Amazon Rise Defies the Odds

The pricey stock has recently bested eBay, Yahoo! and Google.
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Amazon.com (AMZN) - Get Report, known for its useful innovations, seems to have a new invention: A magical device that can cause its stock to defy gravity.

Over the past three months, Amazon's stock has risen the furthest of the big four Internet companies, up 43% as of Friday, compared with gains of 41% and 29%, respectively, for

eBay

(EBAY) - Get Report

and

Google

(GOOG) - Get Report

and a 1% decline for

Yahoo!

(YHOO)

.

All four stocks are up since they began reporting third-quarter earnings a few weeks ago. Google has delivered another stronger-than-expected quarter, while eBay showed it's handling near-term challenges with its usual skill.

Even Yahoo! has managed to claw its way back from what had been an 18-month low, by declaring that a search upgrade that could make it more competitive with Google was on track for an early 2007 rollout.

But there was nothing new in Amazon's third quarter -- certainly nothing that could warrant a 13% boost in its stock price the following day. Nor did the market seem to regard it as a quirk, a temporary spurt caused by short-covering that would soon be corrected. After rising to $37.98 the day after earnings, the stock has since held that ground and more, closing Monday at $38.21.

Some news stories and analyst reports asserted that the surge came because Amazon said its technology and content spending would finally fall as a percentage of revenue. Tech and content spending had risen to 7.8% in Amazon's second quarter, up from 6.4% in the first and 4.4% in the quarter before that. Much of that spending is believed to have been on developing Amazon's ill-starred Unbox video downloading program.

In the third quarter, tech spending edged down to 7.5%. So when Amazon CFO Tom Szkutak said, "We expect the year-over-year percentage growth in technology and content to continue to decrease," investors were euphoric. Maybe, just maybe, Amazon could boost 2007 earnings by 67%, as the Street was forecasting.

But three months earlier, according to a transcript on SeekingAlpha.com, Szkutak said nearly the same thing. On July 25, he said, "We're looking forward to the coming decrease in our year-over-year growth rate in technology and content spending." To say Amazon is worth buying because it's finally vowed to reduce spending is to come to the party three months late.

But really, there's no other compelling reason to account for Amazon's recent gains. Citibank (which has no underwriting relationship with Amazon) even recommended investors take profits on the rise. But so far investors are holding on.

Amazon's recent performance stands out when its fundamentals are compared to those of its three peers -- eBay, Google and Yahoo!.

The biggest stock gain in the last three months has gone to Amazon -- the Internet company with the highest P/E ratio, by far the worst operating margin (lower even than many so-called traditional retailers), and sales and profit growth that was only slightly worse than Yahoo!, which had been hammered for those very weaknesses.

What's going on here?

The bullish explanation is that Amazon is close to turning around its margin problem. Spending on tech and on the waived fees to promote the Amazon Prime loyalty program would be easing. Meanwhile, Amazon was quietly building up new, lower-margin revenue in its Web services division.

Some of those Web services -- offering data storage, computing capacity and its e-commerce code to programmers and sites -- could nurture startups into loyal customers, and even drive new retail business to Amazon through innovations like Flowser, a graphical enrichment to Amazon's site.

But there's also a bearish explanation: Amazon is continuing to face pressure from smaller, often cheaper e-tailers and its recent spending won't shore up revenue and profit as CEO Jeff Bezos had hoped. Further, the recent rise in Amazon's stock is a bizarre aberration, and it will take simply a piece of bad news to send the shorts descending on the stock like sharks on a sick whale.

Amazon has always taken a strong stand that innovation is a worthwhile investment, even if it takes away from near-term profit. It's a fight that many hoped it would win -- not just investors with a long position, but many other public tech companies.

If Amazon loses this fight -- if its recent spending doesn't deliver surprisingly strong returns that silence critics - it will be bad news not just for Amazon shareholders, but for other tech companies looking to invest in their future growth.

That's why it's worth watching Amazon closely, especially in two areas: First, will Amazon show strong year-on-year growth in revenue and profit as operating expenses decline while business picks up?

Second, and more important for long-term growth, will Web services give Amazon the boost it needs? Not just in a potentially rich source of low-margin revenue, but by creating a community of allies interested in helping Amazon get back to the cutting edge of Internet innovation.

The answers to these questions can only come from Amazon's clever CEO, but they will come over the next several quarters. The clock is ticking, Mr. Bezos. But for now, Wall Street is on your side.