(MONEY Magazine) – Back in November, just as its crucial Christmas season was getting under way, Amazon.com invited reporters to its gussied-up warehouse in Fernley, Nev. We'd see the e-tailer's new distribution system and hear the case for its battered stock from CEO Jeff Bezos. But first we walked through a hotel lobby--full of slot machines. An unhappy omen for a company whose stock declined 80% in 2000.

Inside the warehouse the scene was more like a pep rally than a crap game. Addressing dozens of workers, the merry Bezos climbed a pallet and led several cheers. "Yeah, bay-BEE!" he yelled, telling his staff how sales had climbed in November and urging them to be "terrified," though resolute, about the holiday season. When his speech ended, employees approached and asked him to sign their T-shirts. Autographing several with a magic marker, Bezos also inscribed them with his longstanding mantra: "Customers rule!"

If only it were so. Actually, shareholders rule, and they vociferously declared in 2000 that they were sick of financing Amazon's relentless growth without evidence of future profits. Where investors once saw only opportunity, they now saw only risk. In fact, there's plenty of both--which makes the stock, at around $18 as of Jan. 30, an intriguing rather than an outlandish bet.

The Christmas season was a big test for Amazon. Christmas 1999 had not been a success: The company ordered too much merchandise, saw its gross margins shrink to 14% and lost its mystique. It had to write down $39 million worth of inventory. In June, Lehman Bros.' Ravi Suria, who tracks convertible bonds, frightened Amazon stockholders. He called its credit flimsy and pointed out that the company had raised 95[cents] in the securities markets for every dollar of goods it had sold, suggesting that investors, rather than customers, had been keeping the company afloat. Perhaps even more damaging, he tagged the company "a normal retailer," when bulls were counting on a revolutionary profit machine.

In January, Amazon was showing a grimmer face than Bezos projected in November. Amazon's holiday performance was respectable. Fourth-quarter sales totalled $972.4 million, 40% above 1999's fourth quarter, and it finished the year with $175 million in inventory, 20% below last year's figure. It had $1.1 billion in cash on hand. But it clearly expects a tough 2001. It is cutting 1,300 jobs, or 15% of its workforce, and closing a Georgia warehouse (one of eight nationwide) and a Seattle customer service center. The company, which had anticipated sales growth as high 40% this year, to $4 billion, is now aiming for a 20% to 30% gain, to no more than $3.5 billion or so. Yet in an apparent bow to Street impatience, Bezos says he expects Amazon to show its first overall operating profit in the fourth quarter of this year--a departure for a company that had never seen the need to make such predictions.

Surviving Christmas wasn't Amazon's only goal. From the beginning the company has sought to prove to investors that it's not just an electronic retailer but a nimble selling juggernaut that can use the special qualities of the Internet to become a new kind of agent or broker in whatever commerce the Net permits. So can that ambitious vision be achieved, or is it just wishful thinking?

Smart moves

Along with getting packages out the door, Amazon took many steps in 2000 toward meeting that vision. It salvaged its toy store by linking with Toys R Us, added several other merchants and began selling a vast range of products, from kitchen gadgets to table saws. And it created loads of new features on the site aimed at encouraging customer interaction and additional purchases: software programs that allow customers to find whatever they want, receive product recommendations, comment on purchases, record occasions for gifts and even sell used items. (The technology was developed by small firms, including Accept.com and PlanetAll, which Amazon bought with its rich stock in 1998 and 1999.)

So far these gimmicks have worked. Features like the Wish List--which Amazon says has drawn some 4 million users since late 1999--and The Page You Made helped to boost sales 68% and build traffic last year. In mid-1999, Amazon's average active customer spent $108, according to the Precursor Group, a market research firm. Now that number has climbed to $134, says Bezos.

Amazon also appears to be improving its distribution. The company upgraded its U.S. warehouses in 2000 and is apparently gaining leverage with its suppliers too. With 30 million customers, its sales volume is now high enough that it can buy directly from each major record label, book publisher and studio, and get more favorable terms, contends David Risher, Amazon's senior vice president for retail: "The gap between what the customer pays and what we pay is getting better." That has allowed the company to regularly report operating profits on book, music and video sales, the areas the company has the most experience in. "We know more now," says Bezos.

Bulls still believe

Many analysts and money managers believe Amazon is on the right track. "This is still a huge opportunity," says Lisa Rapuano, director of research at Legg Mason funds. Rapuano sees a "very bullish sign" in the fourth-quarter sales jump: She says customers, not pundits, will make this company fulfill its promise. And Precursor Group president Bill Whyman points out that the data Amazon has collected on its customers' preferences put it on the right track for growth. "No one else has a deeper, richer customer profile," he says, "and that separates the winners from losers."

Others agree. Paco Underhill, a consultant and the author of the bestseller Why We Buy, says that Amazon's "customers rule" philosophy can make the site a hub of "gifting," one that consumers trust and revisit often for their shopping needs.

Even skeptical analysts concede that Amazon's clever software programs, which prod customers to buy, can be quite cost-effective. If Amazon can use its software, rather than deep discounts, to induce you to buy a video game with your next paperback, it will save money. And bulls praise the company's alliances, such as the recent one with Toys R Us that exploits both Amazon's size and software. (The older retailer owns Amazon's toy inventory and pays Amazon a fee for acting as its Web presence, plus a piece of each sale.) Some experts believe this venture could provide a template for future deals. Says investment banker Gary Lutin: "If they can do more of that, that's real economic efficiency."

Yet for all this optimism, many investors still grade the company incomplete. Few people can calculate how Amazon's current business model leads to long-term growth of the stock. They mistrust Amazon's financial reports that don't break out results for separate product lines, and they question its strategy of becoming an online superstore. Lehman's Holly Becker is unimpressed with the growth of many of the company's smaller stores and isn't sure it should ever have started selling tools or phones. "I don't think the newer businesses will ever have acceptable margins or returns," she says. Lehman's Ravi Suria is even more skeptical. Profits? Maybe, he says; but only if the company can lower its costs by 20%.

A stock built on hope

Many experts are also concerned about the company's margins. Amazon's sundry new stores make year-to-year comparisons imprecise at best. The company posted fourth-quarter gross margins of 23%, and its operating loss was 6% of sales, compared with 26% in 1999's fourth quarter. That still makes Amazon a company with a $6 billion-plus market cap that has yet to earn a penny. Bezos' baby still burns through capital each day instead of creating it. And whatever comfort investors might take from the promise of fourth-quarter profits may evaporate when Bezos talks, as he did on Jan. 30, about using the U.S. market as a source of funds for overseas expansion.

So this stock remains one built on hope. To invest in it, you have to believe that Amazon is creating and mastering a whole new way of doing business, that after this build-out phase, profits will start flowing, and that the company will defy all conventional models. But even the best technology can't make the company immune to the fads and pressures that plague merchandisers. Gap's price-to-sales ratio is 2.1 and Wal-Mart's, 1.3. Assume Amazon, a discounter, gets a premium for its technology. In a perfect world, at a 1.5 price/sales ratio with 25% annual growth, the stock would reach around $35.34 in five years (assuming it issues no new shares). That may seem like a reasonable gain, but there are many things that could interfere with and derail Amazon's rise. "Retailing is one business where you never win the war," warns Suria. "You are refighting it every December."

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