How lean can Amazon get?

Improved inventory management played a big role in Amazon.com's ability to post its first-ever profit last quarter, but the giant e-tailer may find it difficult to produce a repeat performance.

After accumulating a deficit of $2.86 billion during the past seven years, Amazon reached a milestone in January when it reported a $5 million net profit in the fourth quarter, in part because of its ability to slash costs associated with stocking and shipping goods.

As investors await Amazon's first-quarter earnings report Tuesday, they will be looking for clues to answer a crucial question: Can inventory management continue to boost the bottom line, or was the fourth-quarter report a fluke?

For companies like Amazon, which reported $1.1 billion in sales in the fourth quarter and operates no physical stores, inventory efficiency is paramount. After all, Dell Computer has hoisted itself to the top of the PC market through religious devotion to inventory controls. The PC maker averages a four-day inventory level, compared with two to three weeks for its competitors.

So how Dell-like can Amazon become?

"Amazon is a real star in the supply chain and product-management area," said Scott Elliff, president of consulting firm Capital Consulting & Management. "Over the past two years, they've doubled sales and cut their inventory by 25 percent over the same time...That is unprecedented."

The first quarter is normally a brutal one for retailers, as consumers close their wallets after the holiday spending spree. Amazon is expected to report a first-quarter loss of 9 cents per share, compared with a loss of 21 cents per share for the same period a year ago, according to analysts surveyed by First Call.

But even if the company posts a loss, Tuesday's report will provide some insight into the company's ability to further trim costs without harming sales.

Some believe the company has plucked the low-hanging fruit, meaning that additional savings will be more difficult to achieve and will have less impact.

"Over the past two years, (Amazon has) doubled sales and cut their inventory by 25 percent over the same time...That is unprecedented." --Scott Elliff, president of consulting firm Capital Consulting & Management

"Amazon has done a good job, but I think we've seen the biggest chunk of their savings already," said Safa Rashtchy, an analyst with investment adviser U.S. Bancorp Piper Jaffray. "Every quarter they spend less, and this should continue...But a lot of people have asked why we haven't seen this cost structure from the beginning."

For Amazon, the easiest way to prove its strategy is to continue to post profits. But that's not necessarily the company's goal, according to Chief Executive Jeff Bezos. Amazon's sights for the year are set on becoming cash-flow positive, with more money coming in than going out. To that end, Amazon executives say that the company will continue to tweak its operations, and that there is plenty of room for cutting.

"We still have lots of opportunities for improving," said Cayce Roy, Amazon's vice president of U.S. fulfillment. "There's no shortage of projects."

Compared with the same period last year, Amazon shaved $22 million, or 17 percent, from expenses associated with filling orders in the fourth quarter. Here's how:

• It revamped the layout of its five warehouses, making it easier for the company to locate, sort and ship customer orders.

• It refined the software it uses to estimate customer demand, reducing the risk of buying too much or too little merchandise.

• It partnered with other companies to avoid handling inventory; the partners ship some items, and Amazon capitalizes on its e-commerce expertise.

• It partnered with other companies, handling inventory and shipping duties in exchange for fees and a percentage of sales, while the partner covers the cost of the inventory.

To achieve the first two items on that list, Roy said, the company improved its sales-projection software and its ability to anticipate seasonal and regional demands.

"We rewrote much of (the software) so that we could pinpoint demand in different regions," Roy said.

For example, Amazon used its information to rearrange its warehouses in Delaware, Kansas, Kentucky, Nevada and North Dakota, placing items frequently ordered simultaneously, such as CDs and CD players, closer together. The changes helped lower fourth-quarter inventory levels by 18 percent and cut fulfillment expenses by 17 percent from the same period in 2000.

Goodbye, goods--hello, sales
While tightening its inventory belt was a common-sense solution, Amazon's decision to start handing off inventory to others altogether raised hopes for additional efficiency. But it also heightened fears that the company's golden goose could be at risk.

Amazon's reputation for superior customer service is considered its strongest attribute. Taking orders from consumers and passing them off to a manufacturer or bookseller to fill is an inexpensive way to boost sales, but it also places the company's hard-earned customer service reputation in someone else's hands.

"Amazon has done a good job, but I think we've seen the biggest chunk of their savings already." --Safa Rashtchy, analyst, U.S. Bancorp Piper Jaffray

"We have seen a very interesting evolution where they insisted on owning every piece of the customer experience and then moved toward an open posture where they are outsourcing more and putting their trust into others," said Ken Cassar, an e-commerce analyst at research firm Jupiter Media Metrix.

Amazon has outside distributors for three kinds of products: cell phones, computers and books, excluding those on best-seller lists. CellStar handles the cell phone sales, and wholesale distributor Ingram Micro handles the computers and books.

Computers take up huge chunks of warehouse space, so Amazon's decision to let a partner oversee fulfillment was an obvious choice when the e-tailer opened a computer store last August, analysts said. As for CellStar, that company has expertise in handling the specialized, extensive customer service that goes with signing up new customers.

"It's faster to ship to customers this way," Amazon spokesman Bill Curry said. "We also don't have to receive it into the warehouse, put it on a shelf, take it off the shelf, put it in a box, and send it to the customer."

Amazon plans to strike more such "drop shipment" deals in the future, Curry said, without disclosing which products might be involved.

Some potential areas include electronics, tools and kitchen products, Rashtchy said. These items tend to be bulky and awkward--think vacuum cleaners, food processors and table saws--making them difficult to efficiently stock and ship.

Plus, customers tend to order these items individually, which makes the drop-shipment model a good fit. If an order contains several items, such as a book stocked by Ingram and a game stocked by Amazon, Ingram sends the book to Amazon, which then adds the game and forwards the box to the customer. As a result, the efficiency is greatly reduced.

About 35 percent of Amazon orders include items from multiple product categories, meaning the drop-shipment model has its limitations.

Selling its secrets
Another way Amazon can sidestep inventory is by cashing in on what is perhaps its most attractive offering: e-tailing expertise.

Few Web retailers have been around as long as 7-year-old Amazon, and few have amassed as sizable a cache of e-commerce software and know-how. When it comes to hawking goods online, Amazon is widely considered among analysts and retail experts to be the best.

To profit from this reputation, Amazon launched its Services division in fall 2000. For a fee and often a share of sales, Amazon will perform a range of e-commerce chores for other retailers, such as building Web stores, sharing technology or overseeing fulfillment operations.

"We believe that if Toys 'R' Us and Amazon's other partners do not become profitable soon, they may exit their online businesses completely, which will obviously be problematic for Amazon." -- Holly Becker, analyst, Lehman Brothers

These deals brought in $225 million last year, or about 7 percent of Amazon's total revenue. Amazon's costs in these deals are usually minuscule and profit margins are twice as high as the company's book business. In some partnerships, Amazon is required to invest few resources for the fees it charges.

Last September, Expedia and Hotwire agreed to pay an undisclosed amount for the right to power Amazon's travel store. In other deals, Amazon's investment is higher. The retailer warehouses, picks, packs and ships products for companies such as Target and Toys "R" Us.

Why would Amazon agree to burden itself with other companies' inventories if it wants to rid itself of its own? Because handling someone else's merchandise can sometimes be more profitable for Amazon than selling its own goods.

In the case of Toys "R" Us, Amazon charges fees and takes a percentage of sales but avoids having to shell out money to stock the merchandise--Toys "R" Us is on the hook for that. The nation's No. 2 toy chain also takes on all the risks of getting stuck with excess inventory, the bane of all retailers.

"Handling Target's fulfillment at the same time we use Ingram to drop-ship appear to be contradictory strategies," Curry said. "But we choose the best option when they make sense."

In a recent analyst report, Lehman Brothers analyst Holly Becker sounded a cautious note regarding these agreements, noting that the partnerships have not been profitable for Amazon's partners, with the lone exception of Borders.

"We believe that if Toys 'R' Us and Amazon's other partners do not become profitable soon, they may exit their online businesses completely, which will obviously be problematic for Amazon," Becker wrote.

The partners have already taken their concerns about these partnerships to Amazon. Sources recently told CNET News.com that Toys "R" Us has sought to renegotiate its deal with Amazon because of poorer-than-expected return on investment and a lack of service from Amazon. Other partners, such as Expedia, Hotwire and Overstock.com, had similar complaints about their partnerships with the e-tailer.

The reports and critical analyst comments have sent Amazon's stock down, despite the acknowledgment that these kinds of long-term deals often need to be adjusted.

"While we believe that Amazon may indeed go through occasional problems and renegotiate some deals as it is learning its way through the new service business, it is a significant exaggeration to call the entire service business at risk," U.S. Bancorp's Rashtchy wrote in a report about Amazon.

Keeping customers happy
By cutting costs and boosting margins, Amazon says it can pass along some of the savings to consumers. On the day it reported its first profit, Amazon announced it would offer free shipping on orders over $99; it says its margins allow it to provide that offer indefinitely. The move has put pressure on Amazon's competition, and Web electronics store Buy.com, online toy store eToys and housewares merchant Chefs.com have already started free shipping plans.

"Amazon has the scale advantage on some competitors and can afford to even take some losses," Rashtchy said. "The whole idea is not just to increase sales but to add more shoppers."

Meanwhile, in the services area, Amazon is up against some well-heeled foes, including the e-commerce stores of Yahoo, AOL Time Warner and Microsoft--not to mention the Web operations of traditional retail behemoths, such as BestBuy.com, JCPenny.com and Barnes&Noble.com. Forcing these kinds of companies out of the e-commerce game may be tough to do.

Some analysts say Amazon may choose to drop some product categories that have yet to produce a good return on investment. Though that may pay off in the short term, some Amazon watchers say it would be a mistake in the long run.

"It might prove cheaper, but they could end up losing customers, which is what they don't want to do right now," said Capital Consulting's Elliff. "People go there because they know that for almost anything they want, Amazon will probably carry it--and at a price they can afford."