Amazon's capital spending plans spur debate, worry

There's quite a tug-of-war underway over Amazon's capital spending plans. Amazon reported a solid fourth quarter, but also added that it will continue to invest in fulfillment centers and infrastructure to build up Amazon Web Services.

There's quite a tug-of-war underway over Amazon's capital spending plans. Amazon reported a solid fourth quarter, but also added that it will continue to invest in fulfillment centers and infrastructure to build up Amazon Web Services.

Enter the worrywarts. Amazon is a bit of a conundrum for Wall Street. When the company is harvesting its investments, investors love it. But when the company's outlook disappoints because it is spending on infrastructure some analysts freak. It's a familiar pattern with tech companies:

  • When Verizon said it would do something crazy like bring fiber-optic lines to homes for its FiOS network, there were a few quarters of disbelief. Why would Verizon do that? Today, analyst yap all the time about Verizon's future proof network. Of course, they also want to see better returns out of FiOS.
  • Google has sparked capital spending worries since it went public. Does Google really need another data center? ask analysts. Why is Google handing out bonuses? Google doesn't help matters by saying 2011 will be a record hiring year.
  • And then there's Amazon. The e-commerce company has never really given a hoot about what Wall Street thinks about its investments. The company makes big investments and bets and Wall Street worries. This cycle has been going on for as long as Amazon has been in existence. At some point, you have to trust that Amazon knows what it is doing. Amazon is managing its business not Wall Street.

Here's how Tom Szkutak, chief financial officer of Amazon, outlined the capital spending priorities. He didn't quantify a first quarter spending level, but the last two quarterly tabs have checked in north of $300 million to build out infrastructure.

Szkutak said:

We had to add a lot of capacity, most of which was in the second half of last year. We added fulfillment capacity this quarter, retail business. We added fulfillment capacity this quarter, growing Fulfillment by Amazon business as part of our seller business. We added a lot of infrastructure capacity this quarter -- fast-growing AWS business as well as our retail business.

Now the question will be -- we are not giving guidance beyond Q1, but what will this mean going forward?

We're cautiously optimistic about Q1 with very strong growth. And we will have to see how much we invest throughout the year in 2011 based on that. But, again, I am very, very happy with the capital we are able to deploy. You should keep in mind that with the sheer amount of capacity that we added in 2010 we don't get the optimum productivity on day one. So what that means is we get productivity on those operations. We get returns on those assets that we deploy over a period of time.

But if you look at our history, we've gotten very good returns on that capital. So to me I'm very pleased to put that capital in place. And if we have to add more in 2011 it will be a high-quality problem.

Szkutak added that AWS is growing quickly, but sales are lumpy. AWS growth accelerated from the third quarter to the fourth quarter. Simply put, Amazon is going to invest its capital.

Needless to say, this spending spree on infrastructure has caused some consternation. Susquehanna Financial analyst Marianne Wolk said in a research note:

Fulfillment capacity is for ongoing growth and not a “catch-up.” In particular, we believe Amazon is investing significantly in strategic growth areas such as China, where it faces significant competition from Taobao and 360 Buy, in AWS and Fulfillment by Amazon.

She added that margins at Amazon aren't likely to swell.

The company added 13 new facilities in 2010 and we expect another 10-15 in 2011. Similarly, capex this quarter was high again at ~$300 million in 4Q10. Spending is characterized as “in line with growth,” and not ahead of growth, which reflects new businesses such as AWS and Fulfillment by Amazon as an ongoing addition to expense levels. In other words, if growth remains above 30%, it will need to add more capacity in 2H11.

Hudson Square Research analyst Scott Tilghman said:

While revenue guidance for 1Q looks strong to us, operating income guidance fell short of our outlook as well as the consensus. We believe Amazon is looking for stronger revenue growth in the midterm than we had anticipated, necessitating the expansion costs. But, we believe we may be seeing a repeat of the 2005-2006 spending that at the time weighed on investor sentiment.

Not all analysts see Amazon's penchant for capital spending as a bad thing. Deutsche Bank Jeetil Patel wrote in a research note:

The lifetime value of an Amazon customer has been increasing for several years now, largely owed to the success of initiatives such as Amazon Prime, 3P and Kindle/Digital. In particular, Amazon Prime is helping to drive 25%-plus purchase frequency growth among Amazon Prime customers, resulting in higher ROIs against customer acquisition costs (vs. the corporate average). As unit growth continues to accelerate (off tough comps in 2010), we believe that Amazon is executing on the right strategy of incrementally reinvesting profits back into building a larger customer base that yields attractive returns. In 4Q, we highlight that Amazon spent $53mn (difference between actual vs. estimated operating profits) to acquire an incremental 2-3mn customers, which could potentially yield roughly $200mn in incremental profits over the next 4 years (in our opinion, a good tradeoff).

Disclosure: I recently published a Kindle Single and could derive some revenue from Amazon.