Amazon's discount strategy worries analysts

If Wall Street has one question for Amazon.com, it's this: What now?

Three years ago, the online retailer responded to slowing sales by adopting the strategy of successful retailers such as Costco and Wal-Mart — to deeply discount items and reap a profit by increasing its sales volume.

Coupled with a free-shipping promotion on orders over $25, the online retailer recharged sales growth, particularly in its media business. Although Amazon sells everything from lawn mowers to diamond earrings, the majority of its sales are of books, music, videos and DVDs.

But analysts this year have begun to fret over the company's gross profit margins, an indication of how profitable Amazon could become.

The measurement, the difference between what it pays for goods and services and what it charges, has continued to slide as Amazon deeply discounts items to lure customers.

While the company's discounting strategy has helped spur sales in the past, sales are slowing.

The company yesterday said it expects 2005 full-year sales of between $7.4 billion and $8.15 billion. At its midpoint, that represents a 14.7 percent jump in annual sales when compared with the year before.

That contrasts starkly with the company's projected 2004 sales, which it forecasts to grow between 27 percent and 32 percent.

"The topline growth is almost suggesting a fall off the cliff," said Piper Jaffray analyst Safa Rashtchy.

"Obviously, there is some conservatism there, but it's well below expectations."

Amazon's shares yesterday closed up $1.12, or 2.9 percent, to $39.47 but took a nose dive in after-hours trading, losing $3.53 a share.

The company announced its quarterly financial results after the closing bell.

The company said more customers than ever took advantage of its free-shipping promotion on orders of $25 or more, and analysts expect that trend to continue.

That means less of its sales growth will continue to trickle to the bottom line.

Morningstar analyst Joe Beaulieu said he believes the company's free-shipping promotion is a burden on the company's profit margins.

While Amazon has repeatedly said this investment will be beneficial long-term, Beaulieu said he's concerned that the company's profit margins will continue to erode.

"My concern is if growth slows even more, what are they going to do?" How are they going to juice growth going forward?"

Amazon is headed into its 10th holiday season — the most critical three months of the year — as an online retailer. Last year, fourth-quarter sales accounted for 37 percent of its $5.3 billion in sales.

Amazon and toysrus.com have sued each other over whether each company has honored the terms of their contract. But the company will have enough inventory for the holiday season, Chief Executive Jeff Bezos told analysts.

"We're supplementing our (toy) selection with merchandise from other sellers," Bezos said.

Meantime, the company continued to tease investors about whether it plans to enter the DVD rental movie business.

Amazon.com Chief Financial Officer Tom Szkutak said customers have asked it to offer the service, and that it's a business it could enter easily and affordably, but stopped short of saying whether it plans to pursue the business.

The company operates www.IMDb.com, an Internet movie database visited by some 20 million viewers each month.

"We can afford to offer lower prices in a sustainable way because our customer acquisition costs can be low to none," he said, referring to the IMDB.com site.

Shares of Los Gatos, Calif.-based Netflix, the leader in the DVD-by-mail rental business, have fallen 42.2 percent since the company said last week that it would lower its subscription fee in anticipation of Amazon's entry into the business.

Monica Soto Ouchi: 206-515-5632 or msoto@seattletimes.com

Correction: Information in this article, originally published October 22, was corrected October 22. An earlier version of this story about Amazon.com's quarterly financial results misquoted CEO Jeff Bezos. Bezos said the company would have enough toys for the holiday season despite a legal dispute between Amazon.com and toyrus.com. He said the company was "supplementing our [toy] selection with merchandise from other sellers," not "substituting" the selection, as the story said. The story also gave an incorrect Web address for the company's Internet movie database. The site is www.IMDb.com.