Amazon: After Zappos, Who Else?

Amazon (NASDAQ:AMZN) put the right foot forward when it acquired Zappos last week for $928 million, clearly indicating their belief in the need for a verticalized offering with better margins. It was a move I had been championing for quite a while. Though their recent quarterly results were somewhat disappointing, I still believe Amazon has the right business strategy in place and the right leadership at its helm.

Q2 revenues grew 14% over the year to $4.65 billion while earnings per share fell 10% over the year to $0.32. The market was looking for revenues of $4.69 billion with EPS of $0.31. Media revenues grew 1% over the year to $2.44 billion while EGM revenues grew 35% over the year to $2.70 billion. Excluding the foreign currency impact, media revenues would have grown 7% and EGM 41% over the year.

In other metrics, worldwide units grew 28%, active customer accounts grew 16% over the year to cross 94 million, and active seller accounts grew 21% over the year to cross 1.7 million. Seller units were 30% of total units.

By region, Amazon’s North American revenues grew 13% over the year and 16% internationally. International revenues would have grown 28% on a constant currency basis. The company did notice an industry slowdown in video games and consoles during the quarter.

Kindle continued to be a growth story for Amazon, and sales were fueled by the reduced price of $299. A Forrester report projects nearly 13 million US consumers to be on an e-reading device by 2013. A first quarter Bowker survey also showed that the contribution of digital books grew from 0.4% a year ago to 3% of the $24 billion US book business.

The numbers are small but growing. It is thus no surprise that Google is planning a foray in the market, which already includes Sony for competition. Recently, Barnes & Noble also entered the e-book market through the purchase of the e-book seller, Fictionwise and an aggressive push at increasing the number of titles.

Analysts estimate that Amazon has sold nearly 1 million Kindle readers since the device’s launch in 2007, and Kindle 2 is estimated to have sold nearly 300,000 units since its launch in February of this year. As the market continues to expand, Amazon is now planning to monetize the service through e-book advertising. There are already smaller players such as Wowio which give readers the option to purchase a title for as little as $0.99, or download free an advertiser-sponsored PDF version. E-books do offer highly targeted demographic information about their readers — essential for effective advertising. But whether readers would like their books to be dotted with advertisements remains to be seen.

Meanwhile, the Kindle got caught up in a legal dispute when Amazon deleted several digital editions of George Orwell’s novel “1984” from customers’ readers after the company realized it had inadvertently sold copies without procuring legal rights to the novel. The Kindle reader works on digital rights management (DRM) software, which prevents the illegal copying or reselling of content and which helped Amazon delete the book remotely. While there is no denying that the DRM will help protect copyright privileges, there are many who believe that it gives Amazon too much control over the reader.

Going forward, Amazon expects Q3 revenues to grow 11% to 23% to $4.75 billion to $5.25 billion with consolidated segment operating income to be in the range of $250 million to $305 million.

Amazon is currently sitting on cash and marketable securities worth $3.21 billion. It might be the right time for it to choose some more of its targets. I would recommend the company look at other lifestyle segments to help fill in the gaps with high-margin businesses. Jewelry could be an interesting segment that has the dynamics to make this happen, especially diamond jewelry, and Blue Nile could be a very good target. Blue Nile ended last year with an operating income of 5.4% or non-GAAP EBITDA of 8.5%, a number it has definite plans of improving in the current fiscal. Compare that to Amazon’s last year’s operating income of 4.4%. Nile’s current market capitalization is $681.5 million.

Amazon’s stock is currently trading at $86.49, taking its market capitalization to $37.2 billion.

Besides the luxury range, Amazon could also look at expanding its digital media business by acquiring Netflix. Earlier this month, there were rumors floating to that effect.

Netflix (NASDAQ:NFLX) recently announced Q2 results which were in line with the market’s estimates. Revenues grew 21% over the year to $408.5 million and EPS rose to $0.54 cents. The market was looking for revenues of $409.72 with EPS of $0.50. The growth was propelled by a 26% increase in the subscriber base, which is now nearly 10.6 million strong. Netflix also repurchased 1.6 million shares worth $73 million at an average price of $44.56 per share.

Last quarter, Netflix initiated their Saturday delivery model, which has helped grow their user base. They have already rolled out the service to more than half of their 58 delivery centers and expect to cover all centers by the end of the next quarter.

During the quarter, their subscriber acquisition costs (SAC) were down 17% to $23.88 compared with $28.89 a year ago. A quarter ago, these costs were as high as $25.79 per customer — a clear indication that the company’s brand awareness has helped Netflix grow without having to spend significantly higher in advertising. Additionally, they are benefiting from the shutdown of traditional brick-and-mortar video stores but are being challenged by the opening of DVD kiosks operated by RedBox.

Netflix continued to strengthen ties with CE manufacturers and announced Netflix-ready devices with Sony, Samsung, LG for home theater and Blu-ray disc players.

Many believe that the mail order DVD business will soon be replaced by people watching movies straight from the Internet. No wonder Netflix is focusing on streaming as a revenue generator. Nearly 20% of their subscribers currently use the company’s streaming service. That will change with the two big improvements to streaming slated for the year — Microsoft’s new version of Silverlight, which will speed up video playback, and the upcoming Xbox, which will include a Netflix client with which subscribers can choose movies right on the Xbox.

However, Netflix will have to increase their content for streaming services. They have 100,000 DVD rental titles available but only 12,000 titles available for streaming.

For Q3, the company expects revenues in the range of $416 million to $422 million with EPS of $0.39 to $0.47. For fiscal 2009, they expect revenues of $1.65 billion to $1.67 billion with EPS of $1.65 to $1.82. The market was looking for Q3 revenues of $417.7 million with EPS of $0.45 and 2009 revenues of $1.66 billion with EPS of $1.72.

Their stock is currently trading at $42.20, taking its market capitalization to $2.43 billion.

Amazon already streams full-length movies and television shows and boasts of 40,000 titles available on its on-demand service. Netflix’s 12,000 streaming titles, which are older than the titles Amazon offers, would complement the latter’s collection. Also, Amazon would inherit Netflix’s customer base and strong relationships with studios. Amazon has already achieved good results in the digital media space through their e-books. Movies are just another medium in which they could excel. Besides, Amazon could do with the double-digit margins (nearly 11%) at which Netflix operates.

This segment is a part in the series : Amazon