Amazon Turns in a Smart Third Quarter

Its profits beat analyst expectations, and sales continue strong. But some investors wonder when—or if—tech offerings will pay off

by Robert Hof

The summer quarter is usually pretty slow for retailers online and off, but Amazon.com (AMZN) managed to get more shopping clicks than anyone expected. The online retailer's third-quarter sales rose 24%, to $2.3 billion—nearly hitting the high end of its own forecast three months ago, and beating analysts' expectations as well.

Despite a 37% drop in profit thanks to higher expenses, Amazon's five-cents-a-share profit beat analysts' average estimates of three cents a share. As a result, Amazon's stock jumped 14%, hitting 38.35 in early after-hours trading on Oct. 24.

Sales appeared to be strong across the board. In particular, sales of electronics gear and other hard goods rose 43%, to $699 million, now comprising 30% of Amazon's overall revenue. But Chief Financial Officer Tom Szkutak says lower prices and free-shipping offers helped a wide range of products. "A lot of things we've talked about for a long time have come together," he says. Indeed, a survey by Majestic Research in New York indicated Amazon's prices tend to be among the lowest in its peer group (see BusinessWeek.com, 4/26/06, "Amazon's Brighter Horizon").

Tech Quandaries

That bodes well for the current quarter, as Amazon readies for the crucial holiday season. "We're expecting a pretty strong holiday season," says Majestic analyst John Aiken. That's despite the termination earlier this year of Amazon's longtime deal to run a joint site with Toys 'R' Us. Aiken says Amazon's toy sales haven't dropped off significantly since the deal ended. "Early trends are mildly positive," he says (see BusinessWeek.com, 10/4/06, "Amazon, Toys 'R' Us, Face Off After Split").

The third-quarter results were a big reversal of the second quarter, when Amazon reported disappointing earnings and its stock plunged 22% in one day. Thanks to concerns about the cost of various technology initiatives and free-shipping offers, Amazon's stock is down about 45% since the start of the year.

Indeed, investors' big concern remains the cost of new tech services, which to date haven't produced obvious results. During the third quarter Amazon continued to roll out a stream of new services. They included Amazon Unbox, a video-download service that competes with Apple Computer's (AAPL) recent iTunes video offering. At the same time, the company also de-emphasized its once highly touted A9.com search engine, cutting back on features such as millions of street-level photographs of local businesses (see BusinessWeek.com, 2/3/06, "Amazon's Costly Bells and Whistles").

Ongoing Pressure

Amazon also stepped up services to businesses. It launched a test version of an online computing service, called the Elastic Compute Cloud, that lets other businesses use Amazon's spare computing capacity for a fee. It also began offering a storage and delivery service to other merchants, who can then tap into Amazon's fulfillment, customer service, and delivery systems.

Those still-nascent efforts continue to dampen profits. In the third quarter, Amazon's net profit fell to $19 million, from $30 million a year ago. And analysts want to know more about the actual or potential benefits. "There's no way for us to know if these investments are producing any profit," says Piper Jaffray analyst Safa Rashtchy.

Amazon said pressure on profits is likely to continue. For the fourth quarter, Amazon provided a wide range of possible results, saying operating income could come in between 12% below a year ago and 43% above a year ago. And for the full year, Amazon said operating income could drop between 1% and 22%. Three months ago, it held out the possibility that it might see slight operating-income growth of 2% if everything went well.

Snapping Up Shares

That was the only apparent negative trend, however, and it was a slight one. The biggest relief for investors may be Amazon's sales-growth outlook. The company predicted fourth-quarter sales would rise between 22% and 33%, to as high as $3.95 billion. For the full year, it's predicting an uptick between 22% and 26%, to as much as $10.68 billion. That's up to two percentage points higher than it forecast three months ago.

Amazon apparently considers its stock undervalued. It approved a two-year, $500 million stock-buyback plan during the second quarter and ended up buying half that amount since then. If it can keep up the newfound momentum in the fourth quarter, Amazon may find itself in the favorable position of competing with regular investors for the rest.

Hof is BusinessWeek's Silicon Valley bureau chief.