Watch out Wal-Mart

Amazon: Amazon.com has long been enamoured with scale. The internet retailer expands into new markets like clockwork – it has added everything from electronics to power tools to its initial base in books and DVDs. But despite its best efforts, few customers think of it as a place to buy clothing. This makes the agreement to buy Zappos.com for nearly $1bn in stock a clever way to move forward in the $220 billion US apparel market.

In a way, Amazon needs to keep stoking its machine. The firm has spent heavily on its distribution network. The more sales it can push through this system, the higher the potential profit margins. Or as Amazon has so often done in the past, the more it can reduce prices to increase its dominance in internet retailing.

With its latest deal, Amazon plans to follow a hands-off approach, keeping both the increasingly well-known Zappos brand and the company’s management in charge. This makes sense – the company says it is growing quickly and regularly receives top ratings from customers, so Zappos seems to be doing some things correctly. And Zappos is starting to expand into other markets as well.

Whether the price was right is hard to say. Closely-held Zappos doesn’t release figures on profitability, or lack thereof, though its potential IPO has been the talk of Silicon Valley for some time. But at less than one times 2008 sales, the figure looks defensible. Amazon itself trades at close to twice historic sales. Moreover, the company is paying in shares, rather than dipping into its $2.7bn cash hoard. Amazon trades at more than 50 times estimated 2009 earnings. Trading overpriced stock for a small but ambitious rival looks like a smart exchange.