Amazon Braves the High Wire

Once again, high earnings expectations for e-commerce stars are put to the test.
Publish date:

Updated from 10:57 a.m. EST

Fasten your seatbelts and close your chair trays.

(AMZN) - Get Report

will be reporting earnings after the close of the bell Wednesday.

For the past two quarters, Amazon's earnings reports have seemed to create pockets of great turbulence for its stock. In October, when the online retail giant posted third-quarter earnings that missed analysts' estimates by a penny, the stock fell 12% in a day. Three months earlier, when Amazon also missed by a penny, the stock fell 13%.

Attention Amazon shareholders: If you come across any dropped pennies Wednesday afternoon, crawl under the nearest Bloomberg, tuck your head between your knees and try to think happy thoughts.

Amazon's stock closed Thursday down 0.7% to $42.48 but has rallied more than 25% since its last earnings selloff. Around that level, "the stock is anticipating a clean beat-and-raise quarter," says AmTech analyst Mark Mahaney. "Since we don't have great conviction in this, we would be cautious on Amazon shares going into the numbers." (Mahaney's firm has no banking relationship with Amazon.)

This quarter, there's extra pressure on Amazon not to disappoint. Investors this earnings season have made it clear they want earnings growth from their e-commerce stars -- and they want it now. In recent weeks,


(EBAY) - Get Report

saw its fourth-quarter profit rise 55% while

(OSTK) - Get Report

delivered a small miracle with its first-ever quarterly profit.

Pretty nice, yet both stocks lost nearly a fifth of their value overnight when it became clear that each was taking perfectly good capital out of near-term earnings and investing it instead into long-term revenue growth.

Now it's Amazon's turn in the lion cage. Amazon has signaled that it would devote $150 million in capital spending in 2005, a 75% bump up from last year. To give a rough sense of what that $150 million means to Amazon, it's equal to 81 cents a share. Compare that to the estimated $1.11 that analysts are forecasting for Amazon in 2005.

But that won't happen. CEO Jeff Bezos has good reason to sink more money into the company's future. Put simply, Amazon is seriously losing share in its home market. Merrill Lynch analyst Justin Post estimates Amazon's 2004 U.S. revenue at $3.78 billion, up 16% on the year. But e-commerce sales grew 34% in 2004, according to Forrester Research. Post says Amazon's market share has fallen to 2.6% of all U.S. e-commerce sales, a bit more than half of its 4.8% share in 2001. (Merrill Lynch has no banking relationship with Amazon.)

Upstarts such as Overstock are selling books and music at cost and matching Amazon on free delivery for most of their products. As bothersome as Overstock is, the immediate threat to Amazon lies elsewhere: Overstock's 2004 revenue of $494 million is less than a third of the revenue


Amazon is expected to post for 2004.

The companies that are really feasting on Amazon's market share are big-name retailers setting up shop on the Web. Amazon's traffic grew 6% in November, according to the trade publication

Internet Retailer

, but

saw its traffic rise by 50%, while


saw theirs grow by 92% and 58%, respectively.

"The threat to Amazon from offline competitors is real, and these companies are becoming more focused on the online opportunity," Post wrote in a research report. "Offline retailers' efforts to gain share are likely to continue to pressure industry margins through lower prices or higher marketing spending."

A successful expansion into countries such as Germany and the United Kingdom has helped spur Amazon's growth and kept its margins flush. But not only is international growth slowing -- Lehman Brothers forecast international revenue growth at 52% in 2004 vs. 71% growth in 2003 -- but margins are deteriorating as well. Lehman expects gross margin on Amazon's international business to fall to 17.4% in the fourth quarter from 20.5% in the previous quarter.

Amazon's been down a bumpy road before. Years ago, Bezos put profitability on indefinite hold to expand Amazon's product lines to include first electronics and eventually everything from gourmet cheese to chaise lounges. Skeptics said the debt required would bring certain doom, but Amazon posted its first profit in 2002 and has stayed in the black since.

In 2003, Bezos cut back on marketing to offer free shipping and lower prices. Again, skeptics emerged and gravely shook their heads. But as Amazon's marketing costs fell below 3% of sales last year, compared with 10% in 2002, its base of active customers has risen 48% since 2002 to 46 million in 2004. And those customers are spending more: $149 per purchase last year vs. $127 two years ago.

Critics also chide Amazon for giving offline rivals such as

Office Depot

(ODP) - Get Report

access to its customers and attractive features including its customer reviews. But Bezos has turned this plan into an ace up Amazon's sleeve.

More than a quarter of all unit sales through Amazon's site come through third parties, but Amazon brings in fee and commission revenue at 100% gross margins. Some 10% of Amazon's total gross profit comes from third-party sales, according to Merrill Lynch. Much of it goes into discounting prices on Amazon, giving customers more incentive to buy there.

Mahaney at AmTech noted that eBay's earnings revealed weakness in Germany and softer-than-expected sales in the U.S. Lehman analyst Douglas Anmuth also cited that risk in a research note but said it could be offset by "a late-season surge in online shopping due to later shipping deadlines, local fulfillment through third-party partners and increased adoption of electronic gift cards." (Lehman Brothers has no banking relationship with Amazon.)

Analysts note that Amazon could also benefit from strong sales of hot-selling, high-ticket items such as the iPod, Philips DVD players and Canon Powershot cameras. The 2004 holiday season marked the first in which electronics surpassed books and music as the biggest-selling category on the site. A falling dollar, which added $87 million to Amazon's third-quarter revenue, could also give an unexpected boost.

Amazon's guidance for the fourth quarter calls for net sales to fall between $2.30 billion and $2.55 billion and for its pro forma operating profit to come in between $162 million and $222 million. The company doesn't give guidance at the net-income level or on a GAAP basis. Analysts surveyed by Thomson First Call are looking for sales of $2.42 billion, a GAAP profit of 35 cents a share and a pro forma profit of 40 cents a share.

Given those expectations, there are three scenarios that could disappoint investors: Amazon could miss earnings for a third quarter running; it could revise down its guidance because sales are slowing faster than expected; or it could announce that it needs to boost capex even higher to nurture future growth.

Of course, Amazon could also surprise with stronger-than-expected revenue and healthy growth in its closely watched operating margins, which have been hovering around 7%. But investors have set high expectations for the company -- and they have been reacting to disappointments this year with very foul moods.