What's Wrong With Tech?

So why would Amazon go to all the trouble of negotiating with the notoriously difficult music industry and of launching hardware that would compete with the MP3 players it already sells online? Because the company sees the potential for online music downloads -- and the quickly following online video download -- to erode the most profitable parts of its business, the online sale of prerecorded CDs and DVDs.

In the U.S., sales of prerecorded CDs have fallen 21% since 2000, according to Nielsen SoundScan, and dropped 7.2% in 2005 alone. In contrast, 353 million songs were downloaded online last year onto iPods and MP3 players, up 153% from a year earlier.

If Amazon doesn't do something, the online download technologies for music and video will gobble up its CD and DVD business.

But investors in Amazon don't have to worry about the possibility that Amazon will lose out to the disruptive technology. Even if the company does manage to defend its turf, it will have to spend more money to do so. That means lower earnings, and lower earnings mean a lower stock price.

When Amazon announced its fourth-quarter 2005 earnings, it reported that fourth-quarter spending on technology and content -- money spent to improve customer service, offer new products and fend off competitors -- climbed to 4.4% of sales. That was 1.2 percentage points higher than in the fourth quarter of 2004. And that certainly contributed to the drop in profit margins to 6.6% in 2005 from 7% in the fourth quarter of 2004. Amazon's projected range for its profit margin in 2006: 5.1% to 6.2%.

In periods of technology consolidation, earnings growth trends get more certain, and earnings themselves grow faster as clear technology leaders emerge from the fray. In some areas, a single company -- Cisco Systems, Intel and Microsoft come to mind -- manages to corral the majority of the profits as a technology matures.

In periods of disruption, earnings growth trends get less certain. What growth rate should investors count on from Dell or Amazon over the next couple of years? And that makes earnings less valuable. Investors pay less -- a lower multiple of earnings per share -- when earnings are less predictable.