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Hoeing or excavating?

25 October 2011 By Robert Cyran

Amazon keeps digging the moat around its business. The Internet retailer shocked Wall Street, again, with lower than expected profits due to heavy investment. The expenditure may eventually pay off – that’s why the stock trades at 100 times estimated earnings. But it’s a timely warning that even Amazon must keep girding the barriers to entry.

The latest third quarter is a story Amazon investors know all too well. Sales rose 44 percent. Yet earnings fell 73 percent. And the group led by Jeff Bezos predicts there should be more of the same in the crucial holiday quarter. Amazon says it may even post an operating loss.

The firm pins its performance to heavy investments in everything from increasing the number of its distribution centers by about a third, to buying content for video streaming, to launching multiple versions of its Kindle reading tablet, to new product launches in its online store. All of this costs money.

Bezos says Amazon is running the business for the long run. And there’s no doubt it would still take huge investments for an upstart to build Amazon’s automated warehouses, server farms and tablets from scratch. Any skimping by rivals cowed by Amazon’s huge investments may eventually hurt their ability to match its prices.

However, there is a danger that Amazon is fighting on too many fronts. With each new endeavor, such as its increased efforts in selling electronic gadgetry, it attracts a new array of competitors. Amazon’s return on invested capital has been steadily falling: from 28 percent to 17 percent in the past year. That could suggest rivals are catching up and its moat needs further dredging. Investors should prepare for more.

 

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