Goldman Upgrade Is Golden for Amazon Stock

The Company

Amazon.com (AMZN)

Share price as of Friday's close: $76.46

Share price now: $83.92

Percent change: 7.6%

Volume: 18.5 million shares, daily average 8.4 million

The News

In adding the Seattle-headquartered online retailer to Goldman's influential "Americas Conviction Buy" list, analyst James Mitchell suggested Amazon could expand its revenue by more than 20% annually for the next five to 10 years. He boosted the price target on the stock to $98 from $75. Shares of Amazon closed up 8%.

"Growth-oriented investors see that Amazon is sustaining revenue expansion for longer than most Internet peers, as Amazon's investment of over a billion dollars in physical infrastructure historically limited but now entrenches growth; Amazon's US revenue growth rate caught up with Google's (GOOG) last quarter," he wrote. According to Mitchell, reduced profit margins from the quarter ended March 31, when Amazon beat Wall Street earnings estimates by a penny, aren't going to matter over the long run as long as revenue keeps growing.

Analysts on average expect 2008 sales to increase 32% year-over-year, to $19.6 billion. For 2009 the Street forecasts a 24% gain to $24.4 billion, according to Thomson Financial.

Amazon offered no comment on the Goldman report.

The Analysis

Sketching out a case for Amazon's fortunes doesn't make them a certainty, though, and bidding the stock up double digits won't be every investor's first choice.

Hamed Khorsand, an analyst at Beating Wall Street, a Los Angeles-area equity research firm, says the most important story from Amazon's April 24 earnings wasn't the penny beat, but the margin contraction, which dropped 70 basis points to 23.1%, down from 23.8% in the year-earlier quarter.

"There seems to be no lightening up on the aggressive price cutting at AMZN and this is putting extensive pressure on margins," he wrote on April 24.

"The margins are a big deal," Khorsand says. "These earnings, from my standpoint, were somewhat disappointing. Amazon's focus is on revenue growth, which doesn't translate into profit margin growth."

And looking back at Amazon management's responses to concerns about reduced consumer spending in a recession or near-recession, Think Panmure analyst Ed Weller called them "repeated, if unsatisfactory references to strong sales trends" in his own earnings note of April 24.

Goldman's Mitchell, however, sees the next few years as a period of revenue-driven growth. Amazon's lagged the key S&P 500 stock index for the past six months because of slight gross margin declines, putting it behind Wal-Mart Stores (WMT) and other online rivals. His report says it's time to re-think why that's happened.

"Retail businesses of a certain scale can typically choose to either grow margins or boost sales, with investors generally viewing the latter path as more sustainable," he wrote.

The Bottom Line

Amazon's spent a whole lot of money on initiatives like Prime, it's prepaid shipping service, which has about two million accounts — only 10% of its potential marketplace — and Kindle, its electronic reader, which has yet to come into widespread use.

That spending has cost the company, but it's also added some big benefits. Weller pointed out that its active customer numbers rose 19% in the first quarter and sales per average active customer are up 15%. Throw in the potential impact of tax-rebate checks getting spent online, and the good numbers could very well continue.

"In our view, investors have historically focused on Amazon's margin trajectory because of doubt as to whether its business model was sustainable," Mitchell wrote. "With $15 billion in revenue and $1.2 billion in free cash flow in 2007, we assume that Amazon has proven its sustainability, and that the current downward pressures on margins are a mixture of cyclical forces and discretionary spending (on projects such as Kindle)."

Khorsand isn't convinced. Retail, online or off, isn't for sissies.

"They'll always have to stay ahead of the competition, not just by price but in technology, so the customer is happy with their experience and wants to come back," he says. "They've done a nice job with that, but it's come at a cost to earnings. That kind of investment expenditure is a direct burden on the profit and loss on the income statement."

The kind of success Mitchell posits for this company depends on a brisk pace, and in uncertain times, investors might do better to wait until after Monday's jump for signs it can be sustained.

Also See:

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