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Amazon faces the challenges of its second decade

Competition from traditional retailers and discount pressures loom for the online retailing giant.

Ten years after Jeff Bezos started in his garage, the company is celebrating three things that evaded legions of other Internet start-ups: survival, independence and profitability.

But as Amazon celebrates itself with 10 days of concerts and special offers, profound challenges face the e-commerce pioneer. Profits are stagnating, competition is blooming, and even people who are bullish about the company are concerned about downward pressure on prices.

"The bull-bear divide on Amazon is whether or not it can have double-digit operating margins," said Mark Mahaney, an equity analyst with Citigroup's Smith Barney division in San Francisco. "I'm uncertain they can get there. And right now, they're going in the wrong direction."


What's new:
As e-commerce pioneer Amazon celebrates its 10-year anniversary, competition from traditional retailers and discount pressures loom.

Bottom line:
Analysts, while crediting the company with growing from a money-losing electronic bookstore into a profitable online mall with international reach, caution that the pressure on Amazon's profits shows no sign of letting up.

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It may sound like nitpicking, but financial analysts have always considered operating margins to be an important indicator of Amazon's health. It's a bugaboo the company has dealt with for years: Sure, skeptics wonder, Amazon can be the online world's fast-growing discount king. But can it turn a healthy profit in the process?

Although he upgraded Amazon to "hold" from "sell" in February, Mahaney anticipates that for at least the next two quarters Amazon's margins will be lower than they were in the same period the year before. That has already been the case with the last two quarters. Amazon executives have said publicly that they'd like to get that number up to double digits.

Amazon's operating margins were 7 percent for the quarter ended in December and 7.4 percent for the quarter ended in March. But Mahaney estimates they'll be 6.5 percent for the quarter ended in June--which Amazon will announce July 26--and 5.6 percent for the quarter ending in September.

Profits are down even as revenue goes up. For the March quarter, the company's net income was $78 million on $1.9 billion in sales, down from $111 million on $1.5 billion in sales for the same quarter a year ago. The consensus estimate of 13 analysts surveyed by Thomson Financial Network predicts earnings of 9 cents per share for the current quarter, down from 18 cents a year ago.

Amazon declined to comment for this story. Analysts, while crediting the company with growing from a money-losing electronic bookstore to a profitable online mall with international reach, caution that the pressure on profits shows no sign of letting up.

One reason is that as Amazon turns 10, the competition is closing in.

In a bit of irony to people who remember that not so long ago old-line companies were worried about getting "dot-commed," a significant threat has emerged from brick-and-mortar stores. Bookstores such as Barnes & Noble and general retailers like Wal-Mart Stores and Costco Wholesale have aggressively gone after online sales.

"The bull-bear divide on Amazon is whether or not it can have double-digit operating margins."
--Mark Mahaney, equity analyst, Smith Barney

"The idea was that everyone would shop online and you wouldn't need stores anymore, and these people would be extremely profitable because they wouldn't need to have the stores," said Gene Alvarez, an analyst with Gartner Group. "But then it turned out that multi-channel retailing was the way to go, that consumers mix and match the touch points to their convenience."

Without brick-and-mortar lures and comforts like instant shopping gratification, bookstore cafes and in-person author readings, Amazon is compelled to compete on price and customer service. Increasing shipping costs make the online retailer's price proposition tough enough, and then it has to deal with the world's biggest retailer and low-price champion, Wal-Mart.

Amazon has met the challenge by offering frequent discounts--cutting into profits--and fanatically maintaining customer service. These efforts have succeeded in helping the company build what analysts call one of the Internet's strongest brands.

"We think of Amazon the way we call Scotch tape 'Scotch tape' whether or not it's by Scotch," Alvarez said. "That's what Amazon's achieved with its brand online."

Amazon has exploited that brand to expand into so many areas--through in-house category launches, acquisitions and partnerships--that it has essentially become the primary tenant of its own online mall.

Amazon's mission statement, which states the company's goal to be "Earth's most customer-centric company," goes on to promise "to build a place where people can come to find and discover anything they might want to buy online."

For an increasing number of online shoppers, however, that second goal is more efficiently accomplished by online shopping engines. The shopping comparison business heated up recently with a pair of big acquisitions: Scripps last month acquired Shopzilla for $525 million, days after eBay said it would acquire for $620 million. Google has been testing its online retail search, Froogle, since 2002.

"That's where the search challenge to Amazon's growth comes into play," Alvarez said. "Now that they offer a lot of categories, getting you in front of the product in as few clicks as possible really matters."

More competition looms in the as-yet-undefined world of digital and on-demand delivery. Apple Computer demonstrated the potential of digital delivery with its successful iTunes music store, but that success has yet to be replicated with movies or books.

Amazon has tried to shore up its on-demand offerings with the acquisitions of the BookSurge print-on-demand service in April and of the CustomFlix DVD-on-demand start-up this month.

On average, analysts show ambivalence about Amazon's prospects. Of 22 analysts surveyed by Thompson First Call, six rate it "buy" or "strong buy," 10 rate it "hold," and six rate it "sell" or "strong sell."

Despite concerns about competitive pressure, Smith Barney's Mahaney said his "hold" rating reflects the solid position Amazon has staked out in its 10 years.

"From a really long-term point of view, given where it started, it's a profitable, fast-growing business," Mahaney said. "You're still talking about a company with a market cap of $15 billion. I think Amazon's worth $15 billion."