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Amazon's strategy of big discounts is questioned

By Monica Soto Ouchi
Seattle Times technology reporter

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Three years ago, Amazon.com surprised Wall Street when it announced plans to lay off 1,300 employees and shutter a new distribution center, but the restructuring wasn't the company's only blow.

Holiday sales had begun to slow, and Amazon was still bleeding cash. Analysts were most concerned with the results in its core business of books, music and video, where sales were comparably soft.

"Yes, they'll live; yes, they'll be profitable," one analyst lamented, "but they won't be as big as once dreamed."

Amazon.com indeed got the lesson. After years of aggressive cost-cutting, the online retailer last week reported record sales and profit growth from the holiday season, and an important historical milestone: its first full-year profit.

But its financial results prompted new questions — perhaps more confident ones — about the future of its business:

Now that Amazon is the largest Internet retailer of its kind, does it need to discount so deeply? In other words, is it unnecessarily giving profit away?

Based on assumptions inferred from these questions, Amazon's shares fell sharply last week after the company announced its fourth-quarter and full-year financial results. The company's stock closed Friday at $50.40 a share, down $6.71, or 13.3 percent, for the week.

While the results fell in line with estimates, analysts zeroed in on gross profit margins, an indication of how profitable the company could eventually become.

This measurement, the difference between what Amazon pays for goods and services and the price it charges, fell for the quarter and for the year — most notably in the company's international stores, where it launched new categories and offered deep discounts to spur sales.

The company further sliced into its profits with free shipping on orders over $25 in the U.S., and beginning a similar promotion last year in the U.K. The effect: less of its record sales growth trickled to the bottom line.

"The general feeling out there is that they don't need to be quite as aggressive on their pricing as they have been," said Dan Geiman, a McAdams Wright Ragen analyst. "The fact that they have grown by such proportions and have the market share they do (means): Do they need to be that competitive on pricing? I don't know the answer to that."

Chief Executive Jeff Bezos told analysts in April that the company's international divisions still purchase a lot of its goods through wholesalers and other distributors. As those businesses grow over time, Amazon expects to buy a larger fraction of its goods directly — hence, on more reasonable terms.

He reiterated that point last week, saying the company has made a conscious choice to pass its savings along to customers in the form of discounted items as a strategy for long-term growth.

"We will for years and years and years consistently give back the gains to customers," he said. "We think it's the right way to operate this business."

The company has indeed revived sales over time by adopting the strategy of successful large retailers such as Costco and Wal-Mart: Develop the lowest cost structure possible, pass the savings back to customers in the form of lower prices and then reap a profit by selling a higher volume of goods.

Amazon now offers deep discounts on books and electronics (sales of DVD players, computers and other electronics last year became a $1 billion-a-year business). It has coupled those discounts with free shipping on orders over a certain amount, addressing one of the largest perceived barriers to buying online.

The company had a fourth-quarter profit of $73.2 million, or 17 cents a share, compared with a profit of $2.7 million, or a penny per share, a year ago. Sales rose 36.2 percent to $1.9 billion, benefiting by $98 million from changes in foreign-exchange rates.

For all of 2003, the company reported a net profit of $35.3 million, or 8 cents a share, on sales of $5.3 billion.

Kate Delhagen, vice president of retail research for Forrester, said that while Amazon runs the largest e-commerce site, it will continue to face pricing pressure from larger traditional retailers.

KB Toys filed for bankruptcy protection after the holiday season, blaming Wal-Mart and other discount retailers for offering heavy discounts on popular toys. Toys R Us, whose online site is powered by Amazon.com, also reported poor results.

Delafield Hambrecht analyst Stewart Barry said Internet commerce remains a highly segmented, competitive market, where shoppers can look around.

"In the end, the consumer brand, the Sony or the Ralph Lauren, that's what you're buying," he said. "The question is where you're going to buy it. They'll buy it on several factors: customer experience, reliability of delivery and also, very importantly, price."

For Amazon, beset by overarching questions throughout its existence, the issue no longer is when will it be profitable. For now and the foreseeable future, it has to answer: How far will its discounting strategy take the company? The answer is at its customer's fingertips.

Monica Soto Ouchi: 206-515-5632 or msoto@seattletimes.com

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