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Amazon: Good, Just Not Good Enough

Harry Potter's magic may have dazzled book buyers over the summer, but it failed to sway Amazon (AMZN) investors Oct. 25. Despite selling 1.6 million copies of Harry Potter and the Half-Blood Prince in the third quarter, the online retailer reported that a $40 million legal settlement whacked net income, which fell 44%, to $30 million. And a holiday season forecast that merely matched analysts' expectations sent investors fleeing, knocking down shares by almost 8% in extended trading.

Pottermania did keep Amazon's sales growth humming, at 27%, to $1.86 billion. And as earnings disappointments go, this one was relatively minor. Absent the legal settlement, Amazon would have reported a 12-cent-a-share profit, 2 cents above analysts' estimates.

GASSED-UP SALES? Moreover, even though Amazon is now predicting the strengthening U.S. dollar will reduce reported revenues by $100 million-plus in the fourth quarter, it still expects fourth-quarter sales to rise by between 13% and 24%, to between $2.86 billion and $3.16 billion. That's about the same range estimated by Wall Street before the currency impact was disclosed.

Taken together, those are signs that online retailing in general may end up doing reasonably well during the holidays. Although consumers are generally cautious because of the uncertain economy, the latest retail spending reports indicate that non-auto spending has scarcely slowed, rising 6.7% in September from a year earlier. That's a very small drop from August's 7% increase.

Some analysts also think high gas prices will lead many consumers to skip the mall and buy over the Web, where they can also compare prices more easily. As a result, says Heather Dougherty, senior analyst with the market researcher Nielsen//NetRatings, "We'll see more purchases online."

BIG SPENDER. Amazon had a high hurdle to clear after the second quarter, when better-than-expected earnings catapulted the stock 12% in one day. The shares hit a 52-week high on Oct. 24 before falling nearly 2%, to $46.17, on Oct. 25 just before the earnings report. "The stock had gotten a little ahead of itself," says Scott Devitt, an analyst with Legg Mason Wood Walker.

Investors who had been bidding the stock up likely expected healthier operating margins, a measure of profitability that's been the key concern for the past several quarters. To recharge sales growth, Amazon for more than a year has upped spending across the board, from building new fulfillment centers to hiring hundreds of engineers to offering customers shipping discounts.

That has taken a toll on profit. Amazon reported that third-quarter operating profit, which excludes certain items, fell 32%, to $55 million. Without the legal charge, it would have risen 17%. That still didn't thrill analysts on a conference call. They had a raft of questions about the payoffs from spending on new projects such as the A9 search site and Amazon Prime, which offers free two-day shipping for $79 a year.

STAY TUNED. Amazon Chief Executive Jeffrey Bezos provided no hard answers, but indicated he plans to continue spending. Amazon Prime, for instance, is "expensive, but it has a lot of benefits for customers and long-term for and its shareholders," he said. He said Prime customers are buying more, especially nonmedia wares such as electronics, tools, kitchen gear, and personal-health products.

Likewise, Bezos brushed off concerns about Amazon's technology spending, which rose to its highest level as a percentage of sales since early 2002. Besides A9, Amazon has been spending to develop services for partners to hook into Amazon's backroom database and commerce engine, as well as digital media offerings it has yet to announce. "There's a tremendous amount of opportunity and innovation yet to come," he said.

Amazon may need to keep spending to stay ahead of surging competition—not just online rivals such as eBay (EBAY) and Google (GOOG), but traditional retailers as well. Wal-Mart Stores (WMT), Target (TGT), and others have shown much faster growth in online traffic than Amazon lately. "We expect more competition from traditional retailers," says Merrill Lynch analyst Justin Post.

KEEN CUSTOMERS. Nonetheless, some investors and analysts remain sanguine about Amazon's competitive prospects. For one, e-commerce continues to take share from conventional retail, notes Allison Thacker, co-portfolio manager of the RS Internet Age Fund, which holds Amazon shares. Moreover, Amazon has managed to get visitors to click the buy button much more successfully than the likes of Wal-Mart and Target.

Market researcher Nielsen/NetRatings says more than 11% of Amazon visitors in September ended up buying something on the site, vs. just 3.2% at and 2.4% at

Thacker and Post also are pleased that Amazon has avoided joining the acquisition frenzy that has gripped Internet contemporaries such as eBay, Yahoo!, and Google. "It shows capital discipline," says Post. It just may take a bit longer for that to translate into capital profits.


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