Amazon's Profit Sacrifice Can Work Again

NEW YORK ( TheStreet) -- Amazon ( AMZN) was unprofitable for nearly a decade, essentially hemorrhaging money to ultimately become a retail powerhouse.

Now it seems Amazon will once again sacrifice the bottom line in order to reinvent its e-commerce business into a digital distributor. CEO Jeff Bezos' strategy isn't much different this time around than it was in the late 90s and early 2000 -- overinvest for the long term.

But it seems Wall Street isn't drinking the Kool-Aid, doubtful that Amazon's goal of selling devices so it can sell more movies, books and music will pay off. Shares of the e-commerce giant fell more than 10% in morning trading, but this could represent a prime buying opportunity.
Jeff Bezos, chairman and CEO of Amazon.com, introduces the Kindle Fire.

"We remain buyers of shares of Amazon.com on the share price weakness following third-quarter 2011 earnings results," Deutsche Bank analyst Jeetil Patel wrote in a note. "In a model and environment in which new customers yield an increasing returns scenario and higher lifetime value over time, Amazon is further investing for long-term scale across multiple fronts. The key for Amazon appears to be over-investing to add the right customers in the near-term through various products and services, with an eye towards returns longer-term from this audience."

Amazon reported disappointing third-quarter results, as earnings missed consensus estimates by 10 cents and were significantly off whisper forecasts. But management's outlook for the fourth-quarter -- specifically on revenue -- is really what concerned investors.

The e-commerce giant is predicting a loss between $200 million to a profit of $250 million, which essentially implies a profit margin of zero, according to analysts. Investors may be able to put up with some weakness on the bottom line, but Amazon also issued soft revenue guidance between $16.34 billion and $18.65 billion. This compares with analysts' estimates of $18.15 billion.

"While investors may be partially concerned on a lack of greater revenue guidance in the fourth quarter of 2011 or the profit impact from Kindles in fourth quarter, we think these concerns are somewhat transitory when customer growth of 26% is the fastest since early 2004 and 53% unit growth clearly illustrates that the growth formula remains intact," Patel wrote.

Other noteworthy trends include a 21% jump is U.S. media sales to $4.15 billion. The company also said it is adding 17 new fulfillment cents in 2011, compared with its prior plan of 15.

"We note that Amazon has been through various reinvestment cycles in the past, which have dampened near-term margins," Credit Suisse analyst Spencer Wang wrote in a note. "However, given the attractive growth prospects and the high ROIC characteristics of Amazon's business model, we think this is the right long-term investment decision. Ultimately, we believe value creation is driven by increasing profit dollars as opposed to profit margins. Amazon has employed this strategy in the past to much success."

Amazon is typically tight-lipped during its conference calls and last night was no different. Chief Financial Officer Tom Szkutak drove home Amazon's message about "lifetime value."

"And when we think about the economics of the Kindle business, we think about the totality. We think of the lifetime value of those devices," Szutak said. "So we're not just thinking about the economics of the device and the accessories. We think about the content. We are selling quite a bit of Special Offers devices, which includes ads. We're thinking about the advertisements and those Special Offers and those lifetime value s ."

The hope is that Kindle Fire users will ultimately be more active Amazon shoppers.

Kindle Fire users will receive one month free of Amazon Prime, a tactic used to get more people to sign up for the $79-a-year service. Amazon Prime members receive free two-day shipping, as well as access to about 12,000 (and growing) streaming movies and television shows.

Currently, Amazon Prime boasts about 12 million members who buy four times more merchandise from the e-commerce giant than the regular shopper, according to ChannelAdvisor, an e-commerce business software firm.

Bank of America Merrill Lynch analyst Justin Post estimated that an active Amazon shopper spends about $115 per year on media and that tablet users will spend about 50% more on books, movies, music and games. This could add about $60 a year in annual media sales per Fire customer.

Post also predicts that if 5% to 10% of tablet users adopt Prime and those users spend four times more on average, they could contribute $640 million to $1.3 billion in incremental revenue in 2012.

"Given the speed of the digital media transition, we believe the tech and content investment is justified, with the big question being if the new EGM electronics and general merchandise categories and AWS can deliver margins close to prior peaks. We expect margins to eventually turn, and when they do (maybe not until the fourth-quarter of 2012) we expect the stock to see a positive move," Post wrote.

-- Reported by Jeanine Poggi in New York.

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