The real problem with Amazon

By Robert Walberg

There are plenty of reasons to be disappointed by Amazon.com's (AMZN, news, msgs) latest quarter, but missed earnings estimates isn't one of them.

Net income fell to $22 million, or 5 cents per share, compared to $52 million, or 12 cents per share, a year ago. Wall Street was looking for profit of 7 cents per share. It looks like net income not only plunged 58% year-over-year, but that the number fell 2 cents, or 28%, below expectations.

Those shocking disappointments explain why the stock tumbled more than 15% in before-hours trading. But most earnings-per-share forecasts didn't include a one-time charge of $20 million for the premature and hostile split with Toys 'R' Us. Without that, Amazon would have earned 7 cents per share -- exactly what the Street was expecting.

Expenses are the real sign of trouble

What should alarm investors is the rise in expenses for technology and the company's costly free-shipping program, dubbed Amazon Prime. By signing up for the company's Prime service, customers receive free, two-day shipping on most items for an annual fee of $79. Management can point to top-line growth of 22% last quarter, slightly better than expected, as validation of the program's success.

But most investors see the steady erosion in margins and the downward pressure on earnings and fear that the incentives are too costly. Free shipping also hasn't delivered the promised sales growth.

In fact, the rate of sales growth from year to year continues to fall. Management upped its sales guidance for fiscal 2006 to $10.15 billion to $10.65 billion, so the midpoint of that range represents year-over-year growth of 22.4%. Growth rates for the previous three years were 22.7%, 31.6% and 33.8%. At best, the program is merely helping to stem the rate of decline. Considering the hit to earnings, that's not enough.

Sell books, not fruit

Management is also quick to point to the company's new digital movie/music venture, programs like Amazon Fishbowl, hosted by Bill Maher, and entry into the grocery business as reasons for optimism. But these efforts will either distract the company from its core retail operations (the new show) or put it in historically low-margin businesses (grocery).

Despite efforts to the contrary, Amazon will never succeed in becoming an online destination site like Yahoo! (YHOO, news, msgs), Google (GOOG, news, msgs) or even eBay (EBAY, news, msgs). It is a retailer. Granted, it is one that has mastered its distribution channel like few others, but that still makes money by selling stuff in an attractive format at competitive prices. The only problem is that Amazon still commands premium multiples relative to other retailers, and that's potentially very bad news for shareholders.

As I noted in my article after last quarter's results, Amazon's deteriorating sales, rising operating expenses and premium valuations add up to trouble for the stock. Tuesday's numbers and the stock's continued slide did little to change my opinion.

A simple retailer with Internet valuations

Heavy expenditures on its toy business, to replace its failed relationship with Toys 'R' Us, a continuation of costly shipping incentives and misguided efforts at becoming a Web portal will all continue to depress margins and profits in the quarters to come. The company admitted as much when it lowered its guidance for full-year operating income to $310 to $440 million from $390 to $520 million.

Considering that Amazon ended Tuesday's regular session trading at nearly 3 times the earnings multiple of the Standard & Poor's Retailing Index, that could be very bad news for shareholders. Amazon's high double-digit sales growth and its ongoing -- albeit erroneous -- status as an Internet company should keep it from falling to levels of the average retailer.

Still, there are enough warning signs to suggest further price erosion over the near-term. The stock plunged to $29.51 in extended-hours trading, a new multi-year low. A test of the $25 area looks all but certain.

Robert Walberg is a financial writer based in Chicago, Ill. He was formerly chief equity analyst at Briefing.com. He is a regular guest on CNN's Moneyline. Mr. Walberg ran for Congress in Illinois in 1994.

At the time of publication, Walberg did not own or control shares of companies mentioned in this column.