Why Amazon Could Keep Flowing


By Rob Hof Now that the holiday shopping season is over, it's time for the Amazon (AMZN) bears to come out of hibernation. After an 8% jump in the two days following the Christmas weekend, Amazon.com's stock fell 5% on Jan. 4. The reason for the latest swoon: Citigroup Smith Barney analyst Lanny Baker slapped a sell rating on Amazon, citing new competition and the specter of higher technology and marketing costs this year.

While the bears may be right for now about the stock, they ought to think twice before they sell the company short. The pioneer e-tailer has more going for it than the many analysts with hold or sell ratings -- 15 of 22 who follow Amazon -- give it credit for. Thanks to a number of developments not universally recognized by Wall Street, Amazon may well surprise the bears in months and years to come.

"Most of the Street is pretty negative," says Bear Stearns analyst Robert S. Peck. "We think they're asleep at the wheel."

HOTTER RIVALS. For the moment, yes, investors have some reasons to be wary. By cutting prices and expanding free shipping offers, Amazon's operating margins have declined over the past four quarters. And this holiday season, traditional retailers such as Wal-Mart Stores (WMT) and Sears (S) grew much faster online than Amazon did. "The heat of competition is rising," Citigroup's Baker said in his report. The site also had sporadic outages in November that raised worries about fourth-quarter sales.

All that argues for caution about Amazon's price-earnings ratio of 41 for 2005. That's significantly higher than those of more profitable Internet giants such as eBay (EBAY) and Yahoo! (YHOO). "When margins are declining, it's not necessarily the best time to invest," says Legg Mason analyst Scott W. Devitt, who has a hold on the stock but is bullish on Amazon's prospects long-term.

Patient investors, however, could benefit from holding the course on Amazon. For one thing, its growth remains pretty swift at an estimated 28% this year, to about $6.8 billion. Analysts peg the year-over-year sales growth rate lower for Amazon's fourth quarter, especially in its largest market, North America, at about 16% -- noticeably behind the 25%-plus expected for U.S. e-commerce overall. Since sites such as Walmart.com and Sears.com have seen higher traffic growth than Amazon, that has led some analysts to believe that traditional retailers are stunting Amazon's growth.

JUICY COMMISSIONS. That analysis may be flawed, for two reasons. For one, the Amazon sales growth estimates could prove low. Peck thinks numbers by market researcher Comscore and others indicate Amazon did better than expected in the fourth quarter. He recently raised his estimate of Amazon's North American sales from $1.31 billion to $1.4 billion. Moreover, an increasing portion of sales -- 28% of total units in the third quarter, or about $1.3 billion for 2004 by Devitt's estimate -- come from other merchants such as Target (TGT) and Lands' End selling their wares on Amazon.com. Amazon gets only the commission on those sales, which amounts to less than 10% of the items' full price.

In effect, this business effectively reduces Amazon's revenues. But that's really not a bad thing. Those commissions carry much higher margins, more than double Amazon's 24% gross margins, and don't require additional labor or distribution center space. It's a lot like eBay's much-envied marketplace business, which carries gross margins north of 80%. "The third-party business is under-recognized by a lot of investors," says Peck.

Even Amazon's mainstay retail business may see further improvements as it grows. Unlike retailers, which must build new stores, stock each of them, and hire more people to staff them, Amazon can open new stores with minimal additional cost. It turns over its inventory 17 times a year, close to double traditional retailers. And on average, it gets paid 32 days before it must pay its suppliers -- in essence providing millions of dollars in cash flow. "A business of that sort deserves a premium," says Devitt, though not above about $41 a share.

USUAL VICISSITUDES. Finally, signs are emerging that Amazon's new businesses are starting to get traction. Chief Executive Jeffrey P. Bezos said recently that over the key Thanksgiving weekend consumer electronics passed books as the site's biggest-selling category.

Even nascent ventures such as Amazon's search site, A9.com, are starting to contribute to the bottom line. The site, which like search giant Google (GOOG) earns money for sponsored links to other sites, is bringing in enough revenue to pay for a 1.1% discount on Amazon purchases given to regular A9 users.

None of this, perhaps, will comfort investors who last week bid up Amazon's stock to its highest level since July, only to see shares fall now. But they shouldn't mistake the vicissitudes of the market as a sign that Amazon itself is petering out. Hof is a correspondent in BusinessWeek's Silicon Valley bureau


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