Don't fall for the hype of Amazon.com

By Robert Walberg

It’s been a good quarter so far for Internet retailers, with eBay (EBAY, news, msgs), Netflix (NFLX, news, msgs) and now Amazon.com (AMZN, news, msgs) handily beating Wall Street's expectations. But investors should control their enthusiasm.

Bolstered by strong demand for its electronics, Amazon reported net income of $19 million or 5 cents a share, besting estimates by 2 cents, on sales of $2.31 billion. The company said strong demand for its growing array of products and its Amazon Prime shipping program should help it boost sales in the current quarter by 22% to 33%.

As with eBay and Netflix, many on Wall Street were quick to applaud Amazon’s numbers and the stock surged 14% in after-hours trading Tuesday.

Amazon is over-hyped

Let headline-followers and the fast-money crowd run the stock up if they want, but don’t get sucked in. Amazon is an over-hyped, overpriced stock, with an over-ambitious management team that routinely over promises profits. There's a good reason its shares are off about 19% this year, even after today's after-hours rally.

As far as this stock is concerned, investors should consider it game over.

The reason is that Amazon hasn’t proven that it can grow profitably. Its operating margins slipped to 1.7%, from 2.2% last quarter and 3.0% in the year-ago period. Gross margins also slipped 1.1% year-over-year to 23.8%.

Until Amazon figures out how to grow sales without sacrificing margins, profits will be tough to come by and almost certain to disappoint more often than not. Unfortunately, Amazon’s free shipping program is very costly and continues to pressure margins. In addition, Amazon’s entry into the low margin grocery business certainly won’t help matters. Throw in the added expense of promoting new business areas such as the recently announced auto parts business and it’s difficult to imagine Amazon stringing together a number of strong quarters.

A history of blunders

Investors should consider the numerous boneheaded product decisions by Amazon's management.

The company is scaling back its floundering A9 search engine because it never caught on with users. According to Nielsen/NetRatings, A9 ranked 32nd among U.S. search engines, with about 0.1% of all searches (data for August 2006).

Amazon moved too quickly in unveiling its video downloading service dubbed Unbox. Negative reviews and numerous glitches left open the door for competition -- and sure enough Apple (AAPL, news, msgs) stepped in and will start taking it to Amazon in the quarters to come.

Then, there was the dubious decision to enter the low-margin, highly competitive grocery business and the recent move into the overcrowded auto-parts business, a field generally considered in decline given the increasingly complex and computerized nature of modern automobiles. Well thought-out expansion -- such as the move into electronics -- is good. But expansion for the sake of expansion, and at the expense of profits, is bad.

Now toss in extreme valuations, and there is no reason to buy Amazon’s stock. It closed the day trading at 48 times estimated 2007 earnings of 70 cents per share. By comparison, the S&P Retailing Index trades at about 15 times forward estimates. Even Google (GOOG, news, msgs), which bolstered net profits by 92% in the third quarter, trades at a relatively modest 35 times year-ahead projections.

While Amazon may have beaten estimates, don't forget that it didn’t actually grow its profit. To the contrary, net income fell 36% from $30 million a year ago. And for that performance investors are being asked to pay a premium of 1.4 times Google’s price, and more than three times the retailing industry as a whole. No thanks. I’ll stick with companies that expand profits and margins (like Google and Netflix), or bottom fish with cheap Internet plays like Expedia (EXPE, news, msgs).

Robert Walberg is a financial writer based in Chicago and a regular guest on CNN's "Moneyline." He was formerly chief equity analyst at Briefing.com and ran for Congress in Illinois in 1994.

At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this article.