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Why Amazon's Low Margins Deserve Praise

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The weak operating-income forecast is a disappointment, but make no mistake: Amazon's low margins are ultimately a bullish sign for the company. Here's why.

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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.

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?

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.

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.

But look at how far the company's come.

Amazon will hit the $60 billion revenue mark this year, and the stock is up nearly 15,000% since it came public.

Founder and CEO Jeff Bezos' vision, unrestricted by investors' never-ending concerns over near-term margins, has paid off big-time over the long run. How many other Internet giants from the 1990's are still on top today? I can't think of any.

So let's get into the nitty-gritty of this whole margin business.

First things first: Why did Jeff Bezos launch Amazon? To sell books online, plain and simple.

And what's going on with the book business? It's going digital. Just look at the booming sales of e-readers like Amazon's Kindle and Barnes & Noble's (BKS) Nook, and other e-book-enabled devices like the Apple (AAPL) iPad.

But for an even bigger sign of the times, look at the closing of Borders' stores.

Amazon's been on offense in the physical-book business because it was willing to accept lower margins, and because of the overall growth of online-retail versus brick-and-mortar stores.

But eventually, even Amazon's book business will fall apart.

Amazon's media sales, which represent over a third of revenue, increased by just 26% in Q2 -- much slower than the company's 51% overall growth rate. The business that kick-started Amazon is actually a drag these days.

However, the company isn't sitting still. It's been on offense by jumping headfirst into digital downloads and streams of e-books, video, and music. It's also diversified its product offerings to the point where it can accurately be described as the Wal-Mart (WMT) of the Web.

At the same time, Amazon is building a proprietary-media distribution platform around the Kindle, and becoming a serious player in cloud computing via Amazon Web Services.

The company's current investments are simply what's required to take it to $100 billion, $200 billion or $300 billion in revenue.

Amazon could stop investing today, drive margins through the roof, and see the stock skyrocket even further in the near-term.

But the company's vision is simply too big for such stupidity.

Investors are right to send the stock up, because Amazon is laying the groundwork for long-term global domination in a way that too few companies do.

In fact, I'd start getting worried if Amazon's margins got too high, because that could represent a transition from hyper-growth to an old-age phase with no new markets to chase.

So please, Mr. Bezos, keep on spending.

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No positions in stocks mentioned.
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