UPDATE 4-Amazon cost outlook weighs on holiday prospects

* Q3 EPS 51 cents vs Street view 48 cents

* Q3 revenue up 39 percent, op costs up more than 40 pct

* Sees Q4 operating profit $360 million to $560 million

* Sees Q4 revenue $12.0 billion to $13.3 billion

* Shares fall 3.8 pct (Adds detail on Prime, margins, Q2 costs; updates shares)

By Alexandria Sage

SAN FRANCISCO, Oct 21 (Reuters) - Inc AMZN.O signaled that the cost of expanding its business would grow at a fast clip during the holiday shopping season, sending shares of the world's largest online retailer down 3.8 percent.

Amazon is adding fulfillment centers around the world and spending on technology to support its retail and Web services businesses. Those costs will continue throughout the fourth quarter, Chief Financial Officer Tom Szkutak said.

The company has also been spending on television ads for its Kindle electronic reader as it vies with Apple Inc's AAPL.O popular iPad tablet.

For the fourth quarter, which includes the key holiday shopping period, Amazon said operating income could range from $360 million to $560 million, which could put it in a range from a decline of 24 percent to growth of 18 percent.

“The holidays are a time when you can earn customers, and what we suspect is Amazon has some promotional plans in place to attempt to acquire new customers through either pricing or shipping specials,” said Scott Tilghman, managing director at Hudson Square Research.

“What they might be doing is trading a little (bit) of margin for longer term growth opportunity.”

Amazon has lately been offering free trials for its Amazon Prime discount shipping program, which charges $79 a year for free shipping, in an attempt to capture more repeat customers before the holidays.

Part of Amazon's long-held strategy is to undercut competitors on price -- one that is shared by rival Wal-Mart Stores Inc WMT.N -- as well as to give shoppers perks like free shipping and returns. That has spurred Amazon's sales growth as customers make repeat purchases, but cut into profit margins.

“It’s not a strategy where we’re doing discounts for a short period of time. We’re trying to have great low prices every day,” Szkutak told reporters on a conference call.

Third-quarter operating margin as a percent of total sales was 3.5 percent, below the 4.6 percent a year earlier, and falling short of margins seen in the first two quarters.

Amazon also reported a higher-than-expected third-quarter profit on Thursday, on a 39 percent jump in revenue. But operating expenses surged more than 40 percent in the same period.

Michael Koskuba, senior portfolio manager with Victory Capital Management in New York, pointed out that Amazon shares had run up significantly since their last earnings report.

“A little sell-off shouldn’t be entirely unexpected,” he said of shares. “The story remains quite strong.”

Amazon warned of higher costs this summer, when it announced its second-quarter results in July. Higher spending -- together with profit that fell short of estimates -- spurred a 14 percent drop in shares. [ID:nN22111141]

But the sell-off was short-lived. Since then, the shares have risen 56 percent, as of Thursday’s close.

Bullish investors in Amazon see huge potential for growth, despite a rich valuation of nearly 45 times next year’s earnings, as it digs further into the territory of traditional retailers and digital media. [ID:nN19144715]


Net income in Amazon’s third quarter ended Sept. 30 rose 16 percent to $231 million, or 51 cents per share, from $199 million, or 45 cents per share, a year earlier.

Analysts, on average, expected earnings of 48 cents per share, according to Thomson Reuters I/B/E/S.

Revenue rose 39 percent to $7.56 billion. That was above the 35 percent rise to $7.36 billion expected by Wall Street. At the same time, operating expenses rose more than 40 percent to $7.29 billion.

In North America, third-quarter sales rose 45 percent. They rose 32 percent internationally.

Looking ahead, Amazon said it expects sales in its holiday fourth quarter of $12.0 billion to $13.3 billion, which would mean growth of 26 to 40 percent.

Analysts have been expecting fourth-quarter revenue of $12.3 billion, representing a 29 percent rise over last year’s holiday quarter and near the low end of Amazon’s forecast.

“It’s very typical for the company to provide very wide guidance and obviously, hopefully, they will hit the upper end of it if not beat it,” said Koskuba. “They don’t want to go out on a limb given the economic backdrop which we have right now.”

Also on Thursday, Amazon said it would team up with Facebook, Zynga and other companies to set up a $250 million fund to invest in social media start-ups.[ID:nN2195953]

Amazon shares fell to $158.76 following its earnings report, after closing 4 percent higher on Nasdaq at $164.97. (Additional reporting by Nichola Groom in Los Angeles, Phil Wahba in New York; editing by Michele Gershberg, Gary Hill and Andre Grenon)