Amazon Investors Keep the Faith

by Brad Moon | July 27, 2012 9:04 am

Amazon Investors Keep the Faith

When Apple’s (NASDAQ:AAPL[1]) profit margin declined to 25% for the June quarter and it missed analyst earnings expectations — although still clearing a tidy $8.8 billion profit — investors reacted by shaving over 4% off[2] the company’s share price. So, it stands to reason that when Amazon (NASDAQ:AMZN[3]) reported its quarterly earnings yesterday, announcing a profit of only $7 million (less than a 1% margin) and expectations that it may lose anywhere from $50 million to $350 million next quarter[4], investors punished the stock, right?

Not exactly. Although AMZN initially dropped on the report in after-hours trading, the stock turned up again, after rising 1.4% before the report and inched past $220.

How do you explain the difference in reaction?

Apple and Amazon are two very different companies, but they’re both in the technology sector, and they compete in multiple areas. Amazon is primarily an online retailer that happens to sell hardware (Kindles) to make it easier for customers to buy digital content, while Apple is primarily a hardware seller that also offers digital media (music, e-books, video and apps) to make its devices more appealing to customers.

While Apple remains a very profitable company (with margins that put Amazon to shame), the worry is that its best moments are behind it. The smartphone market has become more competitive, with other manufacturers like Samsung making gains against Apple’s iPhone[5], the company’s biggest revenue generator. That increased competition could lead to downward price pressure, cutting into Apples thick profit margin. At the same time, the iPad is becoming a bigger chunk of Apple’s revenue, but it’s less profitable.

And with Amazon, Google (NASDAQ:GOOG[6]) and others preparing an all-out assault on the tablet market[7], any move by Apple to combat the threats — such as releasing a smaller, cheaper iPad Mini — will likely cut those margins even more.

Amazon is in a different position. When it comes to hardware, the company has always shown a willingness to sell devices at cost or even a loss[8]. The strategy is to get as many Kindles as possible into consumers’ hands, then make money when they use the devices to buy digital content from Amazon. After its first foray into tablets with the Kindle Fire, which sold wildly over the holidays, Amazon is expected to release a slew of new tablets and possibly its own smartphone later this year.

While both Apple and Amazon want net new customers for their devices, Apple’s profits are based on charging a premium, and it counts on existing customers to upgrade regularly. Amazon makes next to nothing on hardware and couldn’t care less if existing customers upgrade — so long as they have a Kindle device.

A price war on tablets and smartphones, or a consumer movement toward keeping a device for three or four years instead of regularly upgrading, could hit Apple hard, but it would have little or no negative effect on Amazon.

Outside of the electronics, Amazon CFO Tom Szkutak pointed out in the earnings call[9] that the company is focusing on building new fulfillment centers across the country. It’s opened six so far this year and is on track to open a dozen more. While they may not pan out to same-day-delivery capability (outside of major metropolitan areas), they will serve to reduce shipping times, making shopping online at Amazon a more compelling option for consumers.

Then there’s the investment in cloud computing. Many people didn’t realize it until a storm hit one of Amazon’s operations in June, knocking Pinterest, Netflix (NASDAQ:NFLX[10]), Instagram and other Web-based services offline, but Amazon’s Web Services[11] — or AWS — is one of the world’s biggest cloud-computing providers. According to Deepfield Networks[12], one-third of Web surfers will use a site or service hosted by AWS at least once every day.

How does all of this explain why investors are letting Amazon off the hook, despite what seems on the surface to be a fairly miserable quarter?

Amazon has made the conscious decision to sink billions of dollars into infrastructure from fulfillment centers to cloud computing and engineering labs. It’s invested in content licensing, patents and acquisitions. It earned revenues of $12.83 billion in the quarter (a 29% increase year-over-year), and the reason for the minuscule profit was operating expenses of $12.7 billion that largely reflect those ongoing expenditures.

Investors are making the calculated gamble that all of these expenses will eventually pay off.

So, while investors are a little wary of Apple and the possibility that it’s facing waning profitability in the face of competition and price pressure, Amazon has positioned itself to take the pain now in return for increased revenue and lower operating expenses later.

If … if, everything pans out, this strategy should add up to significantly increased profitability in the future. The question is, how far out in the future?

As of this writing, Brad Moon doesn’t own any securities mentioned here.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. shaving over 4% off: http://www.bloomberg.com/news/2012-07-25/apple-declines-after-results-miss-estimates-on-iphone-sales-lull.html
  3. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  4. $50 million to $350 million next quarter: http://www.businessweek.com/news/2012-07-26/amazon-s-second-quarter-revenue-profit-miss-est-dot
  5. making gains against Apple’s iPhone: http://investorplace.com/2012/07/survey-iphone-5-should-see-monster-release/
  6. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  7. all-out assault on the tablet market: http://investorplace.com/2012/07/prepare-for-the-coming-tablet-war/
  8. or even a loss: http://news.cnet.com/8301-1023_3-20113292-93/amazon-to-lose-$50-on-each-kindle-fire-says-analyst/
  9. Tom Szkutak pointed out in the earnings call: http://www.marketwatch.com/story/amazon-earnings-fall-as-expenses-increase-2012-07-26?link=MW_latest_news
  10. NFLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=NFLX
  11. Amazon’s Web Services: http://aws.amazon.com/
  12. According to Deepfield Networks: http://www.pcpro.co.uk/news/cloud/374173/one-third-of-surfers-hit-amazon-cloud-each-day
  13. Amazon isn’t only No. 1: http://investorplace.com/2012/07/how-amazon-com-will-kill-costco/
  14. possibly even a smartphone: http://investorplace.com/2012/07/amazons-rumored-smartphone-could-be-the-ultimate-shopping-tool/

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