Wading into Amazon's murky water

Stock Spotlight: The online retailer's stock has grown by leaps and bounds in 2007. But is Wall Street too optimistic?

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By Kenneth W. Musante, CNNMoney.com staff writer

Amazon hopes to create a market for downloadable books and magazines with its new Kindle device.
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NEW YORK (CNNMoney.com) -- Still haven't finished buying all the gifts you need for the holidays? If so, odds are you may be rushing to Amazon.com for those last minute presents.

The popular online retailer is expected to have a huge fourth quarter - analysts expect the company's earnings to more than double and sales to increase 34.5 percent over last year.

This caps what has been an amazing year for Amazon (AMZN, Fortune 500) on Wall Street. The stock is up more than 120 percent, making it the fifth best-performer in the S&P 500 index.

For the full year, Amazon is expected to report that earnings will be up nearly 150 percent and that sales will rise 35 percent. Wall Street has high hopes for 2008 as well, with analysts forecasting sales growth of 26 percent and profit growth of 45 percent.

Amazon.com is "arguably stronger than any other company on the Internet other than Google (GOOG, Fortune 500)," said Stifel Nicolaus analyst Scott Devitt.

But is all this good news already factored into the share price of Amazon.com? The stock has been hot before and burned many investors. Shares surged in 1998 and 1999 but plunged 80 percent in 2000 and another 30 percent in 2001 after the dot-com bubble burst. Still, many analysts do not expect history to repeat itself.

Prime numbers

Amazon has spent heavily to build out features such as personalized recommendations, its one-click purchasing system and Amazon Prime service for frequent shoppers. Those investments may have hurt profits in the past but really began to pay off significantly in 2007.

Amazon Prime, which gives customers shipping discounts for a yearly fee, gives customers more incentive to shop online instead of going to the store, wrote Jeffrey Lindsay of Bernstein Research in a report. He likens it to club programs similar to what you would find at retailers like Costco (COST, Fortune 500).

Lindsay estimates that Prime, which launched in the U.S. in 2005, and was rolled out to Japan, the U.K. and Germany this year, has helped Amazon generate enough new sales to offset increased shipping expenses.

To that end, even though net shipping costs rose 39 percent in the third quarter from a year ago, Amazon's revenue in the quarter increased by 41 percent.

Overall, Amazon has done a better job recently of keeping costs down - in the third quarter, operating expenses were up just 26 percent.

And the company's recent investment in payment service Bill Me Later could reduces costs even further.

Amazon announced earlier this month it was buying a stake in Bill Me Later, which lets people shop online without using a credit card and that it would add the Bill Me Later feature to its site. According to Devitt, this could help Amazon lower its payment process costs by about two percent.

Moving into new markets

Amazon has also never been afraid to expand into new markets. That has often made investors nervous but it's a strategy that worked well in 2007.

The company still is known primarily as a site to buy books, music and DVDs. Sales of media products accounted for nearly two-thirds of Amazon's sales in the first nine months of this year.

But Amazon has also boosted its presence in other areas, such as electronics, toys, apparel and appliances. Sales of electronics and general merchandise now account for 33 percent of total revenue, up from 29 percent in the first three quarters of 2007.

What's more, sales in this division are growing much more rapidly than media, with revenue from electronics and other merchandise increasing 53 percent compared to 29 percent growth in sales of media products.

Still, Amazon is not forgetting its roots. In 2007, Amazon launched both MP3 Downloads, a downloadable music store, and the Kindle, a hardware e-book reader device with a built-in marketplace that lets people download books and magazine content.

But there are risks to both new offerings. The MP3 Downloads store puts the company in direct competition with Apple's (AAPL, Fortune 500) iTunes. And it remains to be seen if there is real market for the Kindle. Other e-reader devices have flopped in the past and it's not clear if there is enough demand for book downloads as there is for music.

In addition, Brian Pitz of Bank of America expresses concern in a report that Kindle could hurt profit margins for Amazon. That's because Amazon, and not Kindle users, will be paying Sprint to use its wireless network to download books and other content.

Amazon has baked the cost of the wireless access into the up-front price of the device, and hasn't revealed exactly how much it costs on their end. Sprint charges its own customers around $60 per month for the same type of service.

But even if Amazon was able to negotiate a much lower rate from Sprint (which it likely did) per device, it would need to sell several books each month per device to recoup those costs. So if the sales for Kindle and e-books are underwhelming, Amazon would be the one left holding the bag with what could be a big wireless data transmission bill.

Future challenges

Amazon.com has a lot going for it. But Wall Street already knows that. The stock is trading at 52 times earnings estimates for 2008. Top Internet auction site eBay (EBAY, Fortune 500), by way of comparison, trades at about 20 times next year's earnings estimates.

But some analysts think Amazon is worth such a lofty valuation because it should continue to grow rapidly. Wall Street, after all, expects the company to report profit increases of 45 percent next year and 48 percent in 2009. And eBay is expected to report earnings growth of 12 percent next year and 17 percent in 2009.

Lindsay dismisses fears that rising fuel prices will lead to higher shipping costs that could hurt Amazon because of the success of Prime. Since customers pay an annual fee in advance to become a Prime subscriber, that would help to cushion the company against shipping cost fluctuations.

Jordan Rohan of RBC Capital is also optimistic about the stock. He predicted in a research report that the rollout of Amazon Prime overseas, particularly in Japan and Germany, will start to pay off soon. His report also said that third-party sales systems like Amazon Marketplace, which lets sellers list new and used items on the site - kind of like eBay - will also continue growing.

However, Mark Mahaney of Citigroup and Douglas Anmuth of Lehman Brothers are more cautious. Mahaney wrote in a report that profit margins are starting to narrow and that the company's earnings growth will also begin to slow.

And Anmuth suggests in a report that Amazon, despite its strong performance, is a bit overvalued by Wall Street, and its stock price may fall once investors begin to factor in the stiffer competition facing the company.

With all this in mind, Amazon does seem to still be a worthy investment for a buy and hold investor but it has its risks. The company is probably going to need to deliver a very merry fourth-quarter report in January to satisfy the momentum investors that have bid up the stock this year.

So if you're buying it now, you just need to be realistic. Don't expect the stock to more than double again in 2008. And be prepared for some volatility in the months ahead.

Analysts quoted in the story do not own shares of Amazon. Citigroup has done investment banking work for the company. To top of page

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