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Amazon.com . . . more than a merchant

Amazon.com . . . more than a merchant

In preparation for the holiday season, Amazon.com stocked its warehouse shelves with an oversupply of books, toys and electronics. It purchased enough wrapping paper to cover 164 football fields, and enough ribbons to stretch from San Francisco to Detroit. Founder Jeff Bezos described the company's investments in four massive new warehouses as the `fastest expansion in distribution capacity in peacetime history'. The goal of the ramp-up was simple: make sure that no customer would click away from the Internet's largest store because what they wanted was out of stock.

The buildup was bold; most retailers would shy away from that kind of preparation. After all, balancing inventory and capacity needs is one of the most critical concerns for any retailer. Sure, too few products can leave customers disappointed. But overstocking is an even bigger blunder that can lead to hefty write-downs and fat losses. What's more, investors see excess inventory as poor management - and a good reason to dump a company's stock.

Amazon's disregard for the most basic rules of retailing raises an interesting question: is it really a retailer? The question is not purely academic. Over the past year, Amazon has expanded from its roots as an online bookseller into a mega-mall hawking everything from power tools to electronics and auctions. Bezos describes his company as a place where people can buy anything. At the same time, he has prided himself in confounding analysts and journalists who seek to describe Amazon in a neat sound bite.

Of course, retailing remains at the core of everything Amazon does. During the peak holiday season, Amazon sales reached a staggering $US16 million a day. But Amazon is a new type of retailer, and not just because it does business over the Internet. It has found a way to leverage its customer base, e-commerce know-how and marketing muscle not only to build its existing business but also to create new kinds of businesses.

Consider the following: over the past 18 months, as its retail operations bled red ink, Amazon acquired ownership stakes ranging from 17 to 49 per cent in six online retailers: Drugstore.com, HomeGrocer.com, Pets.com, Ashford.com, Gear.com and Della.com. According to various estimates, Amazon spent about $US160 million in those investments, which are now valued from $900 million to $1.5 billion. That means Amazon's paper gains from those investments vastly exceed, and might even double, the $559 million in losses Amazon has racked up in its five-year history. And those gains could soon soar when HomeGrocer.com and Pets.com complete their pending IPOs. (Last week, Amazon invested $60 million for a minority stake in same-day delivery startup Kozmo.com, according to sources close to the deal. Amazon refused to confirm or deny the news.)Certainly, these investments don't make Amazon a venture fund. Nor is it a holding company of the likes of Internet Capital Group, which has no operations of its own but has stakes in more than two dozen business-to-business e-commerce companies. Amazon's goal isn't to boost its balance sheet with these investments: `I'm not looking at this [strategy] as a way to get a return on our investment. That's not why we embarked on this whole program,' says Randy Tinsley, Amazon's VP of corporate development. `These [merchants] are very synergistic with our core retail business.'

But if Amazon's greatest profit potential comes not from sales but from investments, Bezos may have succeeded in creating a company that defies categorisation. The question is, what is Amazon's real model?

An increasing number of industry pundits say Amazon has become much more than an online retailer. `I think it is an Internet franchise,' says Anthony Noto, an e-commerce analyst with Goldman Sachs. Just like America Online has leveraged its position as the leading Internet access service and Yahoo its rank as the top search site into a variety of new Internet businesses, Amazon is now able to use its e-commerce prowess to move well beyond its roots, Noto says.

Granted, much of what Amazon is doing is not new. Many large corporations have long had sizeable and active investment arms. Most Internet companies have found innovative ways to turn their traffic into dollars. But Amazon is going beyond that, using its customer base, its online retailing know-how and other assets in new ways to morph itself into a new type of Internet company. What's more, while the giant retailer is fostering a powerful network of like-minded companies that will create the building blocks for further expansion, it is also bolstering its own platform and infrastructure for further ventures that could include selling e-commerce services, fulfilment capacity and even its infrastructure. And as a trendsetter in the industry, Amazon may be mapping out a future that could become the model for other leading e-commerce concerns.

Building a family of companies. Amazon began its e-commerce investing as an early backer of Drugstore.com in mid-1998. That partnership contained the blueprint of things to come. While the investment has had a handsome financial payoff, it also gave Amazon quick entry into a retail category whose business model was fundamentally different from Amazon's core business. The drug industry isn't dominated by powerful distributors, pharmaceutical sales are regulated by state agencies, and the industry is dependent on insurance payment systems that make it radically different from other retail sectors. `It is a very complicated category . . . and an obvious one for partnering,' says Peter Neupert, Drugstore.com's CEO.

Similarly, Amazon's investments in HomeGrocer, gift registry Della and luxury retailer Ashford gave the giant retailer entry into segments that involved specialised industry relationships or complex distribution requirements. `Amazon wants to be the hub for shopping for all major categories on the Web,' says Rebecca Patton, president and CEO of Della.com. `We represented a category of products that Amazon didn't offer.' While Amazon could have chosen to build its own gift registry business, Della had spent more than a year building relationships with a slew of retailers that sell their wares through Della.

If these deals helped Amazon storm into new categories at moderate cost, they also helped its partners get a leg up on their rivals. Many of the deals gave the smaller companies needed marketing, technology and distribution muscle. `For an emerging company like ours, having their expertise allows us to move faster and not make so many mistakes,' says Ken Blue, CEO of sporting goods distributor Gear.com.

But ask any of Amazon's partners what the greatest benefits of these alliances are and they will point out two things: traffic and perception. `The most important thing is the access to the 16 million people who shop at Amazon,' Patton says. Electronic commerce, Patton adds, `is about getting big fast,' and an alliance with Amazon gives companies a huge advantage. Amazon rotates links to partner companies on its homepage.

But the company has also promoted its partners via e-mail campaigns and marketing materials included in boxes shipped to Amazon's customers. A recent Amazon holiday catalogue, for instance, included offerings from Gear, which saved millions in advertising costs, says Gear's Blue.

The `perception' advantage is harder to quantify, but Amazon's partners and industry watchers say it is equally powerful. Being part of Amazon's family of companies discourages potential competitors and carries weight both in Silicon Valley's VC community and on Wall Street. `The market values [Amazon's] partners as potential leaders,' says Lauren Cooks Levitan, an e-commerce analyst at Robertson Stephens. For instance, Drugstore.com's sales, business model and overall market position are roughly equal to those of rival PlanetRx.com. But Drugstore.com commands a value on Wall Street that is nearly 50 per cent larger than that of PlanetRx.

Amazon watchers say part of the power comes from the uniquely close ties it builds with the companies it invests in. Other giant corporations make substantial investments in related businesses, but typically that's the extent of their involvement.

But Amazon has taken significant stakes in its partners, claims one or more board seats, and participates actively in strategic planning. `If I own a large stake, I [have an incentive] to do things for them,' says Amazon's Tinsley.

Backing at a price. Amazon brings a lot to its partners, but it asks a lot in return. `They drive a very hard bargain,' says a Silicon Valley investor familiar with Amazon's deals. `They wield tremendous power, and in order to do a deal you are going to have to do a deal on their terms.' Ashford paid a lot for its relationship. On December 1, Amazon took a 16.6 per cent stake in the then-newly public company. The deal involved paying $10 million and agreeing to promote Ashford for one year. Given Ashford's share price on that day, Amazon's stake was valued roughly at $127 million. That means Ashford essentially paid $117 million for a yearlong set of marketing deals.

No one is forcing these independent companies into relationships with Amazon. But some investors are wondering if these companies are putting too much faith in their Amazon alliances. Some compare it to the early days of e-commerce, when startup companies exchanged huge portions of their marketing budgets for an anchor tenant position on AOL. `There is a lot of value to be had by partnering with Amazon,' says Tod Francis, a partner at Trinity Ventures and an investor in and board member of Della.com. `But you can't build a great brand with just one partnership. It needs to be part of an integrated marketing program.'

Kenny Kurtzman, CEO of Ashford, says his deal with Amazon is `terrific' for his company. `I feel that this deal is fair because it is good for them and it is good for us,' Kurtzman says. If even 1 per cent of Amazon's customers, roughly 160,000 shoppers, buy from Ashford, where the average purchase hovers at around $500, the company's sales could skyrocket, Kurtzman says.

For the most part, these partnerships are too new to cast a judgement on their value. But the experience of Pets.com this holiday season suggests that other types of partnerships may prove more powerful for some retailers. Despite its alliance with Amazon, Pets.com ranked just third in traffic among pet sites, according to a survey of home Internet users conducted by Nielsen NetRatings. PetsMart.com and Petopia.com, both of which have relationships with bricks-and-mortar pet product chains, fared better. Pets.com declined to comment for this story, citing `quiet period' restrictions ahead of the company's planned public offering.

Future returns. Amazon will continue to capitalise on its ever expanding customer base and its market clout. In fact, Amazon is likely to use its power more and more as it continues to set the pace for innovation in e-commerce. `It gives us tremendous flexibility,' says Tinsley. `And in a space that is evolving as rapidly as e-commerce is, having that flexibility is key.' For the time being, Amazon has no plans to expand its investments beyond e-commerce companies. `But going forward, anything is possible,' Tinsley says.

Amazon may already have given hints of its future investing direction: ownership stakes that also bring in revenue. In December, Amazon cut a deal with NextCard to create a customised credit card. The five-year agreement, which includes warrants for Amazon to acquire 9.9 per cent of NextCard, is expected to generate $150 million in revenue for the company. Analysts say that as Amazon seeks to remain at the epicenter of all things e-commerce, it might decide to forego equity stakes and sell the power of its relationships for cash, creating a new, high-margin revenue stream.

Amazon's zShops initiative, in which it invited small merchants to set up shop on its site, holds hints of other new directions for the company. zShops, launched in September, is an e-commerce platform that offers independent stores everything from Web hosting to credit card processing.

There's no reason for Amazon not to offer similar e-commerce services to larger retailers that want to outsource their entire e-commerce operations. The company already has a massive distribution infrastructure, and it could easily choose to lease excess capacity to others. Or Amazon could even package its e-commerce savvy in the form of consulting services, suggests Goldman Sachs' Noto.

`They have developed an authority in e-commerce that allows them to create e-distribution and e-services,' Noto says. `They have all these assets they can leverage to drive revenue.' Just as it has all along, Amazon is rewriting the rules of retailing.


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