Tracking Amazon's Thin Margin

The focus again will be on operating margins, as investors brace for disappointing news.
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Amazon.com

(AMZN) - Get Report

has had a hard time pleasing Wall Street with its earnings numbers. From most indications, investors are likely to again hear a sour note.

Analysts are calling for Amazon to post a profit of 10 cents a share on both a pro forma and GAAP basis, according to Thomson First Call. Revenue is projected to reach $1.73 billion, which would mark a 25% gain from the year-ago quarter.

In addition to Amazon's bottom line, Wall Street will be keenly watching a few other numbers: revenue growth rates, including international revenue growth and operating-profit margin. In particular, investors have recently fixated on Amazon's operating margin.

And Amazon's margins have had a very lilting look to them in the past few quarters. CEO Jeff Bezos has been betting he'll win the loyalty of online shoppers by offering free shipments on orders over $25. He liked that idea so much that earlier this year he began offering free two-day shipping for customers who paid a $79 annual fee.

Bezos believes it's helping push up revenue as well as free cash flow -- a number that he has argued is a more revealing financial measure than net profit (and many analysts agree with him).

But Wall Street kneels at the altar of the income statement, and vocal investors are unhappy that Bezos is handing money over to

UPS

and

FedEx

when it could be going into the investors' own pockets through stock buybacks, if not dividends.

And those irreconcilable views have led to a predictable pattern in Amazon's stock over the past year. For four quarters in a row, Amazon would post a lower-than-expected net profit caused by higher-than-desired operating costs. Investors would slam Amazon's stock down as much as 20% on its earnings report, and the stock would slowly recover, as believers in Amazon's long-term prospects thought they spied a bargain.

All the pieces are in place for a repeat of that pattern on Tuesday. "Focus once again will be on operating margins, which has been the stumbling block for shares over the past several quarters," says Robert Peck, an analyst at Bear Stearns, which has no underwriting relationship with Amazon.

"A sequential improvement in operating margins and any signs from management that they plan to improve this metric will be a positive for the stock," says Peck, adding that he expects "management will continue its relentless focus on initiatives that drive customer satisfaction."

Most other analysts share that view. "Expanding operating margins will remain challenging given gross margin pressure, higher technology and content costs, and the possibility of higher sales and marketing spending in an increasingly competitive e-commerce environment," writes Douglas Anmuth, an analyst at Lehman Brothers, which doesn't have an underwriting relationship with Amazon.

Anmuth expects Amazon's operating profit to be only 4.4% of revenue in the second quarter, down from 5.7% in the first quarter and 6.2% in the year-ago quarter. Peck is calling for an operating margin of 5%. If they're right, Amazon's margin-obsessed bears will be polishing their brickbats.

Peck also points out that Amazon is continuing to see stiff competition from the traditional retail giants whose brand names are luring more online shoppers to their sites. Although Amazon's online traffic grew a respectable 12% in the second quarter,

Sears'

(SHLD)

grew 55%,

Staples'

(SPLS)

grew 63% and

Target's

(TGT) - Get Report

grew 80%, according to Bear Stearns, which relied on CommScore data.

Of course, traffic doesn't always convert to purchases, and the page views of all the traditional retailers are well under half of Amazon's. But if the gap in growth rates continues for a few more quarters, Amazon will lose its lead as the busiest shopping site on the Web.

Also significant is the growth in smaller e-commerce companies and shopping-comparison sites.

Overstock.com

(OSTK) - Get Report

saw its traffic nearly double in the quarter, while

Shopzilla

enjoyed a 57% rise in page views and Froogle,

Google's

(GOOG) - Get Report

comparison engine, saw a 255% surge.

One thing about Amazon's bottom line: As tech companies make the transition from leaning on pro forma earnings (which include stock options and other items) to favoring GAAP earnings, it's causing some confusion, especially among individual investors.

Some investors initially thought that Google had

missed its second-quarter numbers. And analysts such as Dan Geiman at McAdams Wright Ragen believe it might happen again with Amazon.

"Because there is some degree of inconsistency among analysts and their use of earnings estimates for purposes of deriving a consensus estimate (i.e., GAAP vs. some form of pro forma earnings)," Geiman writes, "investors will be somewhat more focused on sales growth and, to a lesser degree, gross and operating margins for the quarter." Geiman's firm has no underwriting relationship with Amazon.