Remapping Amazon's Course

Even if it hits full-year profitability in 2003, as expected, chances are its stock won't be sailing much higher anytime soon

By David Shook

Anyone who has followed the path of's (AMZN ) stock since it reached a record high of $113 in December, 2000, knows that investing in this company requires a gut check. The price fell to a record low of $6 after September 11, but investors who got in at that level were rewarded, as the shares crept up to $20 in May. Now, after a recent swoon to around $13.50, shares are back near $15.

You can read the trajectory several ways. For one thing, Amazon looks like a dot-com survivor -- part of an elite group that's getting smaller by the day. And its future appears solid: It's widely expected that the giant e-tailer will show its first full-year profit in 2003. At that point, investors will have a true picture for assessing Amazon's valuation relative to its retailing peers.

Time to jump on the Jeff Bezos Express? Not so fast. This is where the Amazon picture gets a little muddled. Most of the Street sees Amazon earnings as a big positive next year, but the estimates for return on share value are all over the map -- and valuations for the stock are already quite high no matter which analyst you listen to. Hence, the recent volatility.


  Perhaps it's time to reassess Amazon. It appears to have reached the ranks of established retailers poised for long-term earnings growth. But even analysts who are bullish on Amazon think its shares will have a tough time advancing much above their recent $20 high at anytime soon.

Take Jeff Fieler, an analyst for Bear Stearns who has the highest profit estimate among analysts at the major houses that cover Amazon. He's predicting 2003 net income of $114 million, or 28 cents a share, with earnings growing at an average annual rate of 32% through 2004. But Fieler thinks the stock would be at the high end of its fair value even at $20 a share. His projections for Amazon's profits are as fat as one can find, yet he has the equivalent of a hold recommendation on it.

In deriving a valuation for Amazon, Fieler uses a complex method called the cost of equity, or the annual rate of return investors should expect when investing in a stock. For the average company, the cost of equity is around 11% to 12% a year. For Amazon, Fieler puts it at 18.5% for each of the next three years -- significantly higher than usual because of the risk he believes is inherent in the stock, given Amazon's debt load ($2.1 billion) and lack of profitability thus far.

Applying the cost of equity to his earnings estimates for Amazon, Fieler arrives at a target price of about $20 a share -- roughly equal to its record high this year. Remember, this is the most bullish Amazon analyst on the Street.


  Others believe the e-tailer will record average earnings growth of 20% to 25% a year. While that's impressive, analysts point out that Amazon's starting point -- zero earnings so far -- makes any profit growth appear larger on a percentage basis than it really is. Moreover, questions remain as to how Amazon will handle the competition once other retailers start selling more products online and competing on price.

Already, aggressive rivals are nipping at Amazon's heels -- and not just the Wal-Marts and Sears of the world. On June 25, tiny online retailer pledged to sell books at 10% less than Amazon's prices. "It's a bold move to specifically target the Amazon customer base," said Robert Price, president and chief financial officer of, in a statement announcing the price policy. His company also recently instituted free shipping, in response to Amazon's decision to drop shipping charges on certain orders.

Amazon declined to comment on the moves. And it hasn't given any guidance to analysts on estimated earnings for next year. But in an interview with BusinessWeek Online, even CEO Bezos is cautious: "If you are going to invest in an Internet must be a long-term investor. And if you're a small investor, it should be a small portion of your portfolio, just because of the volatility," he says (see "Chewing the Sashimi with Jeff Bezos").

Bezos certainly has proved skeptics wrong so far, though. Last year, some money managers were speculating about Amazon's demise in the middle of the recession. They said a weak Christmas season might be the last straw after seven years of heavy losses.


  Yet on Jan. 22, Amazon surprised Wall Street with its first-ever bottom-line net profit -- fourth-quarter 2001 earnings of $5 million, or 1 cent a share, following stronger-than-expected holiday sales. That was enough black ink to convince investors Amazon was going to make it. As shares have climbed more 50% since that earnings report, Amazon has been improving its operating cash flow and lowering its order-fulfillment costs. And the accounting woes haunting other companies have yet to darken Amazon's door.

In the first quarter, it improved to a net loss of $23 million, or 6 cents per share, vs. a first-quarter 2001 net loss of $234 million (including one-time charges of $114 million and a goodwill expense of $49 million), or 66 cents. Sales increased 21%, to $847 million, in the first quarter. More important, Amazon's book, music, and DVD division and its services and partnerships businesses are now producing operating profits. In the second quarter, Amazon is expected to report a small overall net loss but also sales growth of 15% to 22% over a year ago.

Institutional investors have certainly taken notice. Janus Capital, which owns 4.3% of Amazon's stock, and Fidelity Investments, with 3.1%, have been among the largest buyers this year, according to securities filings. These investors seem to have faith that Amazon's strategy of selling books, music, and videos alongside TVs, toys, and tools can prove to be an effective business model after all.


  The strategy still contains risks, however. Recently, Amazon began offering free shipping for some merchandise on purchases that exceed $49 (the level was formerly $99), while waging a vigorous effort to price its products as low as they can go. Such aggressive pricing and marketing can certainly reap customer gains. But as soon as answered Amazon's free-shipping offer with its own challenge, Amazon stock dropped 12% in a single day. That's the kind of volatility players in the highly competitive retail business can face.

Bezos said in a recent speech at the Bear Stearns Technology Conference that he's tired of hearing people question whether the company's new focus on lowest-price anywhere can be a sustainable business model. "Is lowering price a sustainable strategy? The answer is pretty clear: It actually is one of best ways to create a sustainable strategy," Bezos said on June 12. "There's a productivity [increase] as you get more scale. You can lower prices, and you get more fixed-cost leverage. It is a sustainable strategy, and there are great companies like Dell and Wal-Mart which demonstrate that."

Most analysts think Amazon will post a net profit in the all-important fourth quarter of 2002, and a stronger-than-expected showing could even put the company near the breakeven point for the year. But all eyes are on 2003, and the estimates among Wall Street pros are as varied as Amazon's retail offerings. While Fieler of Bear Stearns estimates 28 cents a share in full-year profits -- giving Amazon a 2003 price-to-earnings ratio of 48 -- Prudential Securities' Mark Rowan has it delivering about 3 cents a share. If Rowan is right, then Amazon is already trading at a 2003 p-e of 450.


  Either way, that's significantly higher than retail king Wal-Mart, trading at a comparable multiple of 29 times next year's earnings. The average earnings estimate of all analysts tracking Amazon is 13 cents, which would give it a p-e ratio of about 103.

Two years ago, the naysayers warned investors that Amazon faced the risk of insolvency if it kept burning through its cash reserves at the rate it was going in the late '90s. Perhaps they were right -- but Amazon was already cutting costs, improving margins, and spicing up its product mix. In the process, Bezos has silenced many of his critics during a recession that crippled several other retailers.

Still, investors clearly aren't convinced that Amazon will be basking in a windfall of profits next year. If the economy improves dramatically over the next six months and earnings estimates rise for all retailers, could surprise again. But at the shares' current price range, real rewards might be a few years in coming.

Shook covers the financial markets for BusinessWeek Online in New York

Edited by Douglas Harbrecht

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