Amazon: Revenue River, Profit Trickle


By Robert D. Hof Amazon.com (AMZN) offers millions of products for sale on its Web site, and every quarter it seems to offer almost as many ways to disappoint investors. That was certainly the case for its first-quarter report on Apr. 26. Despite posting a 24% jump in first-quarter sales, to $1.9 billion, net profit fell 30%, to $78 million, from a year ago as the online retailer logged an income-tax expense of $56 million for the first time.

But all that was pretty much expected. The bigger problem: Although Amazon edged up estimates for 2005 sales just a hair -- to between $8.2 billion and $8.7 billion -- it kept a lid on its forecast for operating profits this year. Indeed, its operating-profit forecast ranged remarkably widely, from down 10% to up 16%. "The bottom line is: It doesn't look like the June and September quarters will be anything to get excited about," says David Garrity, an analyst with Caris & Co.

STILL BEARISH. As a result, the stock headed south once again. Even after falling 2%, to $32.71, on Apr. 26 before the report, Amazon's stock dropped an additional 4% in after-hours trading. The e-tailer's share price was already down more than 25% since the start of the year, mostly thanks to disappointing fourth-quarter earnings, which knocked the stock down 15% on Feb. 3 (see BW Online, 2/3/05, "Rough Waters for Amazon.com").

The investors' quick reaction wasn't too surprising, since even the deflated stock price left the company little margin for error. Before the report, Amazon's price-to-earnings ratio based on this year's expected profits was 48, which made it even pricier on a relative basis than Google (GOOG). Even at $219 a share, Google sported a p-e of 41.

"The fundamentals at Amazon haven't changed -- revenue growth decelerated and operating profit contracted," says Mark Mahaney, an analyst with American Technology Research. "There's nothing here to change the bears' argument."

FOCUSED ON DISCOUNTS. Amazon's tepid results sharpen a growing divide among Internet companies. Advertising-based concerns such as Google and Yahoo! (YHOO) are outpacing expectations as online pitches continue to capture an ever-increasing portion of overall ad budgets. That's bidding up the prices of search ads, the most popular online advertisements today. Consequently, it's costing Amazon, eBay (EBAY), Overstock.com (OSTK), and others much more to market their wares -- and this is hurting their profits. Amazon's quarterly marketing expenses shot up 32%, to $45 million, far more than its sales increase of 24%.

That's not the only competitive front, either. To stave off rivals, Amazon has had to keep cutting prices and offering free shipping, which it informally considers a marketing expense. Its net shipping loss rose 29%, to $55 million, thanks to free shipping offers and Amazon Prime, a new $79 annual shipping subscription program that offers unlimited two-day shipping on most products. Indeed, that program, introduced in February, is "off to a very fast start," says Amazon.com Chief Executive Jeffrey P. Bezos, and that means even higher shipping costs in the short term.

In addition, the e-tailer has been especially focused on cutting prices in its core U.S. book market. A random check of prices on 20 books, conducted recently by Scott W. Devitt, an analyst with Legg Mason Wood Walker, showed that Amazon prices basically matched those of rivals eBay, Overstock, and Buy.com. That's in stark contrast to the 12%-plus premium it had been able to charge in previous quarters. And the price cuts aren't going to ease anytime soon. In July, Amazon will offer the newest Harry Potter book at a 40% discount.

MORE MERCHANTS. At the same time, like eBay and Overstock, Amazon is plowing more money into developing new features that it hopes will produce more sales and repel rivals. For more than a year, the company has been accelerating its investments in projects such as its A9.com search site, which debuted last year, Amazon Prime, and a Web services program that helps outside merchants tap Amazon's e-commerce systems.

All that is forcing the Net concern to hike research and development spending. Technology and content-development costs shot up 59% in the quarter, to $92 million. To get that work done, Amazon has also accelerated hiring of engineers and scientists. Employee count was up 16% in the quarter, to 9,400 people.

"We're investing substantially in our seller platform," says Bezos. To his credit, that's paying off. Outside merchants accounted for 27% of unit sales in the quarter, up from 23% a year ago. This revenue stream produces much higher profit margins than its retail business

And despite the recent loss of Circuit City (CC) as a merchant partner, Amazon in the past week has signed up Macy's, bebe.com, OshKosh B'Gosh, and Britain's Marks & Spencer as new partners. Says Bezos: "We're seeing very strong interest in building private-label e-commerce sites for other merchants."

LOOKING ELSEWHERE. The e-tailer did offer a few other bright spots. Its free cash flow, which it believes is the most important measure for long-term success, rose 21%, to $417 million. And North American sales are surprisingly strong, climbing 21% -- the highest rate in four years.

Problem is, none of that is falling to the bottom line as fast as most investors want. And that about sums up the dilemma for Amazon: Until it can prove that its sales growth can translate into profit expansion at the same time, investors will park their dollars elsewhere. Hof is BusinessWeek's Silicon Valley bureau chief


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