Why Amazon's Low Margins Deserve Praise

By Michael Comeau When Amazon.com (AMZN) delivered its third-quarter 2010 earnings report on October 21 of last year, there was considerable bellyaching regarding the company's weaker-than-expected Q4 operating margins (see Amazon Making All the Right Long-Term Moves). Investors typically associate weak margins with weak business, and a stock that's sure to fall.

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And this line of thinking makes sense, because margins are key to assessing pricing power and trends. But since that report, Amazon is up 30% versus 16% for the S&P 500. And that 30% number doesn't include yesterday's post-close surge, driven by the company's stellar second-quarter earnings report dropped after the bell. So what gives?

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How can a stock continually go up when investors are consistently seeing margin disappointments? Well, first let's take a quick look at yesterday's numbers: 1. Amazon grew revenues by an impressive 51% to hit $9.9 billion for the quarter, smashing Wall Street's $9.4 billion consensus forecast. 2. Earnings came in at $0.41 a share, beating analysts' expectations by $0.07 a share. 3. Operating expenses increased by 54%, outpacing revenue growth. 4. For the September quarter, Amazon expects revenue of $10.3 to $11 billion, the midpoint of which is nicely ahead of the $10.4 billion consensus.

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5. Operating income is expected to come in between $20 and $170 million, which would represent a year-over-year decline of 37% at the high end of guidance, and a decline of 93% at the low end. So yes, that weak operating income forecast is a stinker, but make no mistake: Amazon's low margins are ultimately a bullish sign for the company. Amazon has faced serious questions over its ability to turn its eye-popping revenue numbers into bottom-line profits ever since it came public in 1997. And those questions made a lot of sense. In those heady days, Amazon was burning through heaps of cash with a business model that can be summed up in one sentence: “Let's sell everything at a loss and make the difference up in volume!” Amazon didn't turn a profit until it earned one penny a share in the fourth quarter of 2001.

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