Amazon's Spending Pays Off

The online retailer seems to be reaping the rewards of its significant investments in technology and new products

Investors wondered for years whether Amazon's (AMZN) heavy spending on new products and technology was worth it. Now it's all starting to pay off, at least judging by the company's latest profit report.

The huge online retailer's earnings per share were 19¢ in the second quarter, up from 5¢ a year ago. It beat analysts' estimates by 4¢. As profits rose 257%, sales increased 35%, showing Amazon is finding both more customers and wider profit margins. Amazon is "gaining market share," ThinkEquity analyst Edward Weller wrote in a client note. "Investments [are] paying off, with customers responding very favorably, what more could investors ask?"

Revenues—at $2.89 billion—beat even the highest analysts' predictions, according to Reuters Estimates. Sales rose 38% in the U.S. and 31% in the rest of the world. Is that a sign of strength in U.S. consumer spending? Not really. "Amazon is unique," says Scott Tilghman of Soleil-Hudson Square Research. "It's not tied directly to consumer spending." Amazon is benefiting from the migration of spending online, which still makes up just a small percentage of total consumer spending, he says.

Keep Them Coming Back

"Amazon has become the default go-to online source for books, other media, and a lot more," Weller wrote. The retailer is boosting sales by adding new product areas, including autos and toys and baby supplies most recently, and it's expanding geographically, especially its international offerings.

Amazon executives say their "Amazon Prime" program has been a big success. Under the membership program, customers can pay a $79 annual fee and get free shipping. The idea is to drive members to become repeat customers who spend more of their money and time on the site. "It's going to keep customers coming back," Tilghman says.

Beyond that, the Seattle company is proving adept at adding sellers to its site. These companies use as a platform for their product sales, and in return pay Amazon a royalty. A year ago, a partnership with Toys "R" Us dissolved, but Amazon was able to find even more third-party sellers elsewhere. "They lost ground and made it back up," Tilghman says.

Is the Stock Price Justified?

All these factors are driving sales, but analysts say profit growth is spiking thanks to slower growth in company spending. Amazon has spent big to add products and build out its technology. Some of these initiatives are part of Amazon's growth plans over the long term. For example, it's trying to sell downloadable music and video online. It's also beefing up its "Web services" business, which allows smaller companies to use Amazon technology to set up their own Web sites. "We're very optimistic about the long-term potential," Chief Executive, Chairman, and founder Jeff Bezos told analysts on July 24.

Many analysts now believe these initiatives, along with continued increases in sales, will pay off just as Amazon's high levels of spending start to decline, at least in relation to its overall revenue. The question is whether all this long-term potential justifies increases in a stock price that, thanks to a 25% rise on July 25, has more than doubled in six months. (BusinessWeek's Rob Hof discusses this question on the tech beat blog.) The stock gained 24.5% today, finishing at $86.18, trouncing its previous 52-week high of $75.35.

Standard & Poor's analyst Michael Souers wrote he believes Amazon "remains expensive, trading at more than 45 [times] our '08 [earnings per share] estimate." (S&P, like BusinessWeek, is a division of the McGraw-Hill Companies (MHP).) Weller disagrees, saying the stock could reach $105, another 22% rise, in a year.

"In the consumer sector, advancing market share and improving profitability often combine to produce years of stock market outperformance," he wrote, "and we think they will here, too."

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