As Economy Slows, Amazon Bets Big on Consumer Electronics

Circuit City (CC Quote) is warning. So is Best Buy (BBY Quote). The economy is slowing. Not too many consumer electronics retailers will be throwing back celebratory shots of eggnog at the office party this year.

All Wet Amazon's downhill course

But Amazon (AMZN Quote) is hoping that this very dicey business will give it a boost this holiday season. In fact, analysts say, the success or failure of Amazon's foray into electronics will play a key role in determining the company's fourth-quarter performance, and thus its stock price, lolling around $25 after missing out on yesterday's Nasdaq rally.

Faster

E-tailer extraordinaire Amazon launched its consumer electronics store in July 1999, and by the third quarter of this year the company said electronics was its second-biggest business, leapfrogging music. "It was our fastest-growing business ever," says company spokeswoman Ling Hong, without giving any details on sales or profitability. (Of course, the higher ticket price makes it easier to quickly hit big sales figures.)

Tons of data are being tossed around about how holiday sales are doing (including many wishful extrapolations from Amazon's own Delight-O-Meter, which tracks the number of items ordered worldwide). Most of it is noise, says Lehman Brothers equity analyst Holly Becker, the newly anointed Internet ax, who believes it's too soon to gauge Amazon's fourth quarter.

Becker's fourth-quarter estimates call for Amazon to show 50% year-over-year sales growth, to $1 billion, and for its operating loss to narrow to 6.6% of sales from nearly 26% a year ago. Moreover, "they have to hit it big in consumer electronics," she said in a media briefing Tuesday. "It's the one variable that could make or break the fourth quarter." (She rates Amazon shares a neutral, and her firm has done no underwriting for the company.)

Sinking Amazon since it came public

Some timing. The consumer electronics market, to put it politely, is sucking some serious wind. Last month Best Buy warned that earnings in the fiscal third and fourth quarters will fall below analysts' expectations. It blamed slower consumer demand and heightened competition. Circuit City, which has a remodeling program to contend with as well as a more reluctant consumer, is also ailing. Margins, which are thin in the best of times, are getting thinner.

It's possible that Amazon is immune to these woes. After all, online commerce is growing far faster than regular old commerce. (Best Buy and Circuit City, for example, aren't looking for 50% revenue growth any time soon.) Amazon spokeswoman Hong says the company got into the electronics business at the behest of its customers. "Customers indicated that buying electronics in the physical world was an extremely frustrating and difficult process because of the lack of good information," she says. "We really feel that we bring value to the experience by providing features like rankings, customer reviews and comparison engines that customers just can't get in the physical world."

Slimming

Perhaps, then, Amazon is gaining share lost by the bricks-and-mortar guys. But can it do so profitably? "This is a business that has always had razor-thin margins," says Alan Rifkin, another Lehman analyst who covers hardline retailers like Best Buy and Circuit City. To make up for low operating margins, those retailers add to profit with private label credit cards, which bring an additional revenue stream on the financing, and on warranties -- neither of which Amazon offers.

The bricks-and-mortar types also make money on volume discounts and vendor rebates. Rifkin estimates that a retailer has to have sales of at least $500 to $750 million to get even the tiniest volume discount. While Amazon doesn't break out sales of individual divisions, Epoch Partners estimates that all of its early-stage businesses combined, from lawn furniture to cameras, have annualized sales of about $600 million.

To be sure, consumer electronics retailers also see higher margins on new products. All of these retailers are banking on things like digital television to boost the industry. Yet items like DVD players are fast becoming commodity items sold by discounters like Wal-Mart (WMT Quote) and Costco (COST Quote). That's leading to discounts that make it tough for the whole industry. Meantime, newer, higher-margin goodies like HDTV won't be adopted by the mass market for a few years.

Slowdown Pullbacks at Best Buy (top), Circuit City

E-tailers like Amazon aren't likely to have it any easier. The features cited by Hong as bonuses for Amazon don't assure that customers will actually make a purchase there. What's to stop someone from using Amazon's handy customer reviews, rankings and comparison engines and then going out to find the desired item at the lowest possible price? Though customers have so far shown themselves willing to buy books from Amazon even when they know they're cheaper at Costco, that may change when the price differential is measured in tens of dollars.

And in a sign that Amazon will compete on price, too, the company is already offering free shipping on orders of $100 or more, extending an original offer until Dec. 10. It's a thank you to customers, says Hong. Analysts wonder if Amazon would be offering the deal if December sales were robust. And while they say it may draw in more customers and thus boost sales, they wonder whether those purchases will be profitable.

It's Your Valuation

All of these factors, taken against the backdrop of a tough industry, are making some observers doubtful about the success of electronics sales on the Web. "The one category I'm not sure can be profitable is consumer electronics," says David Sable, president and CEO of marketing consultant Impiric, which counts Sony (SNE Quote) as a client.

That would be bad for Amazon, whose stock trades at a premium to other retailers (3.7 times sales, compared to Wal-Mart's 1.3 multiple) on the hope that its nascent businesses will grow large and profitable. Should Amazon disappoint in the fourth quarter, its stock could find itself trading at about one times sales, too, says Lehman's Becker -- a multiple closer to that of regular old retailers.

Maybe that's what Amazon has been all along.