How Amazon Cleared the Profitability Hurdle

To earn a profit, it cut costs and started growing again

When Inc. (AMZN ) Chief Executive Jeffrey P. Bezos proclaimed a year ago that the money-losing online retailer would finally earn its first operating profit by now, almost nobody believed him. Instead, investors kept hitting the sell button, knocking the stock down 40%, to around $10. Oops. On Jan. 22, the same day traditional retailer Kmart Corp. (KM ) filed for bankruptcy protection, upstart Amazon shocked everyone by reporting not just an operating profit of $59 million but also a net profit of $5 million in the fourth quarter--no ifs, ands, or pro formas. Investors piled back in, sending the stock up 24%, to $12.60. Crows Bezos: "It's a major turning point for us."

The bubbly CEO may be a perennial optimist, but he's not exaggerating. Granted, the surprise net profit came partly because of a $16 million gain on foreign currency exchange, which might not happen again. And Amazon's net will lapse back into the red this quarter as holiday merchandise bills come due. Yet with operating profits more than 10 times expectations last quarter, there's no question the e-commerce bellwether hit a big milestone. Throwing off a recent slump in sales, which were flat in the third quarter, it hiked the top line by 15%, or triple analysts' expectations, to $1.1 billion. Even more important, it earned a profit by getting the basics right: tangible operational efficiencies, heads-down cost-cutting, and savvy partnership deals with the likes of Toys `R' Us Inc. (TOY ) and Target Corp. (TGT ) "Amazon is just a much more experienced retailer now," says analyst Safa Rashtchy of U.S. Bancorp Piper Jaffray. "They're finally going to see some benefit from that."

So might the entire e-tailing sector. Amazon's profit offers a strong signal that while online retailers may not turn the retail world upside down, they may well become a potent force in their own right. How? Consider that Amazon offered a 30% discount on books priced above $20 in the fourth quarter--a move that helped boost overall books, music, and video sales 5%, compared with a 12% drop in the third quarter. Yet that business still saw operating profits rise 63%, to $64 million, on sales of $538 million. That's a clear indication, Bezos says, that the favorable interaction he has always promised has kicked in: Efficiencies allow for lower prices, spurring sales growth across the board, which can be handled by existing facilities without much additional cost. Says retail analyst Kristine Koerber of W.R. Hambrecht & Co.: "Amazon has proven that e-tailing can work."

Oh, sure, Amazon's particular business model--a "get big fast" strategy forged in times when capital was cheap--won't likely be repeated in this penny-pinching era. That's why venture capitalists have no plans to rush out and fund any Amazon wannabes. But recent profits reported by privately held e-commerce companies such as liquidator, online jewelry seller Blue Nile, and luggage e-tailer eBags haven't escaped their notice. "This isn't going to start an avalanche of new venture investment in e-tailers," says Mayfield Fund general partner Allen Morgan. "But I do think over the next couple of years you will see additional funding in e-tailers and e-tailing infrastructure companies." That's music to the ears of firms such as eVineyard Inc., which is trying to raise a $5 million financing round as it aims for profitability this year. Says eVineyard Chairman Larry Gerhard: "This helps enormously, to have Amazon turn the corner."

How soon the purse strings will open up remains a big question, because Amazon itself isn't home free. It still carries $2.2 billion in long-term debt, which drains about $30 million in cash every quarter. It has to contend with a recession that is not abating. And Bezos' strategy of enticing customers with lower prices is risky--especially since its core business of books, music, and videos may be maturing. Although international sales, largely of media products, jumped 81%, to $262 million, too few customers are buying newer offerings in electronics, kitchen gear, and tools. Their combined sales fell 2% from a year ago as Amazon switched from selling some of the items itself to taking commissions on sales it handled for retailing partners.

Still, progress below the top line is making up for all that. Most of all, it's coming from dozens of big and small improvements in Amazon's network of distribution centers, one of its biggest and most criticized expenses. A year ago, some 12% of incoming inventory ended up stored in the wrong place, leading to lost time and delayed orders. This year, thanks to better inventory software and smarter storage, that was reduced to just 4%. Partly as a result, even as sales rose 15%, Amazon cut fourth-quarter fulfillment expenses by $22 million, or 17%, from a year ago.

Amazon also honed its process for sorting orders for multiple items--a skill it views as its essential edge as it keeps expanding its offerings and adding more retail partners that want to use Amazon's fulfillment capabilities. By reducing the time it takes to get all the items in an order into the sorting system, Amazon shipped 35% more units with the same number of people. Says Lisa Rapuano, research director for Legg Mason Funds, whose market-beating value fund is the second-largest Amazon investor after Bezos himself: "They have made incredible progress in operations."

At the same time, Amazon for the first time farmed out fulfillment of some books to its distributor, Ingram Book Group. Partly as a result, Amazon required 4,000 fewer distribution workers on its peak day, Dec. 11, compared with a year earlier. And with better planning and higher volumes, it could send more trucks directly to cities, bypassing the cost of regional postal sorting hubs and saving millions of dollars in the fourth quarter alone. Says Jeffrey A. Wilke, Amazon's senior vice-president of operations: "We spent the whole year really focused on increasing productivity without more capital spending."

Improvements aside, logistics experts estimate that Amazon's distribution centers are still operating at less than 40% of capacity, half the most efficient level. "At this stage, it's overbuilt," says Richard W. Hallal, principal with Cleveland consultant Logistics Development Corp. So unless Amazon further reduces that capacity by shutting down more warehouses--a move not on its agenda--it must boost sales to maximize the use of its facilities. Although Bezos is forecasting at least 10% growth this year, it's unclear that rate will get operations chugging at optimal capacity.

One method of recharging sales growth is Bezos' much-criticized Wal-Mart Stores Inc.-style approach, adding everything from electronics to tools onto its original books business. Results are still mixed. Although some 35% of customers ordered something besides books, music, or videos in the fourth quarter, that's down slightly from 37% in the third quarter. Bezos says he hopes Amazon's just-announced offer of free shipping on orders over $99 will entice customers to try higher-ticket electronics, tools, and kitchen gear. And analysts say its deals to run online stores for established brands such as Toys `R' Us, Target, and Circuit City should get consumers more interested.

Indeed, those deals boost both the top and bottom lines. The retailers sell their products through the Amazon site and pay the e-tailer fees for handling distribution and customer service. Revenues for these services, which hit $225 million in the fourth quarter, carry gross margins of at least 45%, nearly twice Amazon's retail margins. And the added unit volume helps fill up idle distribution capacity, making the e-tailer more efficient. Says analyst Ken Cassar of market researcher Jupiter Media Metrix Inc.: "The beauty of those two businesses--retail and services--is that they make each other stronger."

Even more lucrative and growing faster yet are Amazon's booming sales of used merchandise. That business made up 15% of unit sales from just 1% a year ago. Those sales carry even juicier 85% gross margins--the same kind of business that has made online auctioneer eBay the one remaining e-commerce darling among investors.

Is all that enough to restore luster to Amazon, which was once valued at more than $30 billion? That will take longer, especially since its market valuation--now nearly $5 billion--is rich next to traditional retailers. Bezos, too, concedes Amazon must continue to get many more small things right before he can build the huge, lasting company he's aiming for. "I don't think the next six years will be any easier," he says. No matter how far Amazon comes, it always seems to have a long way to go.

By Robert D. Hof in San Mateo, Calif., with Heather Green in New York

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