overall success. “Toys are a notoriously difficult market to make money in,” says Rashtchy. “It’s not clear whether Toys R Us would have made even less money if it did its e-commerce on its own.”

50% margins

Under its agreement with Amazon, ToysRUs.com handles its own marketing and merchandising and chooses, owns and manages its inventory, while Amazon handles web site development, order fulfillment, customer service and storage of ToysRUs.com’s inventory in Amazon’s U.S. distribution centers. In spite of ToysRUs.com’s losses, Amazon still earns revenue and profits from its arrangements with Toys R Us and other merchants, including Borders and Target. “Its services division is generating 50%-plus gross margins and growing rapidly,” says Beaulieu.

ToysRUs.com is satisfied with its Amazon alliance and has a services contract that extends to 2010, a spokeswoman says. Target, which has a similar arrangement with Amazon to operate its TargetDirect.com site for Target, Marshall Field’s and Mervyn’s brands, is also satisfied with its deal and recently extended it by two years to 2008.

But even the strength of Amazon as both a retailer and services provider must bend to market forces in e-commerce, where it has more competition as a provider of large amounts of online traffic. So while it has been building a reputation for providing sound e-commerce technology and services as well as consumer traffic, it has also begun to solidify its deals with other retailers by offering more flexible terms, analysts say. In earlier years, when companies would pay a premium for Amazon’s web traffic, Amazon charged higher fees, analysts say.

In revenue-sharing arrangements with partners like Toys R Us and Target, it would charge 10-30% or more of sales depending on volume, Rashtchy says. “Now times have changed and Amazon is being more flexible,” he says, noting that fees now usually run under 20%.

Terms can vary widely, however, based on the type of products sold and the volume of sales. For smaller sellers who list goods through Amazon Marketplace, Amazon typically collects 99 cents per item sold, plus a percentage of the selling price: 6% for computers, 8% for electronics, cameras and other photographic equipment, and 15% for all other items. Amazon waives the 99-cent fee and offers additional listing services for high-volume sellers, or Pro Merchants.

For marketing deals offering sales leads from Amazon.com to other web sites, Amazon has also cut its fees to about $1 per 1,000 clicks from about $10, Rashtchy says.

These cuts serve to reduce Amazon’s margins and, in effect, place downward pressure on its stock price, he says. “Margins are the single biggest metric for Amazon, that’s what everyone in the investment community looks at,” Rashtchy says. “That’s why its stock price has been under pressure.”

The push into technology

Nonetheless, Amazon can be expected to continue investing in competitive pricing and customer service, analysts say. And its stock price, trading recently in the mid 40s, down from a 52-week high of 61 but 65% above where it was a year ago, should remain fairly stable because of its expected ability to keep producing net profits. “We expect them to stay profitable,” Rashtchy says.

Amazon isn’t only relying on its critical mass of consumer traffic and a focus on customer service to keep expanding its market. True to the vision started by Bezos to leverage the unique properties of the Internet, Amazon is aggressively moving into web services technology to make it easier for alliance partners not only to link to Amazon.com but also to gather and analyze product and pricing information from its databases. Web services use open Internet-based standards like XML to build software tools that can automatically retrieve and transfer data among software programs and databases, even disparate ones.

“Before web services, if associates wanted to link to Amazon products, they had to go through laborious product searches, construct a URL to link back to our site and download data,” says Jeff Barr, Amazon’s technical program manager for web services. “Now they can use web services to automatically query Amazon.com to find relevant products for particular categories they want linked to their sites. And they get richer information, like product descriptions and prices set by all sellers of that product on Amazon.”

Better customer experience

Barr notes that thousands of programmers have downloaded Amazon’s free web services developer’s kit for building such tools. Development firm Monsoon LLC for instance, is helping retailers who sell products on Amazon’s international sites to automatically gather data that show how well products sell at different prices in different markets, says Kanth Gopalpur, president of Monsoon. “Many companies are afraid to provide access to their back-end data, but Amazon sees not potential harm but the benefit of bringing data to customers,” he says. “It can make the customer experience a lot better.”

Customers in this case are both the retailers who use web services to link to Amazon and the consumers who eventually purchase products, because both benefit from accessing and viewing more information about products being sold on Amazon, Barr says. Web services are a continuation of Amazon’s strategy of leveraging the Internet to serve consumers as well as other retailers, he adds. “Providing more product information to sellers and giving consumers more information to make better purchasing decisions help to reach an optimal situation to conduct a sale,” Barr says. That, in fact, could be a summary of the Amazon approach.

paul@verticalwebmedia.com

Swinging for distance: Why Golfballs.com sells on Amazon

Tom Cox doesn’t have the same ambition for his web site as Jeff Bezos has for his. Cox’s Golfballs.com had $4.5 million in sales last year, equal to about 8 hours of selling at Amazon.com. But that doesn’t mean they can’t do business together. In fact, Golfballs.com was one of the first sporting goods retailers to sign up to sell in Amazon’s Sporting Goods store. “Buyers associate Amazon with great service and trust, so it’s like having an association with the Better Business Bureau in terms of credibility with Internet buyers,” says Cox, Golfballs.com’s CEO.

Golfballs.com started in 1996 selling used golf balls. But as the Internet matured so did online shoppers and Golfballs.com expanded its inventory. Today, Cox refers to Golfballs.com as a virtual pro shop, offering everything from golf balls (only new ones now) to golf shoes. He operates with 20 employees. 2003 sales were up 25% from 2002.

He attributes a good part of his success to his relationship with Amazon. While some retailers would characterize that relationship as a marketing one, Cox says it goes beyond marketing, especially when compared to shopping portals and comparison sites where Golfballs has a presence. “It’s tough to characterize our relationship with Amazon as part of our Internet marketing strategy, because it’s more than that,” he says. “It’s a relationship with the biggest online retailer in the world and it greatly increases our reach into the online golf-buying market.”