Amazon's sad toy story

"Amazon is very service-oriented, but it took them a long time to get anything done with Toys 'R' Us," said a source close to the nation's second-largest toy merchant. "Amazon frustrated Toys 'R' Us. They're stretched too thin, and there are too many demands for their attention. And look, they've cut all these new service deals without hiring more people."

News of the talks and an analyst report saying Amazon may have to renegotiate the financial terms of the deal sent Amazon's stock down 92 cents, or 6 percent, to $14.82 in midday trading. By the close, the stock was down $1.26, or 8 percent, to $14.48. An Amazon representative declined to comment Wednesday night on the talks, and Toys "R" Us representatives were not available for comment Thursday.

Toys "R" Us is just the latest Amazon partner to say the online giant may have overextended itself by cutting a slew of deals to help other retailers operate their Web stores. At least three other partners--Expedia, Hotwire and Overstock.com--have complained in the last six months that they aren't seeing the service or returns from Amazon that they expected.

The complaints over poor service are a blow to Amazon, which has long prided itself on providing top-notch service to customers. But Amazon's business partners say that same service isn't always extended to them. For example, several complained that Amazon has not adequately promoted their companies. And as Amazon signs more of these deals, some partners worry that service will suffer even more.

"In talking to Amazon management, they've made it clear they want to do two large deals a year," said Jeff Fieler, an analyst at Bear Stearns. "Last year, Amazon did Target and Circuit City. The Borders deal didn't require a lot of bandwidth because it was easily folded into its books business."

Juggling services
Amazon performs a variety of different services for each company. In Target's case, Amazon oversees order fulfillment for Target as well as operates a co-branded Web store within Amazon. Companies such as Expedia buy the rights to market to Amazon's 29 million customers. Expedia and Hotwire power a travel site on Amazon.

Amazon usually charges a flat fee and takes a percentage of sales.

Fieler said the complexity of the Toys "R" Us deal, which includes revenue splits, handling fees, site maintenance and advertising, makes it hard to tell what parts could be up for renegotiation.

Sources close to the two companies said Toys "R" Us CEO John Eyler met with Amazon CEO Jeff Bezos in February to discuss the agreement, which was Amazon's first service deal.

Amazon, which showed a profit for the first time in January, increasingly views these services deals as an important component of its business. They contributed $225 million in revenue during the year, about 7 percent of Amazon's total sales. Besides producing big profits with high margins, the company holds the business model up like a shield anytime a skeptical Wall Street analyst dismisses the company as just a retailer.

The services unit allows Amazon to profit from its e-commerce technology--which most analysts say is the Internet's best--that cost millions of dollars and countless hours in development. By charging companies for the use of its technological know-how, Amazon can describe itself as a hybrid--part retailer, part technology company.

But Amazon is clearly aware of the risks, too, noting in its recent annual report that poor service could derail its deals.

"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 and may affect our ability to deliver services under the relevant agreements," the company said. "If we fail to implement, maintain and develop successfully the various components of such arrangements, which may include fulfillment, customer service, inventory management, tax collection, and third-party licensing of software, hardware and content, our strategic alliance initiatives may not be viable."

Soured relationships
Those concerns are real. A month ago, representatives for No.1 travel agency Expedia and discount travel site Hotwire told CNET News.com that their companies were disappointed in their relationship with Amazon and the return on investment from a deal they signed to jointly operate Amazon's travel store.

Last September, Overstock.com pulled out of a deal to supply Amazon's sites with used computer and electronic gear, citing poor sales.

"These (service) deals do soak up a lot of resources" for Amazon, said U.S. Bancorp Piper Jaffray analyst Safa Rashtchy. "But you know what, where else can Toys 'R' Us go? Amazon might need to make adjustments, but I don't think Toys 'R' Us is going anywhere."

Fieler agreed, saying it was too early to know if a renegotiated deal would be a positive or negative.

"Toys 'R' Us has its own issues. I wouldn't think they would negotiate from a position of strength," he said.

Indeed, Toysrus.com is still losing money, according to Toys "R" Us earnings released Thursday. According to the company, Toysrus.com's fourth-quarter sales were $174 million, up from $140 million a year ago, but the site is still losing money. For the fourth quarter ending Feb. 2, Toysrus.com had an operating loss of $17 million compared with an operating loss of $54 million a year ago.

Toys "R" Us earnings were $158 million, or 78 cents a share on sales of $4.76 billion. Earnings were down sharply from a year ago because of restructuring charges, and sales were off slightly.

News.com's Larry Dignan contributed to this report.