Maybe Amazon Should Stay Put on Profit Growth

 | Jul 27, 2013 | 1:30 PM EDT
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Okay, I get it.

I'm not supposed to worry about Amazon's (AMZN) earnings or margins because the company is building its business. So what matters is the company's 22.4% revenue growth for the second quarter. That's why the stock closed up 2.8% Friday even though the company announced a loss of $0.02 a share, far below the $0.09 Wall Street had projected.

What I don't get, though, is the company's decision to go into the grocery business. Amazon is headquartered in Seattle, so if it wanted to run a grocery business as a hobby or employee service in that city, it would be no big deal. But Amazon has launched a grocery business called Fresh in Los Angeles. Seriously?

According to the conventional wisdom, this is a company that is -- at some point -- supposed to turn its massive scale and its continued infrastructure investments into profits. From that perspective, targeting the grocery business, one of the lowest-margin businesses in the known universe, makes no sense.

But maybe it's the conventional wisdom that needs rethinking, rather than Amazon's business savvy. Let me try that route.

I doubt the grocery business will overwhelm all the great things Amazon has got going for it -- the cloud-computing business and the digital-media business, for example. But it does make me wonder: Does anybody at Amazon have a plan that will actually turn today's investments into profits down the road? Or is the company just throwing investments at stuff because these are opportunities that it knows it has the expertise to execute -- and profits be damned?

Following are some basic and very good numbers from the July 25 quarterly report. Operating cash flow for the 12 months ended in June climbed 41% to $4.53 billion, up $3.22 billion in the year-earlier period. Active users grew by 19% in the quarter to 215 million. Total units sold climbed 29%, as did third-party units sold. Gross margin grew by 260 basis points to 28.6%, thanks to lower shipping costs, the company's Amazon Prime program, third-party sales and growing revenue from high-margin cloud-computing services and its digital-media business.

Some of these improvements in margins are a direct result of Amazon's investments of cash flows back into its own business. For example, spending on new warehouses closer to customers has helped to lower shipping costs. Fulfillment costs as a percentage of revenue fell to 11.2% from 10.1% a year earlier. Amazon did continue to lose money on shipping, however, even if the loss narrowed to 111% from 125%.

In areas such as those, I think Amazon can justify the big spending that turned operating cash flow of $4.53 billion for the last 12 months into free cash flow of $265 million. (Free cash flow was $1.1 billion for the 12 months ended in June 2012, so this year's figure represents a 76% drop in free cash flow.)

Not all of the spending, though, was an investment in improving future margins. Amazon spent $1.4 billion in the fourth quarter of 2012 for the purchase of corporate office space and property in Seattle. One way to think about this kind of big-ticket item -- in fact, the traditional Wall Street way to think about this kind of spending -- is to chalk it off as one-time spending.

Obviously, this thinking goes, Amazon won't be buying new corporate space to the tune of $1.4 billion every year. This mindset is steeped in the Wall Street accounting tradition of ignoring some kinds of spending as if there weren't real money involved.

But, you know, I'm not sure that this applies to Amazon.

The most dangerous thing the company might do right now -- dangerous for Amazon's stock price, anyway -- is trying to generate earnings growth. Think of it: Amazon is owned by a group of investors who are perfectly happy paying no attention to earnings growth as long as they get their year-over-year 20%-plus worth of revenue growth every quarter. Why spoil that by leasing real estate and corporate office space, as many companies do, in order to conserve cash or to increase earnings? Think about how disappointed the current shareholder base would be if Amazon shifted to managing earnings at the cost of revenue growth.

I don't mean to suggest that growing revenue by 20% a quarter is easy. I think Amazon has, in fact, found an extraordinary business model -- or two or three, since I'm not sure that Amazon is still just one company.

But the above would mean transitioning from a company -- and a shareholder base -- focused on revenue growth to one focused on earnings growth. I would suggest that the challenge in doing this would be difficult and hazardous to the share price.

So it's probably a good idea to put off that transition for as long as possible. Maybe that's what the grocery business is all about.

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