Investors Punish Amazon

The stock plunges more than 12% after the company's disappointing earnings report.
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Updated from 12:07 p.m. EDT

Shares of

Amazon.com

(AMZN) - Get Report

plunged more than 12% on Friday as analysts slashed their price targets following a disappointing quarterly report.

Amazon shares finished the regular session at $34.60, down $4.87, or 12.34%. The stock was recently up 7 cents after hours.

Not only did the e-commerce company miss consensus estimates for its just completed third quarter, but it offered a much weaker than expected forecast for its 2005 results. The report marked the second straight quarter that Amazon has missed analysts' estimates and offered guidance that was below the Street's expectations.

The earnings miss in itself would have been enough to prod investors to sell off Amazon's stock, said Mark Mahaney, an analyst with American Technology Research, in a research note issued Friday. But on top of that, the company's operating results are weakening, he said.

"Miss-and-lower quarters simply do not cut it for Internet stocks," said Mahaney, who lowered his price target on Amazon's shares to $39 from $46. The analyst maintained his "hold" rating on the company's stock. (American Technology Research does not do investment banking.)

Amid a slew of similar reports, Amazon's shares were off $4.44, or 11.3%, in recent trading to $35.03.

After the bell Thursday, Amazon said it earned $54.15 million, or 13 cents a share, in the third quarter, up from $15.6 million, or 4 cents a share, a year ago. Revenue jumped 29% from a year ago to $1.46 billion.

Excluding stock-based compensation and other charges, the company would have earned $73.37 million, or 17 cents a share.

Those results came in just below Wall Street's expectations. On average, analysts polled by Thomson First Call expected Amazon to post a profit of 14 cents a share -- 18 cents a share excluding charges -- onsales of $1.47 billion.

But the results came in toward the top of Amazon's own forecast. In July, the company projected it would post operating income of $50 million to $70 million on sales ranging from $1.425 billion to $1.525 billion. Although the company did not provide an EPS prediction, its guidance implied that it expected pro forma earnings of about 13 cents to 17 cents a share.

Going forward, Amazon expects to post fourth-quarter operating income ranging from $137 million to $197 million on sales of between $2.295 billion and $2.545 billion. For 2005, the company expects to show an operating profit of between $400 million and $525 million on sales ranging from $7.40 billion to $8.15 billion. The company did not give EPS estimates.

Last year, Amazon earned $73.15 million, or 17 cents a share, in the fourth quarter, on $1.95 billion in sales.

Assuming that Amazon's outstanding shares increase modestly and the company's interest expenses and income remain similar to previous quarters this year, the forecast implies a pro-forma earnings range of about 33 cents to 47 cents a share for the fourth quarter.

Using similar assumptions, the company's full-year forecast implies a pro-forma earnings range of about 90 cents to $1.04 a share next year.

While the company's fourth-quarter expectations appear to be in line with Wall Street's forecasts, its revenue guidance for next year is far below analysts' estimates.

For the fourth quarter, Wall Street is looking for earnings of 38 cents a share -- 41 cents a share excluding charges -- on sales of $2.42 billion. Amazon's full-year forecast, given in July, implies that it expects to post operating income of about $153 million to $193 million in the holiday quarter on sales ranging from $2.28 billion to $2.48 billion. The company's guidance also implies a forecast for pro forma earnings of about 35 cents to 45 cents a share in the fourth quarter.

The Street has forecast 2005 earnings of $1.23 a share -- $1.36 a share excluding charges -- on $8.27 billion in sales.

Amazon's report came after the bell on Thursday. Earlier in the day, the company's shares closed regular trading up $1.12, or 2.9%, to $39.47.

The company's report is likely to feed growing fears about the company's growth and profit prospects.

Perhaps most disturbing for investors is a subtle shift in the discussion by company executives of its financial goals. In the past, the company set a goal for itself of posting operating profits in the low-double digits as a percentage of revenue.

But the company's recent performance has seemingly put that goal further out of reach. In the third quarter, for instance, Amazon's operating earnings were 5.6% of sales, down from 6.2% of sales in the second quarter and 7.2% of sales in the first quarter of this year.

On a conference call with investors and analysts, Amazon CEO Jeff Bezos said the company is now focusing on absolute dollars of operating profit, rather than percentage margins. Instead of worrying about percentages, the company is using discounts and promotions to lure in customers and get them to buy more from its store, he said.

"It turns out that the best way in our business to maximize absolute

operating income dollars is by lowering prices, offering free shipping, and taking our efficiencies, as we can afford to do so, and give them back to our customers," Bezos said.

The costs of that strategy, though, are clearly adding up.

The company offers free shipping on many of its orders. Because of that promotion, the company's shipping operations lost $41 million on $87 million in revenue. That was even worse than the year-ago period, when the company lost $27 million on shipping revenue of $77 million.

Amazon's rationale for the free shipping program has been that the promotion, plus offering discounted products, are much more efficient tools for customer acquisition and retention than traditional advertising and marketing.

Essentially, company officials have argued, Amazon is taking dollars that would have been spent on advertising and giving them to customers. While the company's gross profit margins have declined, the company's marketing budget should decrease as a portion of revenue, goes this argument.

(Gross profit represents the difference between what a company charges customers for its goods or services and its direct costs of providing them.)

However, as a portion of revenue, the decline in the company's gross profit margin has consistently outpaced the decline in the company's marketing spending. In the just-completed quarter, for instance, Amazon's gross margin declined 88 basis points from the third quarter last year to 24.3% of sales. In contrast, the company's marketing spending fell just 16 basis points from the year-ago period, to 2.35% of sales.

And as it has done in each of the past five quarters, Amazon spent more on marketing in the third quarter than it did in the year-ago period.

Amazon expects to continue to increase the overall amount it spends on marketing, company CFO Tom Szkutak said. However, the company plans to continue to focus that marketing spending on online advertising, rather than on pricey television or print campaigns that it used during the dot-com boom, he said.

Company officials have long emphasized that the company is different from a traditional retailer in that it has little in the way of brick-and-mortar operations. Bezos likes to say, for example, that the company is trading technology costs for the cost of those physical presences. The point being that the price of technology per performance received from it continues to decline; physical store costs continually go up.

Despite this argument, Amazon has seen an uptick in its technology costs in recent quarters, which has cut into its operating margin. In the third quarter, for instance, the company spent $64.8 million on technology expenses, or about 4.4% of total revenue. That marked the third straight quarter, sequentially, that Amazon's technology costs have increased relative to sales.

Amazon is hiring computer scientists and engineers and investing in initiatives such as its A9 search engine and Web services technology, Szkutak said.

"We intend to continue investing in these and other services," he said.

Besides the rising marketing and technology costs, another area of concern for investors may be the quality of Amazon's revenue and earnings.

The company's top and bottom lines, for instance, were boosted by the decline of the dollar vs. other major currencies. That decline inflated the dollar value of sales through Amazon's international stores.

The change in currencies added some $57 million to the company's sales. Had the exchange rates stayed constant, the company's year-over-year revenue growth would have been about 24%.

The decline of the dollar added about $3 million to Amazon's bottom line, or about a penny a share, the company said.