Amazon Prospers on the Web
By Following Wal-Mart's Lead

And each year, it looked as if the Internet retailer might lose. During the fourth quarter of 2000, Amazon had losses of more than a half-billion dollars and missed Wall Street sales forecasts. High costs forced the company shortly after to close two of its eight U.S. warehouses and lay off 15% of its employees. For most of last year, investors worried about Amazon's ability to pay suppliers while the company was saddled with $2.1 billion in debt.

This year, things are different. For once, almost no one is questioning Amazon's ability to survive the holidays. The company has pulled off a sharp reversal in the past year, restoring brisk sales growth in its core book, music and video business. Although net income remains elusive, the company has sharply narrowed its losses. Early this year, Amazon reported a small profit for 2001's fourth quarter, its first ever.

Amazon's surprising formula is exactly what helped ruin many other online businesses and once added to the gush of red ink at Amazon itself: aggressive discounting and free shipping. To pay for those goodies, Amazon is behaving like every other successful mass retailer and slashing its costs wherever it can. A smarter system of processing orders means fewer errors. It has cooked up imaginative ways to cut shipping fees by consolidating orders. And it has a lucrative new business selling new and used goods online on behalf of other merchants. Amazon collects commissions on those third-party sales without the risks and costs of owning the inventory.

Two Choices

Retailers face two choices, Amazon founder and Chief Executive Jeffrey Bezos said in a conference call earlier this year: Work hard to raise prices or to lower them. Amazon, he says, has "decided to relentlessly follow the second model."

Mr. Bezos's biggest gamble is a return to offering customers free shipping of most Amazon products ordered on its Web site. Early this year, Amazon waived delivery charges on orders $99 and above. Later, the company dropped the minimum order size to $49, then to $25 -- about the price of two hardback books or CDs. Amazon says it will decide after the holidays whether to raise the $25 minimum but that it plans to continue offering free shipping in some form.

Market research shows customers hate shipping charges. Online buyers cite shipping discounts as more likely than any other promotion to encourage them to purchase goods during the holidays, according to a recent consumer survey by Jupiter Research, a unit of Jupitermedia Corp.

Growth Booster

Amazon credits free shipping as a key factor in boosting its growth. Third-quarter revenue jumped 33% to $851 million from a year ago, and the company predicts revenue will rise between 19% and 28%, to between $1.33 billion and $1.43 billion, during the crucial holiday quarter. By comparison, overall U.S. retail sales are expected to rise 3.5% during the holidays from last year's levels, according to consulting firm Retail Forward Inc.

Amazon lost $35 million in the third quarter, compared with a $170 million loss a year ago. The company says a more important financial measure is its free cash flow, which it defines as cash from operations, after capital expenditures and interest payments, and excluding noncash accounting items such as asset depreciation. Amazon expects to generate positive free cash flow for the full year. The company achieved this in 1998, with free cash flow of $3 million. This year, Goldman Sachs analyst Anthony Noto expects Amazon to report free cash flow of $110 million. "It means the company will be self-sustaining," says Marie Menendez, senior credit officer at Moody's Investors Service Inc.

Many retailers still consider free shipping as unsustainable, one of the growth-at-all-costs gimmicks that landed so many Internet retailers in the morgue two years ago. After all, a retailer can elect not to charge customers for shipping, but it still needs to pay carriers to deliver orders to customers' doorsteps.

Amazon executives last year vigorously debated the risks of introducing a permanent free-shipping offer. Some company officials worried that customers might not settle for anything else once they got used to no shipping charges, according to people familiar with the discussions. "If you get them trained on free shipping, will you be able to stop it if you decide it isn't working?" one person says, describing those concerns. "Everyone understands that if you head down this path, it's a slippery slope." An Amazon spokesman declined to comment on internal discussions. Mr. Bezos declined to be interviewed for this story.

Amazon competitors have resumed discounting, too. Closely held Buy.com Inc. offers free shipping on most products without a minimum order size and promises to undercut Amazon book prices by 10%. So far, competing offers don't seem to have drained significant amounts of sales from Amazon, most analysts say.

To help offset the costs of free shipping, Jeffrey Wilke, Amazon's senior vice president of operations and customer service, has led an aggressive campaign to cut costs and squeeze more productivity out of workers at the company's warehouses, where orders are processed.

The 35-year-old engineer employs a team of a half-dozen mathematicians who devise models for, say, the best way to spread book inventories throughout Amazon's six warehouses in the U.S. Mr. Wilke is a devotee of "six sigma," a method for using data analysis to reduce errors in manufacturing and service industries. He assigns "black belts" and "green belts" to workers, a six-sigma award system that honors the most creative problem-solvers at its warehouses.

His crusade is helping. Fulfillment costs -- charges incurred to process orders, but not to ship them -- are Amazon's single biggest operating expense. These costs fell to 12% of revenue last year from 15% in 2000. Fulfillment costs in the most recent quarter were $90.3 million, or 10.6% of revenue.

Mr. Wilke also is working to wring more savings out of Amazon's delivery process. With its free-shipping program pushing up expenses, Amazon spent $10 million more on shipping than it received from customers in the third quarter, compared with $2 million a year earlier. One tactic: Amazon is consolidating more of its orders, taking advantage of the greater time it has to deliver products to customers who opt for free shipping. In exchange for free delivery, customers typically agree to wait several extra days to receive their goods. (Customers can choose to pay for faster shipping.)

Consider the benefit when a hypothetical Amazon customer in New York orders a DVD player and a book. One item is warehoused at Amazon's Delaware warehouse, the other in Nevada. Previously, Amazon would have shipped the items in separate packages from its warehouses within 24 hours, effectively doubling shipping costs. But with the extra days it gains to prepare free-shipping orders, Amazon now can have one of its distributors send the book to its Delaware warehouse on a pallet with other books for a nominal fee. Amazon then bundles the customer's order in one box and ships it, saving several dollars in carrier charges in the process.

Break on Rates

The extra order volume spurred by free shipping also gets Amazon a break on shipping rates. The company is increasingly using a method called "postal injection," in which it uses its own trucks or independent carriers to drive truckloads of orders to local postal depots from Amazon warehouses. The procedure eliminates processing steps for the U.S. Postal Service. Amazon won't say exactly how much it saves this way, but one of the shipping companies Amazon works with, SmartMail LLC of Atlanta, says it saves customers between 5% and 17% off the normal price of first-class mail.

Amazon says the cost-cutting has allowed it to resume aggressively discounting many of its products. Two years ago, as investors pressured the company to stanch its losses, Amazon reined in its discounts. In the summer of 2000, prices on many books went up. Discounts on bestsellers, for instance, went to 40% off from 50% off. The company jacked up prices again on many books in early summer 2001. The moves stalled sales growth in its largest retail category -- books, music and video -- where sales dipped slightly last year to $1.69 billion.

Amazon says it began reversing the price increases last year. More price cuts were made in April of this year, when the company lowered prices on all books over $15 to 30% off list price, expanding a discount it previously offered on books over $20. Third-quarter sales for its book, music and video business jumped 17% to $412 million from a year earlier.

"We've chosen to offer great prices to customers because we can afford to," Mr. Wilke says.

A risk is that Amazon could effectively help individual merchants steal new product sales from its own site. Amazon executives say they don't care whether they sell one of the company's own products or someone else's, since the actual dollars that go to Amazon's bottom line are about the same.

The Marketplace business has upset some high-profile groups. The Author's Guild, an advocacy group for writers, earlier this year blasted Amazon for its used-book business, saying the retailer was hurting the royalties that authors receive from new book sales.