NEW YORK (CNNfn) - In "Through the Looking-glass," the White Queen explains the rule is "jam tomorrow, jam yesterday, but never jam today." Alice protests: "It must come sometimes to 'jam today,'" but the Queen replies "No, it can't. It's jam every other day: today isn't any other day, you know."
Lewis Carroll could have been writing about Amazon.com's attitude toward attaining a profit. Traditional retailers made profits in the past, and Amazon will make them in the future, but never profits today. Amazon's chairman and CEO, Jeffrey Bezos, has chosen to place investment in future growth ahead of current profits, essentially following the philosophy that one needs to spend money to make money.
Last year alone, Amazon made $318 million in capital expenditures, much of which went to build five new distribution centers in the U.S. The Web retailer now has 3.4 million square feet of warehouse and distribution space in the U.S. and another 700,000 square feet in the U.K. and Germany, bringing the company closer to the bricks-and-mortar world than the virtual world of the Web.
"They really layered in a whole lot more infrastructure, so now they have to be even larger to break even," said Dan Ries, an analyst at C.E. Unterberg Towbin. "That may prove to be one of the smartest moves ever, but that won't be clear for three or four years. As big as they are, Amazon is still operating below critical mass."
Investors in Wonderland were satisfied with Bezos' approach last year, sending Amazon's stock from about 20 in October 1998 to about 106 in December 1999, at which point the company had a market cap of $37 billion - about four times what Sears Roebuck & Co. is worth, even though Sears has annual sales above $41 billion and makes a profit.
This year, however, investors started to question the White Queen and showed a desire for jam today. Amazon's stock has declined to 31 from around 89 at the start of this year. The company also has about $1.9 billion in debt outstanding, which Standard & Poor's has assigned the dismal rating of CCC-plus, considered a "low junk" grade, and Moody's has given a Caa3, three notches up from the lowest rating on its scale
In a scathing 28-page report issued in June, Lehman Brothers analyst Ravi Suria said that while Seattle, Wash.-based Amazon has distinguished itself as one of the best-established brands in business-to-consumer electronic commerce, "from a bond perspective, we find the credit extremely weak and deteriorating."
Better use of infrastructure is key
A brief look at the company's financial report for the quarter ended June 30 shows how far Amazon has to go before it attains a profit. The company had sales of $578 million and paid its suppliers $442 million for the cost of the merchandise it sells, leaving it with a gross profit of $136 million, or 23.5 percent of sales. From that amount, deduct the $130 million Amazon paid for marketing, sales and fulfillment expenses. Then subtract $67 million for the cost of the technology and content that goes into Amazon's massive site and $28.5 million to cover the company's administrative expenses. The result is an $89.5 million loss before Amazon pays any of the interest on its bonds.
C.E. Unterberg's Ries estimates that Amazon will have to increase its customer base to 35 million people from the 22.5 million it had at the end of the second quarter just to break even. Assuming a moderate increase in gross margins, the Web retailer will need to receive 24 million orders per quarter to cover its overhead costs, up from the 13.5 million purchases per quarter Amazon customers make now.
Still, many securities analysts - including Ries -- say the embattled Web retailer can make a profit if it makes several changes to its business. Most importantly, Amazon needs to make better use of the substantial warehouse and distribution center infrastructure it has built over the past year. Amazon is building a distribution network designed to handle $8 billion to $10 billion in annual revenues; yet the company is expected to have revenue of only $2.7 billion this year.
Thus, Amazon either has to increase its revenue or lease part of its warehouse space to other retailers to be able to attain profitability, according to analysts.
Some Amazon critics believe the company should scale back what has become a far-flung empire and focus on its core businesses - books, music and videos - instead of selling patio furniture and hardware. In fact, the company's only profitable business so far has been its U.S. books, music and video segment, which accounts for about two-thirds of its revenue.
However, Wall Street analysts who study the Web retailer seem to agree that more revenue per customer is the ticket for Amazon's survival.
"They've shown that they can grow revenue and lose a lot of money and they've shown that they can improve economics, but that slows revenue growth," Prudential analyst Mark Rowen said. "They're going to have to find a balance to do both."
In the quarter ended June 30, Amazon's revenue rose 84 percent over the same period last year. However, that total was below Amazon's internal target of 90 percent growth and only $4 million higher than its first-quarter total. Twelve-month sales per customer rose by only $4 versus the previous quarter. The revenue shortfall set off warning bells in the minds of some analysts, who said that if revenue stalls, then chances of profitability could sputter, too.
"With the company running at only 30 percent to 35 percent of capacity, and given a business that scales with volume, this must be a revenue story," said PaineWebber analyst Sara Farley. "More efficient operations can only take you so far."
Role of emerging businesses
Amazon did manage to trim some spending in its second quarter, notably, on marketing and advertising, which came in below the level of a year ago and as much as 5 percent below some analysts' forecasts. Marketing, sales and fulfillment costs declined to 22.5 percent of revenue from 27.4 percent in the same period a year ago. While that reduction helped the bottom line, it also may have constrained revenue growth.
"It appears that to help save the bottom line, the company held back on some marketing expenses," Banc of America analyst Tom Courtney said. "While this spending reduction may have helped lead to a smaller-than-expected loss per share, it may have also contributed to the slowing in revenues," he said.
Revenue from Amazon's core books, music and video segment actually dropped 4 percent in the second quarter from the first quarter. International sales remained flat around $75 million. However, revenue from the company's "early-stage" businesses, such as electronics, rose 23 percent from the first quarter of this year.
"It is becoming quite clear that the maturing nature of the U.S. books and video segment puts increased pressure on Amazon's International and Early Stage business segments to be the driver of Amazon's revenue growth going forward," US Bancorp Piper Jaffray analyst George Konezny said in a recent research report. "If Amazon were to achieve total revenue this year of about $2.75 billion, we estimate that for Amazon to achieve 50 percent growth in 2001, the International and early stage business segments would need to nearly double in size, while the U.S. books and video segment would have to grow about 25 percent."
Leasing space to others
Leasing warehouse space to other retailers is another way to attack the overhead problem, analysts say. Sure, Amazon now has warehouses or distribution centers across the country: Seattle, Delaware, Kansas, Georgia and Nevada, to name a few -- but does it really need all that space?
"They already, in a sense, lease space on their home page to others, such as Drugstore.com and Pets.com, so they're willing to sell access to their customers to others," said C.E. Unterberg's Ries. "So, it seems to me that they'd be willing to sell access to their distribution centers."
Leasing distribution capacity to its partners also would help Amazon protect the value of its brand name, Ries said. When Amazon allows another Web retailer to appear on its homepage, Amazon has an interest in ensuring that the other company's customer service is top-notch. Selling the other company access to Amazon's distribution facilities helps achieve that objective, he said.
Problems with partnerships
Another concern that Amazon needs to address is its partnerships with other e-tailers that comprise the Amazon Commerce Network. Firms such as Drugstore.com and Ashford.com rent space on the Amazon front page, thereby deriving traffic from Amazon's base of more than 22 million customers around the globe.
Based on Amazon's second-quarter comments, it appears that these companies aren't seeing the added traffic they had hoped for and have had to spend considerable sums to acquire new customers. Banc of America's Courtney estimates that Ashford.com's customer acquisition costs from its contract with Amazon are above $1,000 per customer. Amazon itself pays about $17 to acquire a customer.
Because of the bad results from those contacts, companies that belong to the network might not renew their agreements. While Amazon warned analysts about a possible decline in revenue from the Amazon Commerce Network, it didn't explain what it plans to do to improve the situation.
"This is actually a really big deal because in Amazon's earnings, about $24 million in gross profit comes from the commerce network," Courtney said.
To make matters even worse, Amazon invested money in several members of the commerce network. The general decline in the market value of e-commerce stocks is likely to have slashed the future value of those investments, analysts say.
"The company faces market value risk in the shares it holds in its partners as well as collection risk on long-term contracts," PaineWebber's Farley said. "This quarter, those risks began to be realized."
The bottom line
So where does this leave Amazon? Can it pull a virtual hat trick - expand revenue, make better use of its infrastructure, and revamp its commerce network? The company certainly believes it can, and has been saying that it will report profits sometime next year.
"They've got to show the Street and they've got to do it themselves, to get the stock going again, that their growth rate this quarter was an anomaly, not the start of a different trajectory for the growth of the company," C.E. Unterberg's Ries said. For his part, Ries projects that Amazon will become profitable in the fourth quarter of 2001.
Analysts struggle to see the Amazon glass as half full, and point to the all-important fourth quarter, when Christmas wish lists turn into volume dollar signs. In addition, Amazon has reduced its projected capital spending for this year and technology costs as a percentage of revenue are likely to decline in the future also.
"Has Wall Street paid too much for Amazon? Investors bid the stock up too much in anticipation of it growing faster than it's going to grow," Courtney said. "But if Amazon keeps executing and making progress in keeping costs down, it can still work."