Amazon.com: Great Expectations

Shares of Amazon.com have been soaring like Harry Potter on a broomstick. The stock gained a whopping 24% on July 25, to $86.19 -- a seven-year high -- after the online retailer reported that second-quarter profits had tripled from the same period last year and boosted its earnings guidance for the rest of 2007. Those results beat expectations and garnered upgrades from a host of stock analysts.

The run-up adds to the stock's remarkable performance over the past year. Since last August, the shares (symbol AMZN) have more than tripled, tripping up short sellers, who bet on stocks to fall, and many Wall Street analysts. "We have been caught by surprise by the magnitude and speed of the company's revenue growth and [profit] margin expansion," says Bear Stearns analyst Robert Peck, who raised his rating to "peer perform" from "underperform."

Pre-orders of the blockbuster book Harry Potter and the Deathly Hallows and a popular membership called Amazon Prime contributed to strong U.S. sales. The company earned 19 cents per share in the second quarter, which beat the average analyst forecast of 16 cents per share. The company also raised its revenue forecasts to between $13.8 billion and $14.3 billion for the full year.

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Lower costs will give Amazon a tailwind. In the past, the Seattle online retailer has spent a bundle to launch new services and upgrade its technology infrastructure. Its Prime service is a prime example. The service reduces shipping charges on online orders if users pay a $79 annual fee. But Amazon had to give away free trials to generate interest. As the service finds its legs, Amazon won't need to spend as much on promotion. Meanwhile, Amazon has concluded its planned technology improvements, says Value Line analyst Warren Thorpe, who expects the reduced spending to increase profit margins. (Cutbacks in capital expenditures should also boost free cash flow, which is money that Amazon can use to make acquisitions, buy back shares or initiate a dividend.)

After such rapid appreciation, the slightest slip-up by the company could send shares tumbling. "We still project impressive revenue growth and margin expansion over the next five years and think the company can generate triple-digit returns on invested capital over the long term," says Morningstar analyst Joseph Beaulieu. "But even those estimates don't support the company's rich valuation."

The stock is expensive even by dot-com standards. Amazon shares trade at 81 times the $1.06 per share analysts expect the company to earn this year, according to Thomson Financial. Compare that price-earnings ratio with the valuation of eBay, another pure play in online retail. EBay (EBAY; $33.56) trades at 25 times the $1.37 per share analysts expect the company to earn in 2007. Amazon looks a bit cheaper on '08 estimates, trading at "only" 57 times next year's forecasted profits of $1.50 per share.

Amazon will eventually have to prove to investors why its stock is worth such a high premium. For now, though, momentum is with the bulls.