Profit-Hungry Amazon Moves to Cash In on a Rich Customer Base

Analysts say the online retailer's bound to adopt part of the strategy AOL's succeeded with.
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The most valuable thing

Amazon

(AMZN) - Get Report

sells may turn out to be its customers.

The company has famously expanded beyond books to CDs, software, toys and even home improvement products (cement, anyone?). But margins aren't exactly stellar on that stuff; in some cases, they're even lower than on books, as it's tough to make money selling commodity goods. Investors have noticed that profitability may be a ways off: Amazon shares are 36% off their 52-week high and now trade at 72, while other e-tailers, like

CDNow

(CDNW)

, are in

dire straits.

So, in addition to selling more stuff, why not pull an

America Online

(AOL)

and find some way to capitalize on its 17 million customers?

That's just what Amazon is doing, most obviously through deals with companies such as

drugstore.com

(DSCM)

and

Living.com

, giving the newer companies play on Amazon's site (in the form of clickable "tabs") in exchange for cash and equity. That and other forms of customer monetization, to briefly lapse into analyst-speak, could generate revenue of just more than $1 billion in 2005, above and beyond retail revenue, estimated

Salomon Smith Barney

analyst Holly Becker in a recent research note justifying her 120 price target for the company. (She has since left the firm; before departing she rated Amazon shares a buy, and her firm has done recent underwriting for the company.)

Making hay by selling access to customers illustrates two key points about e-commerce. First, because it's hard to make money selling commodity items, more and more companies are going to look to alternate streams of revenue. Second, because no one has really figured out this Internet thing, the business models of even the biggest, most-established online companies are constantly changing. Companies known for selling one thing soon may be making money from something entirely different. (Witness the lemminglike rush to get into the B2B business, now that it's a hot sector.)

More Deals

The most obvious way for Amazon to jump into this is with more deals such as the ones it's recently struck with drugstore.com. These are pure real estate deals, based on running the tabs during a set time period rather than on a strict cut of sales generated from click-throughs, says Ken Cassar, analyst with

Jupiter Communications

. drugstore.com is paying Amazon $105 million over three years for its placement, while Living.com is paying the company $145 million over five years. Amazon hasn't disclosed whether it also will get a cut of each transaction generated by the tabs. (The company wasn't immediately available for comment.)

In addition to its real estate deals, Amazon also could start to accept outright ads on its site, wrote Becker. In fact, she estimates that because of the good demographics of its customers, Amazon could command top rates for its ads. By 2005, the company could generate $302 million in ad revenue. That, combined with revenue from the partnerships, package inserts, advertising on invoices, email-list rentals, aggregate data rental and auctions, add up to the $1 billion.

And the margins are much better than on books or CDs; earnings before interest and taxes could total $817 million, she wrote. Becker hypothesizes that in 2005, this kind of stuff will account for about 7% of revenue, but a whopping 47% of earnings before interest and taxes. "This illustrates both the opportunity and the risk -- as, without meaningful benefits from customer traffic, Amazon's valuation potential will be limited," she wrote. That's important. If you believe Amazon is worth $120, you'd better be convinced it can pull this off.

Pulling It Off

Henry Blodget, analyst at

Merrill Lynch

, agrees this line of business is important for Amazon. "It's a win-win," he says. "Amazon is much more valuable to you if you can find other products on their site, and you're much more valuable to them." He's not so sure about the ads, though. "They don't need to," he says. "They get too much money for integrated promotions."

While Blodget predicts Amazon's retail business will be profitable on its own in 2002, that business will have a razor-thin margin of between 1% and 4%. Layering partnerships and other deals on top of that will bring margins up to between 8% and 10%, he says. (He rates Amazon a buy and his firm hasn't done recent banking for the company.)

It's not, however, a slam dunk. Internet consumers can be prickly when they think they're being hoodwinked. In February 1999, a brouhaha erupted when Amazon confirmed it charged publishers for placement on its site. The company walks a fine line as it tries to generate additional revenue without affecting its image as an objective source of information as well as commerce, says Sara Farley, an analyst with

PaineWebber

. (She rates Amazon shares a neutral and her firm hasn't done recent banking for the company.) Though consumers are realizing that they may have to put up with some ads in exchange for lower prices, they may have privacy concerns if they think Amazon is selling their names.

More importantly, Amazon's success at this requires that the company maintain its popularity as a retailer. If it doesn't attract viewers, it can't command a premium (think of the difference in ad rates between

Who Wants to Be a Millionaire

and reruns of

Charles in Charge

).

Which means that publicly Amazon will stick to its knitting. It will keep selling stuff -- more stuff, of course, but still stuff. Going forward, though, the real profit driver may be the customers who come to its site, not the books that bring them there in the first place.