Amazon: How big can it get?

"We used to ask whether the Internet could support a business like Amazon," said Morningstar analyst David Kathman. "It looks to me that Amazon can survive in some form. The question is, how much can they grow? How big can they get?"

Amazon will be hard pressed for an encore after reporting a net profit of $5.1 million for the fourth quarter on Tuesday, far exceeding analysts expectations and the company's own promise of reaching a pro forma profit, which excludes certain costs. The company posted record sales--$1.12 billion for the quarter, compared with $972 million a year ago.

Amazon said sales growth in 2002 would be 10 percent or more with positive operating cash flow. Pro forma income for operations is expected to be $30 million or more.

"The worst-case scenario for Amazon used to be that they would implode like Buy.com or Enron," Kathman said. "Now, I think the worst-case scenario is if Amazon turns out to be just a retailer; they stabilize, but never get over $5 billion in sales (annually). There's not going to be much interest in that."

And while Amazon is the largest online retailer, it hardly compares to its brick-and-mortar counterparts. Discount retailer Wal-Mart, on the cusp of becoming the world's largest company, is expected to report a $2.1 billion net profit in the fourth quarter on sales of $63 billion.

But Amazon has bucked the odds before. In June 2000, Amazon saw its stock fall 20 percent after Ravi Suria, then a Lehman Brothers bond analyst, declared that Amazon would go broke by the end of the first quarter of 2001. The deadline came and went, and Amazon's bank balance was loaded with hundreds of millions of dollars. The company said in its fourth-quarter report that it has $1 billion in the bank.

At the time, Suria's gloomy forecast wasn't that big of a stretch. Amazon was posting bigger and bigger losses each quarter and burning through its money. Then some old-fashioned business discipline turned around the New Economy poster child. The piles of cash it collected before the dot-com downturn allowed it to fund operations long enough for it to tighten its purse strings and slash inefficiencies while other companies ran out of cash and were forced out of business.

In this extra time, the fat and flabby Amazon buffed up. It cut down on marketing and fulfillment expenses, the latter by partnering with other companies--such as Ingram Micro--to warehouse and ship some of its goods. It also built up its "services business," charging companies such as retailer Borders Group and Target to revamp their e-commerce stores.

"The margins are up because of better inventory management," said Amazon Chief Executive Jeff Bezos. "There is operational efficiency; we're doing things better."

Putting money on free shipping
And now, Amazon is ballyhooing its offer for free shipping on orders of $99 or larger. Instead of spending heavily on expensive advertising, the company has tried to woo customers to its site by periodic price cutting.

But even Bezos acknowledges that it is "absolutely a bet."

Reducing prices takes a bite out of profit margins. In the Internet's heyday, companies systematically would buy customers through giveaways and special price promotions--where they actually paid customers to buy goods. The strategy proved to be extremely costly and produced the additional nasty side effect of spoiling customers.

"I think some people might fault Amazon for taking so long to try (free shipping)," said U.S. Bancorp Piper Jaffray analyst Safa Rashtchy. "Free shipping can draw new shoppers...online. Given what we saw during the holidays, it does increase sales a bit. The odds are good that they can win this gamble."

But it may surprise some shoppers to find that the offer only applies to select items and excludes entire product categories, such as toys, video games, baby products, and anything from Target and Circuit City. What's more, using the service means the item "may take an additional three to five days to arrive," the site says. The offering appears targeted at the company's core books, music and video category, which had negative growth for the first time in 2001.

Moving beyond retail
Some analysts, like Kathman, believe that for Amazon to boost sales and profit margins as well as excite investors, it has to prove that it can grow and be profitable at the same time. Amazon must also prove it's more than just a retail company.

Amazon has for more than a year tried to cash in on its e-commerce expertise, and analysts say the company has to strike more deals like the ones it has with Borders, Toysrus.com and Circuit City.

In most of these services agreements, Amazon creates Web sites and shares other e-commerce technology in exchange for a percentage of sales. These are the kind of high-margin deals that Amazon rival eBay has scored big with--and the kind that entices Wall Street. The auction house charges buyers to conduct business on its platform. Overhead is tiny and there are no goods to buy or inventory to warehouse. The same is true for Amazon's services business.

But as Amazon noted in documents filed with the Securities and Exchange Commission, "These arrangements are complex and initially require substantial personnel and resource commitments by us, which may constrain the number of such agreements we are able to enter into."

Kathman thinks it'll be a while before Amazon will see significant earnings from the services category, which accounts for 8 percent of revenue. He adds that there's no guarantee that it will ever generate big money. That said, if Amazon can't create, as Bezos said, "new inventions" that drive up demand for the company's technology, then what does that make Amazon? Is it a technology company or is it just a retailer?

Shelly Hale, an analyst for Banc of America Securities who follows Wal-Mart, said she was "disgusted by the hoopla" over Amazon on Wall Street a few years ago. Hale said she's glad some reasonable thinking about the company has returned.

But she doesn't want to see the company go away.

"I'm glad they made money because it proves someone can make money over the Internet," Hale said. "But it's still unclear what level of profitability they can achieve."