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Amazon: Back from the Wilderness

By Robert D. Hof For the first time in recent memory, has handed investors a surprise -- the positive kind, that is. After a seemingly interminable string of earnings disappointments, the online retailer on July 26 reported better-than-expected earnings and sales for its second quarter. Amazon (AMZN) also slightly upped its guidance for the current quarter and the entire year, forecasting 2005 sales growth of 20% to 25%, adding up to as much as $8.7 billion.

Investors went wild. After falling less than 1% before the earnings announcement, to $37.74 a share, the stock jumped as much as 11% in after-hours trading. That's a stark contrast to at least the last four quarters, when Amazon's results prompted sell-offs of up to 15%.

"It's amazing how long the negative sentiments have lingered," says Scott Devitt, an analyst with Legg Mason Wood Walker. "But they had a good quarter."

GOOGLE'S GURGLE. This was investors' second positive reaction in less than a week to good news from a major e-commerce company. eBay's (EBAY) stock jumped 21% on July 21 following a resurgence in profit and revenue growth (see BW Online, 7/21/05, "eBay Is Back in the Bidding").

By contrast, major online media and advertising-driven companies such as Google (GOOG) and Yahoo! (YHOO) saw their shares fall on earnings reports that -- while they might be the envy of much of the corporate world, including e-commerce outfits themselves -- disappointed bullish investors (see BW Online, 7/22/05, "Google Proves It's Mortal," and 7/20/05, "A Big Boo for Yahoo!").

Amazon actually reported a 32% drop in net profit, to $52 million, or 12 cents a share. But the second-quarter results included $56 million in income taxes, compared with only $5 million a year ago. That 12 cents per share topped analysts' earnings estimates of 10 cents. Absent taxes, Amazon's operating profit rose 21%, to $104 million, ahead of Amazon's own forecast of $50 million to $80 million.

THE GOOD HOST. Sales also came in slightly higher than expected, rising 26%, to $1.75 billion. The reason, Amazon says, is due to lower prices and free shipping offers that prompted customers to buy more. On top of that, customers apparently snapped up not just items from Amazon's own inventory, but also from outside merchants that sell on Amazon's site.

Much of the earnings upside came from the second straight quarter of more than doubling what Amazon calls "other revenues" in North America. That's mostly from providing an online home to merchants from Target Stores (TGT) and (BEBE) to mom-and-pop sellers.

Unit sales of products offered by those merchants grew by 27% -- considerably more than the rest of Amazon's business. Now, unit sales of those products, which carry higher profit margins because Amazon doesn't have to stock them, represent 28% of overall unit sales at Amazon, up from 24% a year ago.

GROWTH AT A PRICE. Amazon CEO Jeff Bezos attributes the gains to making it easier for merchants to list inventory on Amazon, as well as making the experience of buying from those merchants more similar to buying direct from Amazon. "We want to be at parity with these third-party [sellers]," Bezos said. "We want to cannibalize ourselves in that way."

Amazon has hardly erased all the concerns that dog it. For one thing, it's shelling out more money to spur the higher growth. Spending on technology and content shot up 49% from a year ago, to $106 million, thanks to heavy investments in new services and features such as its A9 search engine. Marketing expenses rose 24%, to $42 million, over the same period. The e-tailer has set up three new distribution centers and plans to open three more by yearend, which will increase capital spending as well.

Amazon suffered a loss on shipping of $45 million, up 31% from a year ago, thanks to free-shipping offers on orders over $25 and a new program called Amazon Prime, in which customers pay $79 a year for free two-day shipping.

POTTER RETURNS. Still, those offers apparently are starting to pay off. Indeed, Amazon informally considers free shipping more of a marketing expense, since it uses the tactic to attract and keep customers instead of any advertising on television.

"Amazon Prime members are buying more and doing more cross-shopping," purchasing more electronics, kitchen, tool, and health products, says Tom Szkutak, Amazon's chief financial officer. That's why Bezos says he's sticking with the incentives. Long-term, he says, "We should see higher share of wallet from those customers."

During the quarter, Amazon took record preorders for 1.5 million copies of Harry Potter and the Half-Blood Prince. But that had little direct impact because revenues from those orders fall in the current quarter that ends Sept. 30. And even then, Amazon expects discounted pricing and shipping to produce breakeven results on those sales.

E-COMMERCE ATTRACTIONS. With Amazon's stock down 15% on the year before the earnings report, some investors were starting to find it more attractive. "I feel like it's getting pretty washed out," says Allison Thacker, co-portfolio manager for RS Internet Age Fund, which holds Amazon shares. She notes that investors stepped back because of Amazon's renewed investments in new features and products, but adds, "That investment is important for the long term."

Some analysts think the frenzy over Google, which abated only slightly with its somewhat disappointing outlook provided last week, could be peaking -- prompting investors to look anew at e-commerce stocks. "The e-commerce companies have the wind at their backs," says Devitt.

That doesn't necessarily ensure smooth sailing. But it sure beats the stiff headwinds that have been slowing them down up to now.

Hof is BusinessWeek's Silicon Valley bureau chief

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