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Amazon's Search for a River of Growth

By Olga Kharif Ever since Jeff Bezos started in his garage in 1994, the online retailer has grown like crazy. Through a combination of deep discounts and promotions such as free shipping for purchases over $25 in the U.S., Amazon (AMZN) is a dot-com empire generating $3.93 billion a year in revenue, selling not only books but CDs, toys, and TVs.

Yet steady earnings continue to elude this Internet survivor. Amazon has yet to reach full-year profitability, staying in the black only in its fourth fiscal quarter two years in a row. Online shopping isn't the new new thing anymore. Internet sales growth will slip to 18.5% in 2003, from 24% the previous year, and it will drop again in 2004, predicts Jonathan Gaw, an analyst with tech consultancy IDC.

What's more, Amazon is struggling to keep the revenue-growth engine running. The rate at which people are going online for the first time has leveled off, according to Forrester Research. The newcomers now tend to be older, and though tech-savvy, they'll need time before they're willing to use credit cards for cyber-shopping, says Jonathan Hurd, an analyst with tech consultancy Adventis.

A POTTER PUSH. Experts have also scaled back their estimates of the online retail market's size: Web sales likely will total 10% of retail in 10 years, up from less than 2% today, according to market consultancy Yankee Group.

Amazon has kept investors satisfied -- mostly by keeping costs under control and maintaining stellar sales growth. But the most recent quarter's performance -- 37% year-over-year sales growth -- likely won't be repeated, partly because Amazon benefited from the launch in June of the latest Harry Potter book, of which its buyers snapped up 1.4 million copies. The weak dollar also contributed 28%, or $55 million, of the revenue increase in the second quarter ended in June, when net sales reached $1.1 billion, up from $806 million in the year-ago quarter. However, many exchange-rate watchers are betting that the dollar will rebound.

Investors haven't jumped ship. Success is priced into the stock, says Jason Schrothberger, a portfolio manager at Turner Investment Partners, overseeing $9.75 billion in funds. But Schrothberger sold his Amazon holdings in July because he wants to see Amazon deliver on what the stock price implies.

RISKY MOVES. The shares are trading at $40, only 7% below their 52-week high of $43.10 on July 24. They trade at 47 times the Street's consensus 2004 earnings of 85 cents per share, according to financial service First Call -- a rich price-earnings multiple for a retailer. Even if earnings delivered an upside surprise, the stock is overvalued, says Safa Rashtchy, an analyst with U.S. Bancorp Piper Jaffray.

Clearly, it's time for "Phase II of Amazon's business plan," says SoundView Technology analyst Shawn Milne. The retailer has to start selling more product lines in more countries. More important, it has to become the online storefront for retailers that don't have a Web presence or want to ax costly efforts to have an online venue. But both those moves carry considerable risk.

In June, Amazon created a special subsidiary focused on creating such storefronts within the site. Some retailers, like Toys 'R' Us (TOY) and Target (TGT), already use this service. These vendors account for 10% of Amazon's total sales -- and could generate 20% of its revenues by the end of the year, estimates Rashtchy.

RATE THE SELLERS? And Amazon deserves credit for building a reputation of unfailing customer service. Users know that the right order will arrive on time. But as Amazon expands into storefronts for others within the site, the risks increase that its partners might not be able to mimic Amazon's track record of quality customer service.

Auction site eBay (EBAY) has prospered from third-vendor trades, argues Diego Piacentini, Amazon's senior vice-president for worldwide retail and marketing. But users know that eBay is a marketplace of individual traders -- whereas Amazon is perceived as a single retailer. Piacentini figures Amazon could resolve the problem by tweaking its site tools so users could rate third-party sellers better. It will also continue to offer a 30-day reimbursement guarantee and kick out retailers that don't meet its standards.

Still, Schrothberger, for one, would like to see Amazon create joint ventures with retailers instead of partnerships that are branded under the Amazon name. Alternatively, it could follow example of online portal Yahoo! (YHOO), which hosts more than 20,000 small businesses but doesn't put its brand on their pages. Piacentini says Amazon isn't considering joint ventures, and he declined to comment on what kind of changes it might make.

FROM AMAZON TO OVEN. Third-party retailing could disappoint investors for another reason: Even though the strategy could boost unit sales, Amazon's commissions for hosting other retailers would likely be small and not make up for slowing overall market growth.

To further ramp up growth, Amazon plans to sell more kinds of products, with new line announcements coming this year, says Amazon's Piacentini. Analysts believe Amazon will introduce things like sporting goods, health and beauty items, and gourmet foods. Still, the e-tailer probably can't make much money on a bottle of shampoo or a frozen dinner.

Amazon plans to keep expanding geographically beyond the six developed countries where it now has separate local-language and -currency sites. In July, it launched its electronics shopping channel, selling digital cameras and DVD players in Japan. However, the Big Six -- the U.S. Britain, Germany, Japan, France, and Canada -- account for 90% of the world's e-commerce. So, the remaining pickings could be slim.

UNPREDICTABLE TEEN. Amazon could also keep finding new ways to cut costs and increase its bottom line, dazzling investors once again. At the end of 2002, it decided to stop its offline advertising -- a huge savings that allowed it to offer more discounts. And it continues to improve service, offering same-day delivery on the latest Harry Potter book. Amazon also recently lowered the threshold for free shipping internationally. "It's a great way to get into a consumer's mind," says Piacentini. "People think of Amazon as a way to save money."

What's more, as its unit-sales volume grows, Amazon, which invests more than $200 million a year in technology, should benefit from greater economies of scale. Already, tech costs stand at only 4.2% of sales, vs. 7.7% in 2001, Milne estimates.

Still, Amazon is fighting a losing battle for sustained revenue growth. This figure will fall from 30% in 2003 to 20% next year, and operating income growth will slide from 91% to 30% in 2004, estimates Thomas Underwood, an analyst with Legg Mason, which owns more than 1% of Amazon.

Piacentini says investors understand that "We're just at the infancy of e-commerce." He adds: "Just let e-commerce become at least a teenager!" But teenagers can be unpredictable and unreliable -- something investors might want to keep in mind as they watch this Internet giant mature. Kharif covers technology and e-commerce for BusinessWeek Online in Portland, Ore.

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