Mathew Ingram: Amazon stuck on a treadmill

Just a few months ago, things weren't looking all that great at Amazon.com. Sales weren't the problem - they've kept right on climbing, just as they have in almost every quarter since the online retailer opened its virtual doors a little over 10 years ago. The thing that has had analysts and investors concerned is the bottom line, which has shown a troubling downward trend over the past year or so, and that in turn has kept the stock price under pressure.

In the last quarter of 2004 - traditionally a good period for retailers, whether online or off - Amazon reported that sales rose 26 per cent, but its profit came in sharply lower than most analysts were expecting, for the third quarter in a row. In the first quarter of this year, the bottom line shrank by more than a third, and the company warned that the second quarter would likely see operating income fall by as much as 42 per cent.

Setting its expectations that low seems to have paid off, however. Amazon reported its second quarter on July 26 and beat both its own and analysts' targets for sales and profit, sending its stock price climbing. Although its net income dropped by almost a third from the same period a year earlier, that was still better than consensus expectations, and sales rose by almost 27 per cent, driven in part by a wave of orders for the new Harry Potter book.

So is the most recent quarter a sign that the tide has turned at the online retailer, or just a lucky break courtesy of a teenage wizard? As tempting as it may be for investors to believe that Amazon is back on easy street, it's going to take more than a single quarter to prove that the past year of slipping margins was just a bump in the road.

What has been troubling analysts about Amazon's underperformance over the past few quarters isn't just that its profit has been falling short of estimates. The worrisome part is why: Amazon's profit margins have been sliding because the company has been spending more on marketing and promotional efforts, and that has pushed its expenses up. And the main reason for those extra costs is that Amazon is facing more competition than it used to.

A decade ago, Amazon owned the online retailing business, and that head start allowed it to become the internet colossus it is now, even after real-world retailers started to get interested in the online market. The company came under fire in its early years for its commitment to growth at any cost - a strategy that led to rapidly rising sales, but a conspicuous lack of profit. To a certain extent, Amazon is being accused of doing the same thing now.

In the last quarter of 2004, operating expenses rose by 32 per cent and marketing costs rose to 2.3 per cent of sales. As a result, Amazon's operating profit margin sank to 7 per cent of sales, from almost 8 per cent in the same quarter a year earlier.

"Margins are going in the wrong direction," said American Technology Research analyst Mark Mahaney. Piper Jaffray analyst Safa Rashtchy said: "Competition is seriously hurting Amazon and it needs to increase spending just to keep up with the market."

The problem isn't just competition. As Amazon - which began as a book seller - has branched out into more markets, from electronics to gardening products, its profit margins have come under increasing pressure.

Amazon founder Jeff Bezos chose books as the foundation of his empire because they are easy to order, store and ship, and that has meant fairly high margins, even with low prices. Not all products share that kind of profile. Electronics, in fact, is a notoriously low-margin market.

Bezos seems unconcerned about the slipping margins. He says the thing investors should be paying attention to is cashflow, and there Amazon is doing just fine. Not that long ago the company didn't have any at all, and now it is in the US$500 million range annually. Just as he did in Amazon's early days, Bezos maintains that all his high-cost marketing expenditures are worth it because they will increase the company's market share.

But is a larger share of the market worth anything if profit margins continue to slide? Investors celebrated the fact that Amazon's profit didn't fall by as much as expected in the second quarter - pushing the stock up by almost 10 per cent - but they conveniently overlooked the fact that the retailer's profit margin slipped again, to 6 per cent from 6.2 per cent a year earlier. The fact remains that Amazon is having to sell more and more to make up for the fact that its profit margins are continuing to slide.

That equation works fine so long as Amazon can maintain its 25 to 30 per cent sales growth, but what happens if that too begins to slow? Then the retailer's profit margin problem could become even more troubling than it is now.