Amazon Poised for Big Payoff

Stock quotes in this article: AMZN , WMT  

"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.

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