Amazon's Popularity Gets Pricey

A 40% run-up last week may have closed any near-term opportunity.
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Investors perhaps got a little ahead of themselves with

Amazon.com's

(AMZN) - Get Report

impressive first-quarter results.

Last Tuesday, the online retailer

announced revenue and earnings that blew by analysts' expectations. The company also reported unexpected gains in its closely watched operating margins and said that spending on technology and content would grow at a slower pace than it did over the last year.

Shares of Amazon -- already the best-performing of the big Internet names -- soared 40% to close the week at $62.60. But after a run of nearly 70% since lows hit last August, it's difficult to see how adding another $8 billion in market capitalization this week is warranted. (The stock was recently off 1.3% to $61.76 in Monday trading).

Indeed, while Amazon's results essentially ruined the bear case for the stock -- and sent a massive amount of short-sellers running for cover -- even Amazon bulls came around to sounding a note of caution on Friday. "We believe the company is performing above even our own optimistic expectations, which would make us comfortable being buyers again in the low $50s," Stifel Nicolaus analyst Scott Devitt wrote in a note on Friday downgrading the stock to hold. Stifel Nicolaus makes a market in Amazon shares.

With a forward price-to-earnings ratio of about 53 and a price-to-earnings-to-growth ratio of 2.53, Amazon is the most richly valued big Internet company by a wide margin. Auction giant

eBay

(EBAY) - Get Report

, for example, trades at a forward P/E of 22 and a PEG ratio of 1.26.

And while expanding margins coupled with heady revenue growth -- on top of Amazon's already-monstrous sales -- might be appealing to investors, it's reasonable to wonder whether it isn't already priced into the stock.

Devitt, a believer in Amazon's e-commerce prospects, estimates that 2007 and 2008 earnings per share will come in at 96 cents and $1.20, respectively. Largely in line with the 95 cents and $1.20 analysts surveyed by Thomson Financial/First Call are expecting, Devitt's estimations give him a price target of $55.

The aggressively bullish sentiment in the stock might be stemming from those looking beyond e-commerce to some of Amazon's more technically ambitious projects. This includes the Unbox service, which lets users download digital content. "While this video venture is still is in the early stages, we think that the company may look to expand into the digital music arena shortly," Deutsche Bank analyst Jeetil Patel wrote in a research note on Tuesday. Deutsche Bank makes a market in Amazon shares.

Patel is even more optimistic about Amazon's bid into Web services such as S3 and EC2, which sell storage and computing capacity to other businesses. "We think the Amazon Web Services initiative represents a very large opportunity in outsourcing the hardware/storage/software requirements to operate a scalable Web infrastructure using the company's existing hardware and storage and computing infrastructure on an a la carte/per hourly usage basis," he wrote. "We think this Web services opportunity could be just as significant as the company's core e-commerce service."

While Patel notes that both initiatives are still in the early innings, he writes that they will begin hitting the company's bottom line in 2008. He forecasts pro forma earnings per share of $1.64 for 2007 and $1.95 for 2008.

Still, while Patel's earnings estimates are among the most bullish for Wall Street analysts, his 12-month price target for the stock is only $60 -- below where it closed on Friday.

Given that Amazon's stock price seems to have outpaced the valuation warranted by even some of the most bullish forecasts, investors may be better off finding ways to profit from a pullback rather than get behind it at this point.

But with the enormous momentum now bolstering the stock, it would be inadvisable to short it outright.

Purchasing put options for the right to sell the stock at a predetermined price might be a safer way to go. Put options with a $60 strike price that expire on June 15 trade at $2.54, for example.

However, there isn't any obvious event approaching that would trigger a fall in Amazon shares. Instead, a gradual decline in the stock could ensue as the euphoria wanes, if the overall bull market wanes or if other macroeconomic new puts a dent in Amazon's prospects.

Taking a short position in the stock while simultaneously buying for the $65 call options may therefore be an even better way to go: Investors would profit from a downward move beyond the price of the expired options. And if the stock rallied again, losses would be limited. (Of course, investors should close their short positions before the options expire to protect themselves from downside risk.)

It's tough to see, though, how Amazon shares can sustain such lofty levels once traders return to looking ahead rather than behind.