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Amazon Poised for Big Payoff

Kevin Kelleher

It's shaping up to be a make-or-break year for shares of Amazon.com (AMZN Quote).

Ever since Amazon turned profitable in 2002, critics have hammered CEO Jeff Bezos for being a spendthrift on things such as free shipping and new technology that a retailer has no business getting involved with.

They point to the slim and ever-deteriorating operating margins to make their case.

Sure enough, Amazon's margins haven't looked very good for the past couple of years.

After peaking at 6.4% in 2004, Amazon's operating margins slipped to 5.1% in 2005 and even further, to 3.6%, last year (see chart below).

That was Amazon's lowest operating margin since 2002, when operating profit was 1.6% of revenue.

Making matters worse, Amazon's gross margin slipped to 22.9% in 2006 -- its lowest mark in six years -- as lower-margin goods such as electronics made up a larger portion of its overall revenue.

Even using the cash-flow figures that Amazon tends to prefer as a measure of fiscal health, 2006 was a weak year. Free cash flow dropped 8% to $486 million. Operating cash flow, after rising for the previous three years, fell 4% to $722 million.

So the bears' case against Amazon could be summed up rather bluntly: its business plan is weakening the company.

The bull's case can be put just as succinctly: You ain't seen nothing yet, folks.

Or, in the recent words of Bill Miller, manager of the Legg Mason Value Trust fund and the perennial Amazon bull whose 15-year winning streak against the S&P 500 was halted in part by Amazon's sluggish stock: "100% of the information you have about a company represents the past, and 100% of the value depends on the future."

That is, Amazon's historical financial performance may look bad, but the company should be turning a corner any quarter now. Investment in new areas and greater economies of scale should start to kick in and drive up profit and revenue alike.

"Just as was the case in Costco's business ... AMZN will lever and experience a cycle of outsized equity returns," recently wrote Scott Devitt, an analyst at Stifel Nicolaus, which has no underwriting relationship with Amazon. "Amazon is singularly focused on one extremely important constituent -- ITS CUSTOMER -- and we believe that this attitude toward its business may be its most valuable hidden asset."

There is some recent evidence that the bulls are right about the customer focus. Amazon's critics often point out that big-name retailers such as Wal-Mart (WMT Quote) are horning in on Amazon's online act. But while Wal-Mart's online presence is catching up to Amazon in pageviews, it's doing a terrible job of turning those views into purchases.

According to data from Compete.com, Amazon saw 10.7 million transactions in December 2006, its busiest month, while Wal-Mart saw only 3 million. The year-on-year growth rate of Amazon's transactions, at 29%, also outpaced Wal-Mart's 21% growth rate. Wal-Mart was the second-busiest retailer in terms of online transactions, but it was a very distant second.

Still, investors who have been hearing this optimistic argument for years would be justified in wondering just when the long-vaunted turnaround is going to happen. The answer, just possibly, may be right now.

In 2006, Amazon spent heavily on technology to launch a downloadable video business and a new line of business that rents out its powerful back-end operations such as storage and programming. Both are potentially high-margin businesses, although to date the movie downloads haven't fared as well as the Web services.

That investment squeezed margins last year, but Amazon vows the heaviest spending is over. In its most recent quarter, operating expenses and operating profit both showed a substantial improvement from the previous quarters. Operating expenses were 16.4% of revenue, the lowest figure in eight quarters.

The big question facing Amazon is whether it can hold back spending while its recent investments add to revenue. And here Amazon is frustratingly murky: The midpoint of its revenue guidance suggests sales will rise 25% this year, but its operating income guidance suggests margins will continue to deteriorate.

Amazon is perhaps just being conservative on its operating income guidance to buy some wiggle room and offer a chance for a positive surprise. Analysts are counting on 51% growth in its EPS this year. That sunny view assumes at least a bottoming out in its operating margin, if not outright improvement.

It's almost too bad Amazon isn't a private company. Its noble focus on its customers is a sound business strategy that will generate strong growth in time. But for a public entity, the mix of falling margins and high stock valuation is like blood in the water for hungry corporate raiders.

A year of rising earnings would buy a lot of goodwill with Amazon's investors. But if Bezos can't deliver soon on the promised operating leverage, then watch out: Things could get messy.