Amazon Pursues Growth At All Costs

In 2007, Amazon’s stock price appreciated by over 125%. How does it look in 2008?

Amazon preserves leadership in its core retail business, while layering on a variety of “services”.

Amazon posted Q407 results in line with the Street’s estimates. Revenues grew 42% y-o-y to $5.67 billion from $3.99 billion in the quarter a year ago driven by growth in the international markets. Net profit climbed up 112% to $207 million or $0.48 a share, from $98 million or $0.23 per share a year ago. Total Media revenue reached $3.3 billion, up 33% y-o-y; and Total Electronics and Other (EGM) sales grew 58% y-o-y to $2.2 billion.

Quite unexpectedly, gross margin declined 70 bps to 20.6% largely due to changing product mix, while the pro forma operating profit margin was 5.80%, up 10 bps y-o-y effected by increased promotional activities. Active customer accounts exceeded 76 million, up 19% y-o-y and 17% q-o-q. Amazon ended the quarter with FCF of $1.08 billion, up 55% y-o-y. Notably, Amazon’s recent innovation, Kindle is performing better than the Company’s expectation.

For the full year, total revenue grew by 38.55% to $14.84 billion. Net income stood at $476 million, and gross profit margin was 22.6% versus 22.9% in the last year. Free cash flow for the year increased to $1.18 billion, up 143% y-o-y.

For 2008, Amazon has provided a revenue guidance of $18.75-$19.75 billion, projecting a growth of 26%-33%. The revenue forecast is $3.95-$4.15 billion for 1Q08. Operating income is expected to be $785 million and $985 million for the full year. But the profit margin is expected to hit 5.8%. This is far below what the Street was expecting. The Company has clearly indicated its intention of increasing its focus on growth and cash flow, rather than on operating margin.

The Company has delivered strong top line growth, but its bottom line disappointed the investors, largely because of continuous margin pressure. The main reason behind this was that that the Company has been inching more towards product diversification, where some products like electronics may generate lower profit margins. Worse, they have all sorts of fulfillment related service offerings in the mix which have questionable profitability. Fulfillment was $193 million or 8.3% of sales, up 16% y-o-y.

Amazon’s announcement of the $300 million acquisition of Audible.com, a digital audio books provider, will contribute to expanding its existing digital audio content programs. The deal is expected to be completed by 2Q08. Electronic distribution businesses are definitely part of Amazon’s ongoing strategy, and their Kindle effort is one in this direction. Amazon has also had its eye on the movie download business, and has been active in music already. They have, however, exited the DVD rental business in UK and Germany, a move that I applaud.

Amazon has revealed its plan of selling storage, computing power and other behind-the-scenes data center services.

All this diversification aside, my biggest interest is Amazon’s Marketplace service, positioned against eBay. That happens to be the key to its profitability equation. The business is still quite small, but promising. Investors who care about business models and profitability ought to track it closely.

As for the stock outlook for 2008, Amazon is hardly a recession-proof stock.