Amazon's Foe in Race to Profitability: The Middleman - TheStreet

When

Amazon.com

(AMZN) - Get Report

entered the consumer electronics business in 1999, it alienated some big electronics manufacturers by buying from unauthorized middlemen and selling at cut-rate prices in the name of gaining market share.

Now, getting those guys on its side is one of Amazon's most important goals. But it isn't going to be easy.

As growth cools in Amazon's core books business, its only money-making segment, the company's prospects for profitability increasingly hinge on its fast-growing consumer electronics store. But that business isn't profitable and may not reach the black anytime soon, analysts say. Meanwhile, investors have been restive, demanding to see results now.

Compounding this dilemma is the reluctance of most of the major electronics manufacturers to sell directly to Seattle-based Amazon, which forces Amazon to pay higher prices for the electronics it sells. Some major manufacturers, most notably

Sony

(SNE) - Get Report

, are going so far as to steer customers away from unauthorized dealers. As a result, investors and analysts will be eagerly listening for Amazon's progress on the direct-buying front at its annual analyst day Tuesday.

The Middleman

From the beginning, Amazon's practice of buying goods from dealers unauthorized to sell to retailers and selling them at cut-rate prices has

irked officials at the major electronics manufacturers, such as Sony and

JVC

. Manufacturers like to control who sells their products, and usually they have strict guidelines for how a retailer can display and sell its gear. In return, the retailer benefits from lower prices, manufacturer promotions, cooperative advertising and the ability to sell warranties.

"A lot of manufacturers, starting out, were afraid of online retailers," says Don Benecke, president and chief executive of

Horizon Marketing

, a Midwest electronics distributor. "They said, 'We want to make sure they sell at the same price as our regular retailers, or else they will get mad at us.' "

For its part, Amazon is aggressively trying to expand the number of manufacturers it buys directly from. Yet the largest remain holdouts.

Falling Water
Amazon's stock since IPO

At Sony, which has had a "very acrimonious" relationship with Amazon, according to a source, a spokesperson said only that Amazon isn't an authorized dealer and that the company's focus is on developing its own online shopping site,

SonyStyle.com

. Sony also is focusing on working with established retailers with Internet offshoots, such as

Best Buy

(BBY) - Get Report

and

Circuit City

(CC) - Get Report

.

In fact, on its Web site Sony has a list of reasons why customers should buy only from authorized Internet dealers. "Only authorized dealers have access to Sony product managers and specialized customer service representatives," reads one passage. In addition, the site says that some unauthorized dealers have sold products without serial numbers, which voids the warranty. (According to two sources, customers have purchased Sony goods on Amazon, only to find them missing serial numbers.)

An Amazon spokeswoman says she is unaware of any such instances, but emphasized the company will go to lengths to satisfy the customer. "We work really hard to focus on our customers at Amazon.com and we are genuinely passionate about doing what's right for the customer and committed to 100% customer satisfaction," says Ling Hong, the spokeswoman.

The company has made efforts to soothe those damaged relationships. For example, at one time officials at JVC, the large Japanese maker of televisions, stereos and other gadgets, were steamed to see its goods on sale at Amazon at low prices, which strained some of JVC's existing relationships with distributors. JVC took its gripe to Amazon, and the issues have been addressed, says Patrick Koehn, JVC's sales manager for the Western U.S. But that doesn't mean the company is eager to sell to Amazon.

"We are new to the e-commerce business," Koehn says, "and want to feel out that class of trade." Koehn says JVC will "probably not" decide to give Amazon authorized dealer status in the near future. He says JVC would like to see Amazon turn a profit over several quarters, and would have to weigh how Amazon sales would affect its current dealership relationships. "We want to proceed with caution to make sure we won't lose anything," he says. "We want to keep other customers informed. A decision that is made with any distributor would have some effect on the marketplace."

This Time It's Different

Clearly, this is not the books business.

Internet merchants that have been successful at securing deals with the major manufacturers have tended to be focused solely on consumer electronics. For example, privately held

800.com

, based in Portland, Ore., buys directly from virtually every maker of electronics.

"We designed our business model to be a full-service retailer," says Greg Drew, 800.com's president and chief executive. "Amazon designed its business around commodity products, a self-service business. We have a room full of product experts that will help you before the sale. When you become authorized to sell a product you become trained by the manufacturer."

In one case, 13 people from one manufacturer flew in from three countries to spend days scrutinizing how 800.com runs its business before deciding whether to allow the company to become an authorized dealer. "That's how serious these guys take this," he says. "If you look at Amazon, have you ever tried to find a phone number on the site? It's very hard. That's why you have manufacturers being very, very careful as to who they authorize."

Drew explains that Amazon does not have staff with expertise in electronics that were trained by the manufacturers to help customers choose between models. This approach is fine for books, he says, but when buying electronics consumers often need a little hand-holding.

Amazon counters that it has a contingent of customer service representatives that are well-versed in consumer electronics.

"Where consumer electronics is concerned, we have specially trained customer service representatives who handle specific electronic questions and issues," says Hong, the spokeswoman. "In fact, many of our vendor partners provide specialized training for this group of customer service representatives so they are even better equipped to serve our customers."

Big Impact

How important is all this to Amazon's bottom line? Plenty, according to Mark Rowen, a

Prudential Securities

analyst who has a rare sell rating on the stock and bases a large part of his bearish view on the lack of profitability in Amazon's consumer electronics business. (Prudential has had a banking relationship with Amazon.) Amazon shares recently traded at $16.82, well off their 52-week high of $58.13.

Consider this: In the first quarter Amazon's media business, which includes books, music and videos, posted dismal growth. Revenue rose just 2% from a year ago, to $409 million. Meanwhile, sales in the consumer electronics category, which also includes tools and kitchen products, jumped 56%, to $116.5 million. These trends corresponded with industrywide data compiled in the first quarter by

Forrester Research

and the

National Retail Federation

that showed slowing growth in online book sales but a strong increase in purchases of electronics online.

But while Amazon expanded its gross margins in its electronics category, its pro forma operating margins were still a negative 39%, and its pro forma loss in the segment was nearly $46 million.

"It has been our contention that if the most profitable part of Amazon's business is not growing, and the most unprofitable part of its business is growing rapidly, the company will begin to experience economic deterioration," Rowen wrote in a recent research note.

According to another industry source, buying direct, on average, can add around 11 points to gross margins, including the lower price and savings from advertising. This represents nearly half of the typical margin of around 25% enjoyed by retailers like Best Buy and Circuit City. Or take this simple example: an authorized dealer would buy a DVD player that retails for $200 for about $150, whereas someone buying through another channel would likely pay $175, people in the industry say.

Taking Longer

For its part, Amazon says it is making progress. Gross margins in its emerging business segment -- which includes electronics, kitchen and tools -- did improve in the recent quarter much quicker than analysts expected.

"Buying direct is a very important part of our long-term strategy," said Carl Gish, Amazon's vice president of electronics, in a recent interview. "We are continually making progress along many fronts." He says Amazon is now direct with over 200 manufacturers, and will announce deals in the coming weeks with several "well-known" companies.

At camera maker

Minolta

, which went direct with Amazon a little over a year ago, company officials have nothing but praise for Amazon. "It's been a good partnership with them," says John Bruel, Western regional manager at Minolta. "They are obviously a leader in Internet commerce."

But as for the others, which include such industry juggernauts at Sony,

Panasonic

, JVC,

Kenwood

and

Toshiba

, Gish says: "I don't want to speculate on what reasons these companies are choosing not to sell direct. Some companies take longer to establish those relationships."

Indeed, it took 800.com nearly three years to get every manufacturer on board. And if Amazon's experience in other lines of business is any guide, there is room for hope. For example, the company launched its music store in 1998, and only in the first quarter of 2001 did it reach a distribution deal with record label

BMG

, the remaining holdout among the major record labels.

Tick Tock

Of course, the company could alternatively form an alliance with a bricks-and-mortar electronics retailer, similar to the co-branded site it operates with

Toysrus.com

, considered by many one of Amazon's shrewdest moves. Such a possibility has analysts touting the potential benefits, such as being able to capitalize on existing relationships manufacturers have with a certain retailer. Amazon's deal with Toysrus.com, for example, allows the company access to some of the hottest video game systems, such as Sony's

Playstation II

, notes Shawn Milne, an analyst at

Wit Soundview

.

But hopes for a similar deal with an electronics retailer may be wishful thinking.

The company has held talks with Best Buy, but according to a source those have since ended. The company has said it is open to such partnerships, but with August generally considered the deadline for inking a deal in time for the holiday season, time may be running out.

The clock, too, is ticking in the race for profitability.