Technology

Amazon: Giving Away the Store?


Revenue growth outstripped predictions, but margins are slimming and some say the e-tailer has to spend too much to lure customers

It was a happy holiday shopping season for Amazon (AMZN). The e-commerce giant reported sales of $3.99 billion for the last three months of 2006, a 34% increase that beat the Street's average estimate of $3.77 billion. But the better-than-expected fourth quarter was not enough to distract analysts and investors from signs that the days ahead could be challenging.

Amazon's stock closed the day up more than 2.7% at $38.70. But shares declined slightly in trading immediately following the Feb. 1 earnings announcement, reflecting investor and analyst concerns that Amazon's profits are coming at a greater cost to the company.

Squeezed at the Margins

Fourth-quarter gross margins showed the lowest growth in about five years, missing many analysts' expectations. Net income declined from $199 million, or 47¢ per share last year, to $98 million, or 23¢ a share, during the final three months of 2006. For the full year, operating income declined 10%, to $389 million, compared to $432 million in 2005. Amazon executives attributed the decline to increased spending in technology and content intended to grow the number of consumers who shop on the site.

The somewhat disappointing margins continued a trend. Last quarter, the company posted a 37% drop in profit (see BusinessWeek.com, 10/25/06, "Amazon Turns in a Smart Third Quarter").

During the call, Amazon Chief Financial Officer Tom Szkutak cautioned analysts against becoming too concerned with declining margins. He said that Amazon was investing in the site and offering lower prices to attract more customers overall and break into new product categories. "Even though you have seen gross margins come down, a lot of these new categories have a lot of meaning for us," said Szkutak.

For some analysts, however, the pressure on the margins was a warning that Amazon needs to offer too sweet a deal to entice buyers. Tim Boyd, an analyst at Caris & Co., says the margins prove his thesis that the company is underperforming. "It was never in dispute that these guys can generate tremendous top-line growth," says Boyd. "But ultimately it does come down to the bottom line, and it's just not there."

Shipping Pains

Boyd blames free shipping and low prices for the margin pressure. The company has relied on both to encourage more people to shop on the site and entice buyers to look for goods in new categories. In the last half of 2006, the company expanded its Super Saver Shipping program, which offers free shipping and a longer wait for selected items. It also shipped more goods for free through its Amazon Prime program, first introduced in February, 2005, which provides free two-day shipping and $3.99 overnight shipping in the U.S. to users who agree to pay a $79 annual fee.

In a press release before the earnings call, Amazon founder and chief executive Jeff Bezos said the free shipping led to more spending. "Amazon Prime members spent more with us across categories as they took advantage of unlimited free two-day shipping," he said.

Amazon's investment in new categories also increased costs for the retailer. The company launched a new automotive parts and accessories store in October. It started a shoe and handbag store, called Endless, which also offers free overnight shipping and a lengthy return period. It also was forced to launch its own toy and baby stores after splitting with Toys 'R' Us. While the new categories help sales, Amazon must invest in technology to launch the categories and in manpower to attract new vendors as well as spend money on deals such as shipping to entice people to shop for the new merchandise.

Yet another factor putting pressure on Amazon is increased competition in the e-commerce market. Google (GOOG), for example, has become the first stop for many online shoppers that once started their online browsing on sites such as Amazon (see BusinessWeek.com, 11/13/06, "Jeff Bezos' Risky Bet").

Declining Growth

In a note to investors, Goldman Sachs (GS) analyst Anthony Noto said he believes Amazon's margins are unlikely to see significant improvement in the coming year. "We continue to believe that the company will require continued investment both to drive sales at Amazon.com and to build new brands," wrote Noto.

Szkutak said he anticipates Amazon's revenue for the first three months of 2007 will grow 25% or more, falling somewhere between $2.85 billion and $3 billion. Amazon said operating income, however, is expected to come in between $82 million and $122 million—ranging anywhere from a 22% decline to 16% growth compared to the first quarter of 2006. For the full year 2007, the company anticipates that operating income will be $355 million to $505 million, or somewhere between a 9% decline and 30% growth. The guidance didn't sit well with analysts. In his note, Noto wrote: "Results/guidance reinforce our doubt that Amazon margins are truly at a trough and we see a return to double-digit incremental margins as unlikely in 2007."

Another margin decline isn't likely to go over well with analysts, regardless of how much sale volume the company sees. "The fact that they had such tremendous revenue growth and margins were still down—that makes me more bearish," says Boyd.

Holahan is a writer for BusinessWeek.com in New York .

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