Will Amazon Ever Return To Profitability?

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 |  About: Amazon.com, Inc. (AMZN)
by: Jordan Lund

Summary

Amazon recently missed its Q2 earnings estimates and it is important to look into why this occurred.

Recently, Amazon has been ramping up its operating expenses and capital expenditures.

Amazon has been making a concentrated push into same day delivery, local services, and small merchant relations.

As many people are aware, Amazon (NASDAQ:AMZN) missed their second-quarter earnings estimates and the stock dropped close to 20% over the coming weeks before rebounding slightly. Taking a look at the earnings release numbers, we see that revenue met expectations and grew 23% over last year. Where Amazon missed expectations was by posting a net loss of 27 cents a share, compared to an average estimated loss of 15 cents and a loss of 7 cents in the year-ago period. These wide losses are expected to continue into the third quarter. Net losses are projected to be between $410 million and $810 million (which management attributes largely to stock-based compensation and amortization of intangible assets), compared to a loss of $25 million in last year's comparable period.

Now that we have the headline numbers out of the way we are able to dig a little bit deeper and see what is the driving force behind this downtrend in earnings. What immediately jumps out is the increase in operating expenses, which easily outpaces the growth in revenue. From 2010 to 2013, operating expenses have gone from $6.2 billion to $19.5 billion, an increase of 213%! Whereas revenue went from $34.2 billion to $74.4 billion, which is still a respectable 118% increase, but is only slightly over half the pace of operating expenses. Following this trend in increased spending is the ramp up of capital expenditures in recent years, which have more than tripled since 2010, and are on track for their highest year yet. Through Q2 Amazon's capital expenditures were already 60% above last year at this time. The very next line within their 10-Q states that "we expect this trend to continue over time." In order for this to be sustainable, Amazon's initiatives must be able to quickly return cash to the company.

(The numbers in the previous paragraph have been taken from Amazon's 10-Q and 10-K reports)

Over the past three months, Amazon has released a wide array of new products, services, and openings. While this list is not all-inclusive, it does give insight into what some of the company's key initiatives are. I will start off with an area that Amazon has been pushing for years, same day delivery. Early in August, Amazon doubled the number of cities (from 6 to 12) that it offers same day delivery in, and within the last week announced that the service will also be available in yet another city, Atlanta. In order to make this possible, and for future expansion, Amazon opened its first sortation center in late July, with plans to open another 15 by the end of the year.

These centers will allow Amazon greater control in the delivery chain by handling their own packages until the last possible moment, ultimately reducing shipping costs. However, start up costs for these centers are not cheap, with a Robert W. Baird & Co. analyst estimating costs of over $100 million a piece. These investments may be necessary since there have been several signs that Amazon is not able to cope with the increasing shipping costs. These signs range from the most apparent, including the increase in the price of Prime membership from $79 a year to $99 a year in early 2014 and the Q2 shipping costs coming in at over $1.8 billion, to the more obscure new programs such as offering Prime members a $1 video credit for slower shipping and the opening of these "sortation centers." Amazon has been sinking billions of dollars into being the fastest delivery service around in order to get closer to the instant gratification of a brick and mortar location.

Amazon has also been expanding its "Prime" service offerings. The first of these additional features was the streaming of movies and TV shows online through Prime Instant Video. When this service was originally released for free for Prime members it only included 5,000 titles that were mostly classical or documentary in nature. Since that time, Amazon has gradually increased its selection, which reached over 25,000 titles by the end of 2012 with the Epix addition. Other content additions of note were the release of original content in 2013 and the signing of HBO in 2014, which has been rumored to carry a price tag of $300 million over three years.

Within the last few months, Amazon has released Prime Music and Kindle Unlimited, a book and audio book service that will not be included in the cost of a Prime membership. Both of these services are expected to follow the movie streaming model, starting out small to establish a base while quickly adding content. Prime music has already added hundreds of thousands of songs for streaming and Amazon is still in talks with Universal to add their content to the service. These services will allow Amazon to draw more people into their ecosystem and create additional revenue streams (Unlimited has been estimated to be able to bring in $1 billion a year), but at what cost?

It is widely known that the cost of content is growing as more companies fight over streaming rights, and this is not even taking into consideration the cost of original content, using Netflix (NASDAQ:NFLX) as a point of reference. Amazon is also not the dominant player in any of these markets. Netflix and Hulu Plus have recently dominated the online movie steaming space, Spotify already has over 40 million active users streaming music, and Oyster and Scribed offer cheaper book services that also have deals with some of the top five publishers (which Amazon does not). It will be interesting to see how these services add to Amazon's business model and how they will impact the bottom line moving forward.

Amazon has also been trying to establish itself within the local services market. In June, Amazon added to Amazon Local service with a food takeout option that will be competing with Gubhub. Initially, this service will only be available in select markets. Another local program that will be rolled out to select areas later this year is designed to connect regional professionals with consumers who need a particular service, similar to the start up Thumbtack or the eBay (NASDAQ:EBAY) test product eBay Hire. This market is estimated to be as large as $400 billion. Both of these new programs are expected roll out gradually at a pace similar to what has been seen with Amazon's grocery delivery service, Amazon Fresh.

What may set Amazon apart in the local service category is its expansion into the mobile payment field. Earlier this month Amazon released a point of sale system, Amazon Local Register, which allows small business owners to accept credit card payments on the go through a downloadable app and card reader that can attach to smartphones and tablets. In order to use this system, the small business owner must purchase a $10 card reader from Amazon, which will essentially be free since the first $10 in transaction fees are credited back to the customer's account, and download the free mobile app. Amazon has entered this market and immediately undercut the competition (Square, PayPal, Intuit) on transaction charges. As long as a customer signs up by October 31, they will pay 1.75% for each transaction, after October 31 they will have to pay 2.4% of each transaction. Amazon's vice president of local commerce has been quoted as saying that "some business owners say the only thing that would make them change (point of sale) systems is cost savings." By offering this limited time lower fee Amazon is hoping to quickly entice local merchants to join its growing local services solutions.

Conclusion

Amazon is attempting to expand by diversifying its product offerings and by entering new markets. It currently is giving up short-term gains, as can be seen in its most recent earnings release, for what it hopes to be sustainable long-term growth. This article has not even begun to explore all of the new initiatives that Amazon has launched even within the last three months. If you are interested in other projects Amazon is currently working on, investigate their expansions in China, India, recurring billing, hardware (Fire Phone, Fire Tv), and their purchase of the video game streaming service Twitch, along with a host of others. While I believe that Amazon will continue to disrupt many conventional and new age industries, I will be avoiding shares of the company at this time. I will closely watch how these new products play out and how they impact Amazon's earnings in the future. For my risk profile, it is necessary for me to see evidence that management's investments are paying off by adding sustainable revenue streams that will also increase their earnings figures.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.