Fun Is Done for Amazon's Toys R Us Deal

Amazon.com's (AMZN) toy story isn't looking like much fun right now.

Toys R Us (TOY) has sought to renegotiate its alliance with the online retailer, on the grounds that the company was paying Amazon too much and getting too little in return, says a person familiar with the matter. The alliance is key to Amazon's success, because it accounts for much of the Seattle-based bookseller's fastest-growing and most-profitable segment.

In February, high-level executives at both companies met to rehash the deal, according to that person who is familiar with the matter. The meeting included Amazon CEO Jeff Bezos and Toys R Us chief John Eyler, along with several underlings, this person says. One hedge-fund source says the meeting ended with the companies agreeing to reduce Toys R Us' annual payments to Amazon; the companies didn't immediately return calls seeking comment.

Regardless of whether Toys R Us succeeded in reducing its payments, what's clear is that a relationship that Amazon watchers have high hopes for, may not be working as well as expected. Indeed, any reduction in revenue from the deal is sure to rankle Amazon investors, who have worried recently about the departure of key executives and heavy insider stock sales. Those trends suggest executives and directors aren't overly optimistic about the company's prospects, observers say. Amazon fell 27 cents Wednesday to $16.04.

Robust

Analysts have long trumpeted the robust growth of Amazon's services segment, which includes the Toys R Us deal along with similar partnerships with discounter Target (TGT) and consumer electronics retailer Circuit City (CC). The companies don't provide numbers, but the Toys R Us deal is widely understood to make up the largest component of Amazon's services business.

Serve and Volley Service sector looks like Amazon's big growth engine

*Estimates according to Deutsche Banc Alex Brown

Any reduction in money received from Toys R Us could easily reduce Amazon's earnings and revenue growth forecasts, analysts say. Wall Street expects Amazon's service revenue to grow 20%-30% in 2002 -- more than twice as fast as the company as a whole, which is expected to grow 12%, according to Thomson Financial/First Call.

Maintaining growth in the services business is key for Amazon's long-term profit outlook, as more dollars hit the bottom line from this business than from other divisions. Last year, gross margins in services hit 56%, compared with 27% for the U.S. books business and 26% overall.

"I think at the time they originally agreed to the deal it was a different environment," says Mark Rowen, an analyst at Prudential Securities who covers Amazon. "eToys was still in business and Toys R Us was losing a ton of money. I can see why Toys R Us would want to renegotiate." (Rowen has a hold rating on Amazon, and his firm doesn't have an investment banking business.)

Amazon and Toys R Us inked a 10-year deal in August 2000. Amazon took over the toy seller's online offshoot, Toysrus.com, which had been bleeding cash. In return, Toys R Us agreed to pay Amazon a fixed fee, a cut of revenue and a per-item fee for fulfillment, according to the terms announced at the time.

Neither party has disclosed exact numbers, and analysts have long been frustrated over Amazon's reluctance to giving details of its service segment. But some analysts estimate Toys R Us may have paid Amazon between $100 million and $135 million in 2001 -- potentially more than half of Amazon's total service revenue of $225 million last year. The company's total sales last year were $3.12 billion.

Turnaround

After famously losing money for years, Amazon swung to the black in the fourth quarter, with its first-ever profit. Meanwhile, shares have nearly tripled from their post-Sept. 11 low of $5.51. Yet, the company isn't projected to post another quarterly profit until the fourth quarter of this year, and full-year profitability won't come until 2003 at best.

Meanwhile, Amazon recently announced that Warren Jenson, the company's chief financial officer, will leave later this year. The announcement was widely considered as a blow to Amazon, as Jenson was well-regarded for steering the company toward profitability. In addition, the fact that Jenson left $3 million in potential bonuses on the table has raised some eyebrows. David Risher, Amazon's marketing and merchandise chief who also has a solid reputation in financial circles, will leave this month; his departure was announced in November.

While Amazon's service business is a profit center, Toys R Us continues to lose money on the Internet. For the first three quarters, the dot-com operation lost some $59 million. Toys R Us has predicted Toysrus.com would at least break even in the fourth quarter, which the company is expected to report on March 14.

On a March 6 conference call hosted by Lehman Brothers, Diego Piacentini, Amazon's senior vice president for worldwide retail and marketing, stressed that the two companies have a long-term deal and that Amazon provides good service. When asked if Toys R Us was dissatisfied with the terms, the executive replied, "I can't say."

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