Amazon's Costly Bells and Whistles

The online retailer is stepping up spending on new Web features and services. That's crimping profits and trying investors' patience (AMZN) Chief Executive Jeff Bezos insists it's still Day One on the Internet, so he must keep spending to pursue new growth opportunities. But investors are getting increasngly impatient for a new day to dawn -- when the pioneering online retailer's investment in technology will finally start paying off.

If it's growing profit they want, they'll have to wait a while longer. On Feb. 2, Amazon said fourth-quarter net profit fell by 43%, to $199 million, as sales rose 17%, to $2.98 billion. The profit drop was expected, thanks to increased spending on new tech development and free-shipping offers, as well as a big one-time tax benefit in the year-ago quarter. Sales also came in a hair short of the nearly $3.1 billion that analysts had forecast.


  But the bigger concern for investors is that Amazon continues to toe a conservative line on the coming year. For 2006, it expects sales growth of between 16% and 23%, slightly below or merely matching the larger e-commerce market, which is expected to expand about 25%.

More worrisome, Amazon said first-quarter operating income could decline by up to 35%. It also predicted operating profit could range from a drop of 14% to growth of 18%.

Why the seemingly endless pressure on profits? Mainly because new opportunities beckon in digital media, online advertising, and more. And more than ever, those opportunities are up for grabs. "We increased our cost structure substantially, but we see a lot of opportunity going forward," Bezos said in a conference call with analysts.


  So do a lot of other Internet players that have been similarly punished for disappointing fourth-quarter results. Yahoo! (YHOO), eBay (EBAY), and Microsoft (MSFT) also have been hiking spending on Net initiatives, partly as response to Google's (GOOG) incursions into seemingly every online market. Even mighty Google saw its stock fall 7% on Feb. 1 after new investments in its international operations contributed to reduced profit growth (see BW Online, "Google: Just Not Good Enough").

"Everyone's spending because there's this battle for what's next," says Scott N. Devitt, an analyst at investment bank Stifel, Nicolaus & Co. "Google's the leader in terms of forcing everyone to spend and improve their customer experiences." Some Amazon investors, at least, decided they no longer want to wait for Day Two. In extended trading, Amazon's stock fell about 9%, following a 3% drop before the announcement, to $42.74 a share.


  None of this means Amazon is in significant trouble. Its sales growth, while a slight disappointment, remains relatively high, given that the company this year may well pass $10 billion in sales, a level that makes rapid growth more difficult. What's more, growth actually would have been five percentage points higher, or 22%, if the strength of the U.S. dollar hadn't reduced the value of overseas sales.

Finally, a gradually increasing portion of its unit sales are by outside merchants -- 28% in the fourth quarter. That tends to depress dollar-sales growth because Amazon books only the commission received on those sales, not the total revenue value. But those sales carry much higher profit margins. Indeed, despite the profit drop, Amazon actually beat estimates by a few pennies a share.

Still, Amazon is making long-term bets that could keep many investors on the sidelines for months to come. One hope is that reduced prices, both on products and especially on shipping, will capture new customers and cement the loyalty of existing ones. Thanks to free-shipping offers such as its Amazon Prime program, which gives customers free two-day shipping on most orders for $79 a year, Amazon incurred a shipping loss of $78 million in the quarter. Moreover, it began offering free trial memberships in Amazon Prime, which could further hike shipping losses this year.


  The good news is that those losses, up 17% last quarter, aren't increasing at a higher rate than sales. So the cost relative to sales is steady or even dropping slightly -- a sign that Amazon is gaining efficiencies from the practice. "We're getting more share of wallet, and we're seeing customers buy more [from] other categories," noted Tom Szkutak, Amazon's chief financial officer.

The bigger bet is in spending on technology, which jumped 57% in the fourth quarter, to $132 million. For the past year or so, Amazon has been hiring hundreds of engineers and programmers for a wide variety of initiatives, from search to Web services for outside merchants selling on Amazon's site.

The key questions investors have: What's the payoff -- and when? "Their R&D spending has ramped up a lot in the last 12-to-18 months," says Allison K. Thacker, co-portfolio manager of the RS Investment Age Fund, which holds Amazon shares. "I would really like to know what they're spending the money on. I'd like to know what the benefit is."


  But Bezos shed little light on the timing of a payoff. He noted only that Amazon expects to "utilize" what it's building in the next couple of years. Projects include its A9 search service and various digital-media initiatives, including new programs called Amazon Pages and Amazon Upgrade that will let customers buy digital versions of pages, chapters, and sections of books, as well as entire books, in digital form.

Although Amazon executives wouldn't discuss specific plans, the company is widely rumored to be preparing digital music and video offerings.

Some investors seem willing to give Amazon the benefit of the doubt on its tech spending. "This is a management that's doing the right thing," says Timothy M. Ghriskey, chief investment officer at Solaris Capital Management, which holds a small number of Amazon shares. "But investors aren't ready to pay [up] for that." Still, Bezos & Co. might want to set their clocks ahead some.

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