Amazon Poised for Big Payoff

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

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.