Amazon Investors Feel the Sting

Executives lowered short-term expectations but say expensive initiatives will pay off down the road. How patient will investors be?

The rule is no pain, no gain. So, analysts were expecting to see Amazon (AMZN) in some hurt from a second quarter focused on expensive development and expansion initiatives intended to fuel future growth. But, oh, the pain!

The online retail giant reported net income of $22 million, compared with $52 million in the second quarter of 2005, even as net sales rose 22%, to $2.14 billion for the period. Both the net income and revenue figures fell slightly short of analysts' cautious second-quarter estimates, which had taken into account heavy R&D expenditures (see, 4/26/06, "Amazon's Brighter Horizon").


 Where the sting really came, however, was in Amazon's outlook for the near future. Company executives lowered their expectations for the third quarter, citing the margin impact of continued investment to expand sales offerings and aggressive pricing to launch new sales categories. Among other areas, Amazon is investing heavily in toys in the wake of the termination of its contract to sell goods for Toys R Us.

The loss of that contract, after a messy legal battle, cost Amazon $20 million in the second quarter. "We want to have very competitive pricing when we have the new categories," explained Chief Financial Officer Tom Szkutak on the July 25 call to investors. He added that, though the company expected the new categories would pay off big long term, "we think it is going to be expensive short term."

The company now anticipates operating income for the third quarter will be between $7 million and $42 million, representing a decline of between 87% and 24%, when compared with 2005's third-quarter results. For the full year, the company expects operating income to be between $310 million and $440 million. That would be 2% growth on the high end, or as much as a 28% decline, compared with the previous year.

Analysts and investors were disappointed to hear how long the pain would last and were wary of whether the gains would be worth it. The stock, which closed at $33.59, fell more than 12% in after-hours trading.


  In a note to investors, Goldman Sachs analyst Anthony Noto expressed his disappointment: "Amazon reduced its operating profit guidance by 15%…which appears to be a departure from a return to double-digit incremental operating margins," he wrote. "The company needs to resolve several company-specific issues (i.e., its proprietary toy offering as well as its digital strategy) and simultaneously show stronger incremental margins before we can consider becoming more positive on the stock." Noto has a neutral rating on Amazon's stock and has more confidence in the growth potential of other tech companies such as eBay (EBAY), Yahoo (YHOO), and Google (GOOG).

For Amazon's margins to get significantly better, some of Amazon's recent investments will have to pay off. In the past three months, Amazon began offering on-demand printing of hardcover and softcover books through its subsidiary BookSurge. It also began selling on-demand DVDs of TV programs through CustomFlix Labs and, in June, launched a grocery channel that sells bulk nonperishable items.

The company even began selling storage on its server for Web 2.0 companies (see, 3/13/06, "Amazon's New Product: Storage"). In another initiative, the company expanded its Amazon Prime service, which offers free two-day shipping in exchange for a nearly $80-a-year subscription fee. During the July 25th earnings conference, company executives said the free-shipping program has increased sales volume by creating customer loyalty and encouraging customers to try out new sales offerings. However, they admitted it also affected profit margins.


  During the earnings conference call frustrated analysts peppered company founder and CEO Jeff Bezos with tough questions about whether all the heavy investments will be worth it. He said he believes that the company will end up turning a profit on even some of its more controversial investments, including those in groceries and toys.

"The energy that we put into building those fly wheels today will continue to pay dividends 10 years from now," said Bezos. Amazon spent $167 million in the current quarter on research and development, which the company calls technology and content.

With all the money Amazon is spending to improve and expand services, it probably will see gains, at least in revenues, over the long term. But the question for now is, can investors stand the pain?

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