This article is part of our Rising Star Portfolios series.

Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how Amazon.com (Nasdaq: AMZN) innovates.

Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare Amazon's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Amazon has spent an average of 5.5% of revenues on R&D. The following table summarizes how Amazon's R&D expenditures relative to revenues compare with some of the company's closest peers.

Company

2006

2007

2008

2009

2010

LTM

Amazon.com

6.2%

5.5%

5.4%

5.1%

5.1%

5.6%
eBay (Nasdaq: EBAY)

8.3%

8.1%

8.5%

9.2%

9.9%

10.4%
Rackspace (NYSE: RAX)

0.9%

2.4%

2.0%

2.0%

2.4%

N/A
Netflix (Nasdaq: NFLX)

4.8%

5.9%

6.6%

6.9%

7.6%

7.4%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

When it comes to comparing Amazon with its brick-and-mortar retail competitors, one statement summarizes the dynamic perfectly: Wal-Mart (NYSE: WMT) doesn't even bother reporting its R&D total. It's not large enough to be an item that's even discussed (aside from one quick mention) in its entire 10-K annual report. Clearly, Amazon is competing on a different plane.

So I've tried grabbing slices of businesses that Amazon competes against. eBay fills the role of a competitor that runs an online marketplace. Rackspace competes against Amazon in the cloud-hosting space. And Netflix is meeting increased competition as Amazon promotes its free streaming media library to members of its prime service.

Yet none of these competitors captures the whole of Amazon's business well, or how innovative the company has been. The obvious example of Amazon's research and development would be its popular e-reader, the Kindle. The device has proved immensely popular and moved Amazon to a leadership position in delivering electronic books.

What Amazon does so well is to go beyond the initial innovation and stays committed to its products on a long-term basis. Consider the Kindle once again, essentially since Amazon has featured the e-reader on its front page ever since it was released. That might seem insignificant, until you realize all the potential revenue Amazon has foregone by leaving the Kindle up there. The Kindle is an amazingly popular product, but it appeals to only a slice of Amazon's user base. Especially with the ability to target logged-in users, Amazon could have sold more by featuring different products in a move that would have appeased analysts looking for higher growth today. However, Amazon's banking on the fact that by heavily promoting the Kindle while the e-reader market is still in its growth stages, greater riches will await the company down the road.

Beyond the Kindle, you could also look at the company's push into cloud hosting. The idea originally formed from the basis that Amazon had to create enough server capacity for peak times during the holiday season but otherwise had high excess capacity. Some engineer at the company then took this idea to the next level and suggested renting some of this space out. That's a tremendously innovative idea. However, the real beauty has been Amazon's commitment to the idea, and how much extra work it has put into making its EC2 platform the dominant cloud-hosting service.  

Acquisitions 
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's take a look at Amazon's free cash flow over the past five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

Amazon investors have long taken note of the company's ability to produce cash flows well in excess of its reported earnings. However, total cash flows after acquisitions have been trending down since their 2009 high. There are a couple different reasons for this. First of all, as the company grows in size and expands its cloud-hosting services, it has to buy plenty of new data-center hardware that has been raising its capital expenditures. Second, Amazon has gotten more acquisitive and is snapping up smaller rivals.

Although Amazon's competitive position as the largest online retailer is extremely strong, a few other companies have been able to outfox their larger rival by focusing on smaller niches. For example, last November, Amazon shelled out $545 million to buy Quidsi, the parents of diapers.com.  If Amazon has to continue buying up smaller rivals focusing on particular niches, it could be a concern. Yet with only two major acquisitions -- the other being Zappos -- there are probably more important areas to keep an eye on.

Final thoughts
It's hard to argue against the statement that Apple (Nasdaq: AAPL) gets the best R&D bang for its buck, as the company spends just over 2% of all revenue on R&D yet consistently runs circles around competitors spending at five times the rate. But Amazon deserves credit not just for coming up with new innovative ideas and products, but also for having a long-term focus that gives these ideas the best chance of success. If Amazon's not the best tech innovator, it's at least an all-star.

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