Image source: Amazon.com.
The outlook for Amazon.com's (AMZN -2.56%) fourth-quarter earnings isn't very good. Management's guidance for the quarter indicates that investors will probably see a decline in operating income year over year. Management expects $0 to $1.25 billion in operating income for the fourth quarter, compared with $1.1 billion last year.
Amazon's revenue guidance of $42 billion to $45.5 billion is largely in line with analysts' expectations, but the operating margins are much lower than expected. Amazon exhibited a similar performance with its third-quarter results, meeting revenue expectations but falling well short on earnings results.
The fourth quarter is typically Amazon's most profitable of the year. Should investors panic that margin is taking a hit?
Building out the fulfillment network
Amazon CFO Brian Olsavsky told analysts in the company's second-quarter earnings call that it would ramp up its fulfillment network openings. And that's exactly what happened.
Amazon opened 18 new fulfillment centers in the third quarter. It has already opened five more in the fourth quarter. That ought to complete its fulfillment center build-out for the year, which Olsavsky noted is 26 new centers -- an increase from 14 last year.
But even with the buildout complete for the year, Amazon still faces costs with getting those fulfillment centers online and running at full capacity. During the company's third-quarter earnings call, Olsavsky noted, "There will be a cycle where those [fulfillment centers] will be more productive next year than they are this year and more productive in 2018 than they are in 2017."
These fulfillment centers are imperative to Amazon's operations. In the fourth quarter last year, it faced capacity issues, which led to higher fulfillment costs. Fulfillment costs have continued to climb through 2016 as it brings more fulfillment centers online.
A growing percentage of its sales is coming from its Fulfilled by Amazon program, which requires more warehouse space. Additionally, Prime membership continues to grow, which requires more fulfillment centers to guarantee two-day shipping. As more fulfillment centers move to full capacity over the next couple of years, fulfillment costs as a percentage of revenue ought to decline.
Continued investment in Prime Video
The other major area of investment is in Prime Instant Video. Olsavsky told analysts that Amazon is doubling its content budget for the second half of 2016. It's tripling the number of originals on Prime compared with last year.
Prime continues to grow rapidly, and video is one of its best onboarding tools. When Prime trial members use video, Amazon sees higher retention rates, and it sees higher renewal rates from full Prime members who use video.
Originals can be some of the most cost-effective content for a streaming service, but they're extremely front-loaded. Netflix (NFLX -9.09%) found originals to be some of the most efficient content on its platform. What's more, originals are an effective tool to reduce churn, as they allow for something new every month.
Investing in video is a key way to grow Prime memberships, which is one of the three pillars of Amazon's business. Of course, that Prime membership growth needs to be supported by more fulfillment centers, which has caused an increase in the amount Amazon is spending. All of this goes to support future revenue growth. As long as revenue growth remains on track -- and it is -- there's not much to be worried about with Amazon's margins.
