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Amazon's Margins: When Will Wall Street Care?


It looks like it will be another quarter in which Wall Street will turn a blind eye to what is expected to be lackluster operating profit margins at Amazon (AMZN). But how much longer will revenue growth divert attention from declining profitability?

This shift in sentiment could come as soon as the fourth quarter, with Amazon's outlook for the holiday period being the biggest risk to the stock on Tuesday.

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Amazon's operating margin hit a five-year low last quarter and is poised to narrow further in the fiscal third quarter to its lowest point since 2002, UBS analyst Brian Pitz estimated.

With the launch of the Kindle Fire, margins are expected to be squeezed even further as Amazon likely will take a loss on the device.

While the $199 tablet, which will officially launch on Nov. 15, is pegged to be the hottest gift for the holiday season, investors may not continue to overlook thinning margins if Amazon doesn't find a way to turn more profit from its lower-priced items, specifically its digital content. And if revenue growth begins to slow, the focus will have to turn to margins.

The key isn't how many Fires are sold, a figure Amazon will unlikely reveal anyway, but how much of Amazon's digital content is subsequently purchased via the device.

Kindle Fire users will receive one month free of Amazon Prime, a tactic used to get more people to sign up for the $79-a-year service. Amazon Prime members receive free two-day shipping, as well as access to about 12,000 (and growing) streaming movies and television shows.

Currently, Amazon Prime boasts about 12 million members who buy four times more merchandise from the e-commerce giant than the regular shopper, according to ChannelAdvisor, an e-commerce business software firm.

Bank of America Merrill Lynch analyst Justin Post estimated that an active Amazon shopper spends about $115 per year on media and that tablet users will spend about 50% more on books, movies, music and games. This could add $57 per year in revenue and $14 per year in incremental gross profit, which would help cover the hardware costs.

Assuming 5% to 10% of tablet users adopt Prime in 2012 and 2013, Post estimated these users could contribute $550 million to $1.1 billion and $750 million to $1.5 billion of incremental revenue in 2012 and 2013, respectively.

"We think Street perception on investments will remain positive and would regard margin related weakness as a buying opportunity in front of what we expect to be very strong tablet launch in November," Post wrote in a note.

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