Shareholders Lose Patience with Amazon's Spending

04/26/2014 12:00 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The recent first quarter earning numbers released by this online giant raised a lot of shareholder questions, and MoneyShow's Jim Jubak thinks it might not take much more to cause extreme frayed patience among shareholders.

Where are the Amazon.com (AMZN) activist investors?

I certainly understand the activist point on Apple (AAPL). They point to the $150 billion in cash on its books at the end of the March quarter and argue the company needs to either distribute the money to investors (at a faster rate than in the planned dividend increase and stock buybacks updated on Wednesday, April 23) or show the investments in new products that will give investors a better return on that retained cash than they could get themselves from an Apple distribution.

But what about a similar—but not identical—activist case for Amazon? The company's first quarter earnings report released last night sure raised big questions about how the company is investing shareholder cash.

Earnings per share of 23 cents met recent analyst projections—but only because those projections were way down from January when analysts were looking for 54 cents a share before a rough fourth quarter led to a round of big cuts in projections. Excluding one-time items, operating profit declined by 19% from the first quarter of 2013.

Revenue for the quarter did grow to $19.74 billion, up 23% from the first quarter of 2013, beating analyst projections of $19.4 billion.

But the quarter did show troubling weak spots in revenue growth in the current quarter and in long-term trends sales trends. International sales lagged, at 18%, the companywide growth rate. Overseas sales of media—digital movies, TV shows, and books—grew by less than 4%. And it looks like deals that now have Amazon customers paying sales tax in individual states could be having an effect on sales. A study from the National Bureau of Economic Research that looked at sales in California, New Jersey, Texas, Virginia, and Pennsylvania—all states that have recently begun collecting sales tax from Amazon transactions—concluded that collecting sales tax cut Amazon expenditures by an average of 9.5%. But for me—and I'd guess for at least some of the investors and traders who have the stock down 9.78% today, April 25, at the close—the big problem is the company's continuing spending binge—and questions about how much in profit (and when) that spending will bring to shareholders. Expenses rose 23% in the quarter. The biggest increases came in fulfillment expenses (up 29%) and technology and content costs (up 44%). That reduced the company's operating margin to 0.7% in the quarter, down from 1.1% in the first quarter of 2013. The company's explanation for its spending has always been that it needs to invest in its business to grow—and to achieve comfortable profits somewhere down the road.

In some parts of its business that seems to me to be a perfectly logical plan. For example, the company's continued spending on warehouses in the United States—building more in the Unite States that are closer to big customer clusters—continues to very gradually reduce the big losses that Amazon reports every quarter on shipping. Shipping revenue climbed in the quarter by 34% and shipping costs rose by 31% from the first quarter of 2013, and that reduced the company's shipping gross margin loss to 115% from 121% in the first quarter of 2013. Building more warehouses in China, Spain, and Italy to support growth there is also a necessity, especially if Amazon is to become a real competitor with China's Alibaba on its home turf. (And given Alibaba's global ambitions, I don't think Amazon can afford to give the Chinese company a free pass on its home turf.)

But do the huge investments in a grocery delivery service, a set top box called Amazon Fire, and a wand called Dash that can be used to reorder items with a wave at their bar codes fall into the same category? Maybe Amazon needs a set top box to compete with Netflix (NFLX) in the market for the streaming delivery of digital content. If Amazon is to sell digital content, it really can't allow competitors to control the point of sale that argue goes. (This is the same argument behind the Kindle.)

But groceries? If your goal is to sell everything to everyone, then this makes sense. If your goal is to make a profit for shareholders, it's hard to see a rationale for building the infrastructure to compete in the low margin grocery business. The average publicly traded grocer showed a 1.9% operating margin in 2012, according to Yahoo Finance.

And this is business already target by Wal-Mart (WMT), which has pushed up the portion of its sales coming from groceries to 55% in 2013 from 24% in 2002. I'd note that hasn't pushed Wal-Mart's gross margins higher—gross margins for the company have declined in the last four years to 26.7% from 27.3%.

The logic in moving into the grocery business for Amazon and Wal-Mart is the same: cross sell. Consumers that visit a store—brick and mortar or online—to buy groceries will buy a DVD or place a pharmacy order.

I think if this initiative were coming from another company, it wouldn't be such a big deal. But the push into groceries along with the Wand and Amazon Fire have increased doubts among shareholders about Amazon's financial discipline. The company just seems to be throwing money at ideas and opportunities and some investors have started to question whether these newest ideas are a good use of shareholder cash.

And all it takes, as the reaction to yesterday's earnings report indicates, to crystallize those doubts is a quarter where expenses continue to soar and operating margins sink.

For the quarter that ends in June, Amazon has forecast an operating loss of somewhere between $55 million and $455 million. That compares to an operating profit of $79 million in the second quarter of 2013.

If that forecast is accurate, expect a bit more frayed patience among shareholders.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of Amazon as of the end of March. In preparation for closing the fund at the end of May, as of the end of March I had moved the fund's holdings almost totally to cash.

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