Its sights now set on increasing profitability, internet retail stock Amazon (AMZN) is regaining popularity. Founder and CEO Jeff Bezos says operating profits will improve thanks largely to a slower rate of spending in technology and content. Pleased by this prospect, investors pushed Amazon stock up nearly 18% this week.
I think investors are getting unduly excited.
For years the market has treated Amazon like a start-up, valuing the stock on its sales growth potential while by and large ignoring its earnings power. But nearly ten years after Amazon's IPO, investors are growing impatient. They want to see stronger signs of profitability. To keep the market happy, Amazon has started easing up technology and content spending.
Investors should be asking themselves: can Amazon hit the brakes on technology and content spending without slowing down its sales growth, the main driver of its hefty $16 billion market cap?
So far, things don't look that bad. In the third quarter, growth in technology and content spending rose by 42% as compared to 60% for the past three years. Meanwhile, third quarter sales grew by 24%.
But it's far from clear whether Amazon can slow spending while its high sales growth rates are subject to fierce competition. One of the few ways Amazon has held its own against Overstock.com (OSTK) eBay (EBAY), Wal-Mart (WMT) and Best Buy (BBY) is by investing heavily in whizzy technology and attention-grabbing content.
Amazon's recent entry into digital entertainment and distribution puts it up against the likes of Apple (AAPL), Time Warner (TWX) and Internet heavy hitters Yahoo! (YHOO) and Google (GOOG), raising the technology stakes higher. Spending on innovative technology is not something Amazon can afford to put on the backburner, at least not for long.
Including cutbacks in technology and content spending, Amazon's operating profit is expected to come in at about $590 million for the year, or about 4% higher than last year. That kind of profit growth is nothing to write home about. Wal-Mart, by comparison, is forecasted to grow operating profits this year by almost double that rate, yet the retailer is valued at about half Amazon's operating profit multiple.
I'd say Amazon is in a pickle. Slowing down technology expenditure is probably the quickest way to jack up profits, but, even so, it's not enough to make the stock look attractive. At the same time, cutting technology spending could hurt revenue growth, prompting investors to regard Amazon as something less than a high-flying internet stock. Until Amazon gets around this problem, investors are best to not brave the amazon.