Patently a problem?

Impressive sales at the ‘world’s biggest bookseller’ are masking falling profits and costly litigation, but the financial markets still love Amazon, says Dominic Dudley.

Although Amazon.com made its name by selling books over the internet, these days it offers a great deal more, including jewellery, food and clothing.

It likes to boast that it has “the earth’s biggest selection” and the statistics are certainly impressive. According to research company Comscore, the e-commerce giant attracted over 133 million visitors last month. That’s almost one in five Web users, and more than media heavyweights like Apple’s iTunes and YouTube can achieve.

Sales growth is also extremely healthy. In the three months to the end of September, sales jumped 24% on the same period last year to $2.31bn (£1.23bn).

But there are problems, too. In the past week, IBM has launched a number of lawsuits against Amazon over technology patents believed to lie at the heart of the company’s operations. On top of that, profits are falling.

Amazon has gained some big third-party customers in the UK, such as Marks & Spencer, this year. But it has also lost some, including Waterstone’s. The company does not give details of individual country performances, but says that its sales are strongest outside North America, including the UK.

But it is a relatively low-margin business. Operating profits were down 28% to $40m (£21.4m) in the three months to the end of September. The net profit was $19m (£10.1m), compared to $30m (£16m) in the third quarter of 2005. The fall in profits has been blamed on high levels of investment in technology and content.

Its marketing spend has also been accelerating faster than revenues, as the company works hard to keep attracting customers. It spent $64m (£34.2m) in the past three months on marketing, with increasing amounts going to areas like affiliate and search engine marketing.

But observers wonder whether the company has failed to spend money where it really needs to, namely on licensing patents from IBM.

Amazon had to pay $40m (£21.4m) in a separate patent litigation settlement last summer. Now, IBM says that Amazon is using technology covered by five of its patents. On October 23, Big Blue said that it had filed two patent infringement lawsuits in district courts in Texas against Amazon. It is seeking “unspecified damages” after what it says has been almost four years of trying to stop infringements by Amazon.

“We filed this case for a very simple reason,” says John Kelly, senior vice-president of IBM Technology and Intellectual Property. “IBM’s property is being knowingly and unfairly exploited.”

The patents cover the use of advertising in an interactive service, data storage, the ordering of items in an electronic catalogue and other elements – all of which are fundamental to Amazon’s business. IBM says that Amazon has wilfully infringed, and continues to infringe, its patents.

IBM claims it has happily licensed its e-commerce patents to others on fair terms, including the ones it is suing Amazon over.

Observers have reacted unsympathetically to Amazon being sued, remembering its own claims to have patented a “one-click” ordering system in the past. The financial markets, however, appear unfazed. Its share price climbed last week in the wake of the results and the lawsuits – with investors more impressed by the sharply rising turnover than anything else.

The company is now worth over $15.7bn (£8.4bn) and keeps on growing. In recent weeks it has started selling car parts and movie downloads from Hollywood studios. It is also providing more business-to-business services, including logistics, customer service and website technology.

Founder and chief executive, Jeff Bezos, says: “We’re pleased with the strong revenue growth and rapid adoption of Amazon Prime,” referring to the company’s membership programme for its customers. He adds that there will be continued investment in new retail categories and Web services.

The company says sales in the final quarter of the year, including the crucial Christmas period, could reach $3.95bn (£2.1bn) – that would mark a 33% improvement on the same period last year – and for the year as a whole could reach $10.68bn (£5.7bn), which would be 26% up on 2005. Profits, however, could be as low as $339m (£181m), 22% down on the 2005 figure.

Bezos says that technology and content spend will increase in absolute terms but could drop as a percentage of turnover, as it seeks to boost profits.

It is not yet clear how serious the lawsuits are for the company. But one thing is certain: turning around the profits will be key if the company is to keep the confidence of its supporters and investors.

Facts and figures
• It was set up by Jeff Bezos in July 1995
• It sells goods across 35 product categories – as well as the books it made its name with, it now sells furniture, musical instruments, pet supplies and car parts
• It runs websites for the US, UK, Germany, Japan, France, Canada and, under the Joyo.com brand, China
• Since 2000 it has offered its e-commerce platform to other retailers
• Its newest initiative is selling movie downloads under the Unbox brand in the US. This was launched in September
• Sales for this year are predicted to be between $10.35bn (£5.5bn) and $10.68bn (£5.7bn); operating profits are expected to be between $339m (£181m) and $429m (£229m).

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