Will Amazon.coms Growth Strategy Work?

It was a statement unusual in its candor. Cornell Williams, Vice President and Chief Technology Officer for Gap Inc. Direct, the online division of apparel retailer Gap Inc., was at an e-tailers conference in mid-2003 when he was asked about his companys decision a year earlier to sell clothing through Amazon.com while maintaining its own retail Web site. "When I go to Amazon, Im not looking for apparel," Williams told attendees. "Right now, the Amazon relationship does not have a primary revenue impact [on the Gap]."

Odds are, thats the last thing Amazon.com Inc. management wants to hear. The company that debuted eight years ago as an online bookseller and became the Webs paradigmatic retailer is in the midst of a difficult transition that has gone mostly unnoticed. With its book and CD sales beginning to slow and international expansion peaking, Amazon is quietly trying to transform itself into a technology company, a portal and infrastructure provider for would-be e-tailers.

Its a difficult gambit that represents an intriguing disconnect between a central tenet of Amazons growth strategy and the general view of Amazon that has driven its stock this year to levels unseen since the dot-com crash. While Amazons top executives, led by CEO and president Jeffrey Bezos, contend that Amazons future depends on signing up more and more third-party retailers to sell products through Amazon.com, most analysts have ignored this plank of Amazons platform. Instead, theyve staked their buy ratings on the notion that Amazon is still a sexy, fast-growth e-tailer, even without third-party partners. Whether Amazon will be able to live up to either the internal or external expectations is an open question, but the attempt will go a long way toward finally addressing a larger issue: What does it take to make money online?

"Amazons having an identity crisis," says Carrie Johnson, senior analyst at Forrester Research Inc. "Which is not to say that they wont overcome it. What they look like is up in the air."

A close examination of Amazons numbers hints at how tough it is to sustain profitability as a pure-play e-tailer and why the company is taking a different course. While Amazon had operating earnings of $52 million in the third quarter of 2003—its first operating profit in a quarter that doesnt include the holiday season—it was a muted accomplishment. Once interest payments of $30 million on a $2-billion-plus junk bond offering at the height of the dot-com boom are subtracted, Amazon is left with just $22 million in profits on revenues of $1.1 billion. And even those slim earnings required that Amazon stifle spending on marketing, technology and content, setting budgets in these essential categories at virtually the same levels as the previous year. Some of this was easier to swallow because of smart cost- containment decisions: A couple of years ago, Amazon switched to Linux as its primary architecture. Since then, Amazon has lowered technology expenses by about 20 percent, according to a report by Forresters Johnson. But many of the cost cuts that Amazon has undertaken to ensure profitability are not choices an expanding business usually makes.

When did Amazons earnings ever have much to do with its share price? To view a chart click here.

"Online retailers have had to cut back their spending appetites in order to find a way to sustained profitability," says David Fry, president and CEO of Fry Inc., which designs and manages e-tailer Web sites. "That means they cant do everything they once thought they could do when budgets seemed limitless."

Next Page: Amazon cuts sales growth even though it is number one in brand recognition and customer satisfaction.