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Shine Comes Off Amazon

Since posting fourth-quarter earnings, the online retailer's stock has fallen 24%. Here's why.

Updated from Feb. 3


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reported its fourth-quarter earnings, its stock has fallen off a cliff. The tumble picked up speed Tuesday, suggesting this may be more than a typical sell-the-news reaction to Amazon's quarterly results.

Shares in the online retailer dropped $3.33, or 6.9%, to $44.94 Tuesday while the broader market was up modestly. That pushed the stock's total decline to $10.80, or 24%, since Jan. 27, when the company

issued its earnings report. (The stock was rebounding a bit Wednesday, recently up 36 cents, or 0.8%, to $45.30.)

Buy-side analysts speculate that the selloff is a result of a number of factors: profit-taking, institutional selling and disappointment with the company's gross margins. While some think the online retailer's stock will rebound quickly, others aren't so sure.

The key problem Amazon faces is that investors' perceptions of the company are changing, said Gary Farber, a partner with the hedge fund Nightingale & Farber in Seattle. It used to be viewed as more of a technology company. But the company's declining gross margins have investors seeing it more as a retailer -- and an expensive one at that.

"The stock hasn't changed, the company hasn't changed, but the psychology has changed," said Farber, whose fund has no position in Amazon.

The psychology seemed to start changing as soon as Amazon reported its earnings. The company's profit met analysts' expectations -- on better-than-expected revenue. But analysts were clearly worried about the decline in the company's gross profit margin, or the difference between what a company charges customers for its goods and services, and its direct costs of providing them.

In the quarter, Amazon's gross margin as a portion of sales fell 1.6 percentage points to 21.9% vs. the fourth quarter of 2002. The company attributed the decline to its free-shipping promotion, and to its strategy of cutting prices on its products.

On a conference call following the company's earnings report, Amazon's analysts grilled Chief Executive Jeff Bezos and CFO Tom Szkutak about whether that strategy was the right one.

Cutting prices is a more cost-effective means of driving sales than spending money on television or other advertising, Bezos and Szkutak argued. They pointed to the company's bottom line as proof that the strategy works. Last year marked the first year Amazon posted a GAAP profit for the entire year.

"We are not trying to optimize the company for gross margins. We're optimizing it for free cash flow in absolute dollar terms," Bezos said on the call. "We will for years and years and years give back the gains that we get in terms of lower prices. We think that's the way to optimize this business."

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But Bezos and Szkutak did little to squelch investor concerns. Many analysts have been expecting the company's gross margin to increase.

A key concern centers on commissions from third-party sales through Amazon's Web site. Such sales offer the company high gross margins, because Amazon typically carries no inventory related to those sales and doesn't have to pay for shipping third-party products.

Because Amazon gives only sketchy details about third-party sales, it's difficult to tell how much money the company is really earning from them. But the company's decline in gross margins indicates that Amazon is not earning as much from third-party sales as analysts expected, or margins on the goods it sells directly slumped drastically in the quarter.

Either way, the decline in gross margin could be a concern if the company decides it needs to spend more money on advertising, or if its other operating expenses start to spike. Because its gross margin is so small, Amazon could have little money left over to absorb such costs profitably.

"These are retailer margins -- and not even that," said Farber, noting that many retailers posted better gross margins than Amazon recorded in the fourth quarter.

Still, the explanation for the selloff could be a little less complicated.

Amazon's shares rose 179% last year. Prior to its earnings report, Amazon's stock was trading at 85 times the company's projected GAAP earnings for 2004. That was a significant premium to e-commerce rival


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, which was trading at about 65 times its 2004 projected GAAP earnings at the time.

"I think what we have is people profit-taking," said Susan Fulton, president of Fulton Breakefield Broenniman, which manages about $200 million in assets. "I thought

Amazon had run ahead of itself before it reported earnings."

Fulton, whose fund is long Amazon shares, said she's not concerned by the selloff, adding that her firm has been using the stock's decline as a chance to increase its stake in Amazon.

"It's a stock we like," she said. In terms of the company's prospects, she added: "We just think we ain't seen nothing yet."

Likewise, Lisa Ketrick, a buy-side analyst who covers the company for TCW, said she's not concerned by either Amazon's gross margin or its recent stock slide.

"We're looking at their operating margin expansion," Ketrick said. "That's what they said they would do and they're doing it." (TCW is long Amazon shares.)