Amazon's 3-month gain defies the odds

By TheStreet.com

Amazon.com (AMZN, news, msgs), 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, news, msgs) and Google (GOOG, news, msgs), and a 1% decline for Yahoo! (YHOO, news, msgs).

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 report -- certainly nothing that could warrant a 13% boost in its stock price the next 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 were reported, the stock has since held that ground and more, closing Nov. 6 at $38.21.

What powered the quarter

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 Chief Financial Officer 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 Wall Street was forecasting.

But three months earlier, according to a transcript on SeekingAlpha.com, Szkutak had 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 has 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 with those of its three peers.

Skewed valuations

The biggest stock gain in the past three months has gone to Amazon, the Internet company with the highest price-earnings 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 that of 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 Chief Executive Officer 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.

Why Amazon is worth watching

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 have 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?

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

By Kevin Kelleher, TheStreet.com