Amazon's spending on the rise

Investors balk at the increasing costs, but Amazon has a good reason for it.

By Kim Peterson Jul 26, 2010 3:43PM
Profits © CorbisHow much leeway are investors willing to give Amazon (AMZN)?

The company issued disappointing earnings news last week, causing some to speculate that Amazon has dropped the ball at a crucial moment. The stock is on a downtrend, falling about 5% in the last two weeks.

So is Amazon blowing it just as competition from Apple (AAPL) and others gets stronger? "Darling, the wheels just came off," writes the Financial Times. Let's take a look at some of the details:

Sales are strong. For the quarter ended June 30, Amazon saw a 41% increase in sales to $6.6 billion. That's a tremendous increase, especially because Amazon's sales were already so big to begin with. In North America, sales grew by 46%, and international sales were up 35%.

But expenses were up. The number that made investors queasy was the 40% jump in operating costs. This comes after we've seen an uncanny ability by Apple to hold costs down while profit soared. For Amazon, the extra expenses were partly due to hiring 2,200 more employees and opening 13 new fulfillment centers.

Some analysts questioned the company's increase in marketing expenses, according to The Wall Street Journal. "Is there something about the business that means going forward you are going to have to spend more on marketing?" asked Mark Mahaney of Citi.

Changing businesses. Amazon sells more in the category of electronics and general goods than it does in traditional media (which includes books, DVDs and video games). The quarterly growth in the media category was only 18% compared with 69% in electronics and general goods.

It's understandable that media growth would slow as digital media continues to supplant the paper-and-disc business. But can Amazon keep pace with its digital-media sales? That's unclear.

Poor returns. Another number of concern: the return on Amazon's invested capital dropped to 34% from 42% a year ago.

Mixed forecast. For the current quarter, Amazon is expecting sales growth of between 27% and 40% -- an extremely wide range at this point. And operating income might only grow by around 24%.

Investors were bummed because Amazon didn't live up to the massively high expectations they placed on it. Heading into the earnings results, Amazon was trading at 42 times future earnings. That's since been grounded to a more realistic 31 times future earnings.

Bottom line: Investors shouldn't be too freaked out by the quarter. It's been years since Amazon expanded its fulfillment centers, and it costs money to do that and hire the people to work in them.

Amazon has moved from a books-and-music vendor to a general retailer, competing directly with the likes of Wal-Mart (WMT) and Target (TGT). It's expanding internationally at a brisk pace, and the growing pains that come with all this growth are to be expected.

But one area where Amazon could be more transparent is its Kindle business. The company keeps its Kindle sales data close to its vest, which was fine when the e-reader was just an up-and-comer at the company. But now, as Kindle continues to gain momentum (despite the iPad's impressive release), Amazon needs to give investors more to go on.

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