Amazon's Climb: When Will the Music Stop?

The timing could not have been better. On the same day that Amazon.com's (NASDAQ: AMZN  ) stock price hit a new high, Bloomberg reported on an interview by CEO Jeff Bezos where he talked about what he thought investors should really be focused on.

He said profits are overrated, as the retailing giant aims to boost cash flow at the expense of just about everything else, including profit margins: "It's the absolute dollar free cash flow per share that you want to maximize. If you can do that by lowering margins, we would do that. Free cash flow, that's something investors can spend."

And setting expectations about the type of business you're running is critical, according to Bezos. He even cited Warren Buffett on his analogy: "Just don't hold a rock concert and advertise it as a ballet."

But Amazon could have the opposite problem here. With lean earnings expected over the coming quarters and a big ramp-up in costs, the company is set to turn in some mellow results. Yet investors are dressed for a lollapalooza style jam session.

Is Mr. Market due to get rocked?

Stairway to heaven

AMZN data by YCharts.

There's no denying the stock has been on a tear. It's up 200% in five years, or more than 500% from the low it hit in December 2008. With that climb, Amazon's market cap has ballooned to over $120 billion, almost twice eBay's and more than half of Wal-Mart's valuation.

It's true that there are some solid sales trends behind the rally. Annual revenue has rocketed from $19 billion in 2008 to $48 billion in 2011. And the 2012 fiscal year should see the company break $60 billion in sales. Amazon has been leaving traditional retailers in the dust, poaching market share from the likes of Best Buy (NYSE: BBY  ) , which can't seem to defend its business. Even after it promised to compete more aggressively, the company's sales fell by 4.3% last quarter. In fact, things are looking desperate for many bricks-and-mortar retailers. Target (NYSE: TGT  ) just announced plans to match prices with Amazon all year long, after a test run this holiday season. That might help protect some share, but it's hard to see how the retailer can maintain that pricing.

And selling stuff isn't Amazon's only growth source. The company's Kindle tablets did well over the holiday season, so we can expect digital sales to rise as customers stuff their holiday presents with e-books and HD movies. Then add Amazon's Web services division to the mix. That business could be contributing $2 billion or so in revenue, and is primed to grow as more companies move to a cloud-based infrastructure.

Rock you like a hurricane
So what's not to love?

In a word: costs. As Bezos hinted at in his interview, the company fueled its meteoric revenue rise partly by sacrificing margins:

AMZN Operating Margin TTM data by YCharts.

Some of that drop is due to increased spending for content in the streaming fight against Netflix (NASDAQ: NFLX  ) . Netflix shells out more than $2 billion a year on content, and the price of admission for competing in that market is probably well over $1 billion for Amazon.

But a lot of Amazon's margin pressure has to do with its liberal free shipping policy. The company's been delighting customers by waiving billions of dollars in shipping charges. Amazon sets the standard in online customer satisfaction thanks to its efficient delivery and great selection. But it's also hard to complain about "free."

You gotta have faith
Then why not raise prices or roll back some of the shipping offers so the business can throw off some profits? After all, there are plenty of retailers that manage to deliver strong shareholder returns despite low margins. Just look at Costco (NASDAQ: COST  ) . Operating at near break-even margins, the company has grown revenue by 40% over the past five years. And yet profits are up by 33% over that period, with dividends paid out to shareholders a full 70% higher than they were in 2008.

But Bezos isn't interested in raising prices:

We don't do that because we believe -- and again we have to take this as an article of faith -- we believe that by keeping our prices very, very low, we earn trust with customers over time and that that actually does maximize free cash flow over the long term.

The heart of the matter
Amazon's expected to turn in a sizzling $22 billion quarter to end its 2012 fiscal year. But analysts see earnings as continuing to deflate. And rising costs are the big question mark. With the company already valued at more than two times sales, investors are showing a lot of faith that Amazon's long-term bets will play out.

Champagne Supernova
Amazon has been a longtime pick of Motley Fool superinvestor David Gardner, and has soared more than 
1,640% since he recommended it in September 2002. David specializes in identifying game-changing companies like this long before others are keen to their disruptive potential and helping like-minded investors profit while Wall Street catches up. Learn more about how he picks his winners with a free online tour of his flagship service: Supernova. Inside you’ll discover the science behind his market-trouncing returns. Just click here now for instant access.


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