Caution Scribbled in Amazon's Margins

SAN FRANCISCO -- Have shares of Amazon.com ( AMZN) gotten a little ahead of themselves?

On Wednesday, the online retailer's stock was enjoying the benefits of the broader market finally finding a direction other than down. Amazon was recently up $1.84, or 3%, to $63.54.

But the company's shares have now jumped 80% since late November, when everyone was feeling depressed/shocked terrified about the Dow Jones Industrial Average dropping below 7,400. Ah, the good old days.

To say Amazon has separated itself from the pack is an understatement -- in the past three months the stock is up nearly 40%, while the S&P 500 is down 20% and the Nasdaq has fallen about 10%.

Amazon's newish designation as a stock with which to weather the recession -- it sits, for example, on Barclays' "Top Picks" list with Google ( GOOG), Netflix ( NFLX) and Blue Nile ( NILE) -- was cemented in late January, after the company's holiday quarter blew away Wall Street estimates.

Even better, the company's projected range for first-quarter revenue, which bracketed the average analyst forecast, held up the promise that Amazon was going to be one of the rare stocks in the first half of 2009 to not cause investors to sigh heavily.

In addition, the company's Kindle electronic book reader has evolved from "Who would ever buy that?" to become both a strengthening company brand and a conduit for related sales. Collins Stewart analyst Sandeep Aggarwal projected on Monday that Kindle sales would come in at $265 million to $305 million in 2009, with gross profit of $55 million to $70 million. If you think about it, that's larger than most U.S. businesses.

Nearly five weeks later, however, it's perhaps time to prod at Amazon's share-price valuation and its ability to outperform in the face of consumer retrenchment.

The stock now has a trailing 12-month price-to-earnings ratio of 42.7. This is still below its valuation for much of 2008, when the stock was sailing along in the $80 range, but you won't find many stocks sporting this multiple at the moment.

On the other hand, you won't find many stocks that are predicted to post revenue growth of more than 14% in 2009, and then tack on another 17.5% rise in 2010.

But as the company showed over the holidays, growing revenue is no big thing. As Needham analyst Charlie Wolf pointed out last month when throwing a buy rating and $72 price target on the stock, Amazon has instituted a scorched-earth policy in pricing to boost revenue growth as the company chooses to focus more on free cash flow (its cash flow minus capital expenditures) than earnings per share.

That strategy has paid off, as Amazon posted revenue growth of nearly 30% in the holiday quarter and rattled off its fourth-straight quarter of improving free cash flow per share.

However, this has come, as one might guess, at the expense of margins. The company's operating income as a percentage of revenue has now fallen for three straight quarters, and investors could wonder if Amazon will soon begin to reach the dirt of its own scorched earth.

And, this just in, the macro-economic outlook has become no less dire. People are losing jobs, they are increasingly underwater in their homes, and, unsurprisingly, they're beginning to revert to saving more money. As we saw Monday, personal saving as a percentage of disposable personal income was 5% in January, compared with 3.9% in December.

This isn't to say that Amazon shares won't join in the fun if Wednesday's broad market rally can follow through for more than one day (or even this day).

It does, however, seem unlikely that Amazon's 60-percentage point outperformance over the S&P can hold throughout 2009.

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