There was certainly a lot of tension with Amazon.com (Nasdaq: AMZN) investors before the company reported its third-quarter earnings last week. Between the ongoing meltdown in Internet-focused companies, the second quarter's anemic growth, and a long train of bad news surrounding the company (see the living.com bankruptcy and the price-testing fiasco for examples), the concerns about Amazon's future appeared quite valid.

Then, lo and behold, Amazon's report actually showed that the company rocked in the third quarter. Adjusting for a one-time, at-cost sale of inventory to new partner Toys "R" Us (NYSE: TOY), sales were up 74% year-over-year and 7% sequentially. While the modest revenue increase was a welcome sight after the second quarter's flattish sequential growth, where Amazon really shined is in the efficiency department.

Marked Margin Improvement
One of the best ways to see how efficiently a company is operating is by looking at its profit margins. For Amazon to indeed attain profitability down the road, its sales growth must be accompanied by reduced costs per sale. The mile markers to profitability are marked with increasing margins, and Amazon passed quite a few of these mile markers in the third quarter. Look at these figures and see if you can see some trends evolving: 

                    Adjusted
          Gross     Operating    Adjusted 
          Margin     Margin     Net Margin
Q3 1999   19.8%     -22.3%       -24.1%
Q4 1999   13.0%     -25.9%       -27.3%
Q1 2000   22.3%     -17.3%       -21.2%
Q2 2000   23.5%     -15.5%       -20.0%
Q3 2000   26.2%     -10.7%       -12.1%
A couple notes about the above numbers. First, the adjustments I made to the company's operating and net margins ignore the accounting costs of intangibles, stock-based compensation, merger, acquisition, and investment-related costs. Basically, I'm trying to weed out the noncash charges as well as the expenses not related to Amazon's core businesses.

In addition, it's worth noting that Amazon's fourth quarter last year involved several items that hurt profitability. First, the company overstocked many items and was forced to write down and discount a portion of its inventory. Amazon's recent deal with Toys "R" Us will mitigate this risk this coming holiday season.

Second, Amazon purposely spent an oversized amount on order fulfillment and shipping to make sure that customer orders arrived in time for the holidays last year. While some of Amazon's competitors stumbled, Amazon's shoppers had a largely hassle-free experience. We'll see if this focus on customer satisfaction will pay dividends this year and beyond. I'm thinking it will.

A wise man once said, "If you don't change your direction, you will end up where you are headed." The company's net profit margins are still quite negative, but the direction in which they are headed is something we certainly approve of. If the company can continue to mix top-line growth with profit margin expansion, the company will indeed become profitable down the road.

Just extrapolate the trends above. Either way, Amazon certainly appeared to have both ingredients for profitability (increased revenue and improving margins) in the third quarter.

Looking Ahead
While the third quarter was a positive one for Amazon, the real test for the company lies just ahead for the holiday season. Again, last year was quite challenging for Amazon in the profitability department. It will be interesting to see if the company can continue to roll along on its path to profitability while maintaining customer satisfaction levels.

Between the company's earnings press release and the following conference call with analysts, Amazon was fairly explicit about what it expects to see in the fourth quarter. Namely, it expects:

  1. Roughly $1 billion in sales, even with the reduced top-line contribution from the company's toy store. (Profits from toys should be up, however.) For comparison's sake, Amazon did $676 million in sales in last year's fourth quarter.

  2. Exceptionally strong cash flow from operations. The company expects to end the quarter with cash and marketable securities of more than $1 billion. This would suggest that Amazon expects operating cash flow to exceed $100 million in the fourth quarter, up strongly from last year's $32 million.

  3. Pro forma operating losses (very similar to my adjusted operating margin above) of between 5% and 8%. If achieved, the trend toward profitability would remain in place.

  4. Gross margin to be slightly down sequentially, but up strongly year-over-year. The Toys "R" Us deal will boost gross margins from here forward. Still, some of the company's newest and fastest-growing retail categories, e.g. electronics, have lower gross margins and will reduce overall gross margins as they make up a greater percentage of revenue. (That said, it is worth noting that electronics may have lower gross profits on a percentage basis, but can be quite lucrative on an absolute-dollar basis.)
If the company can achieve its targets as outlined above, it will pass yet a few more milestones along its path to profitability. The outlook that Amazon gave for the rest of 2001 also looks quite positive. It expects sales of more than $4 billion and positive cash flow from the second quarter onward. Positive cash flow is a preamble to real profitability.

Jumping the Shark?
No, I don't think Amazon has jumped the shark just yet. Sure, it has had more than its share of implosions and failures -- just pull up a quote on partner Pets.com (Nasdaq: IPET), or think about the logistics of profitably shipping a lawn tractor.

However, Amazon has also had a few home runs. The company's core business of selling books, music, and videos is starting to produce substantive cash flow; its electronics store is also starting to gain some traction (now the second-largest retail category for Amazon); and operating efficiency is improving across the board. While many challenges still lie ahead, I believe Amazon's future will be much brighter than its recent past. I'll soon be writing more long-term analysis on the company's prospects for Motley Fool Research.