Quotes of the Day

Amazon executives have to be smiling.

The online retailing giant, unscathed by the recession, is on a tear, posting robust earnings growth while many other retailers are licking their wounds. Analysts believe the company's profitable run isn't over yet, and say that concerns over competition in its trendy e-reader business are overblown.

It's been an "Internet gold rush," in which online retailers that offered merchandise cheaper, faster and more efficiently were the big winners, and Amazon led the way, says Marc Ostrofsky, an Internet consultant and author of "Get Rich Click."

As brick-and-mortar retailers slashed inventories to offset the pullback in demand, shoppers stampeded online to see the full selection at competitive prices, says Keith Jelinek, a director at AlixPartners. "It was definitely a competitive advantage for Amazon," he says. The Seattle-based retailer posted a 40% earnings increase in full-year 2009, with the biggest gain coming in the fourth quarter, where net income shot up 71% — far above Wall Street's expectations.

Amazon didn't just have a broad product selection during the holiday season, it had a firm grasp of the consumers' many needs. Cash-strapped shoppers flocked to the site for its low prices, ready-to-ship inventory, shrewd consumer product reviews, low shipping fees and the holiday season's trendiest gadget, the Kindle. It refused to back down from pricing wars with Walmart and Target over books, and made a big push into electronics to tap the void left by the demise of Circuit City and Tweeter over the past year.

Amazon's sales grew 42% in the fourth quarter, outpacing e-commerce in general, which rose 5% to 10%, according to Colin Sebastian, senior research analyst at Lazard Capital Markets. "Amazon has emerged as the Walmart of the online retail world," says Sebastian.

But it's Amazon's foray into the digital-book business with its groundbreaking Kindle reader that's been making the biggest headlines lately, as sales far exceeded analysts' expectations. Its decision to allow customers to download best-selling books from its e-bookstore to the Kindle for only $9.99 a pop played a big role in stimulating demand. "When we have both [hardcover and e-book] editions, we sell six Kindle books for every 10 physical books," said Jeff Bezos, founder and chief executive of Amazon, in a statement.

However, Kindle's lead and popularity are far from entrenched as the book industry braces for a digital revolution similar to what happened to the music industry more than a decade ago. So far, Amazon's Kindle has had a first-out-of-the-gate advantage over rival e-readers from Sony and Barnes & Noble. But industry experts believe the recent launch of Apple's highly anticipated iPad tablet, a device that offers Web-browsing, e-mail and other laptop functions in addition to an e-reader, could be the Kindle's biggest threat yet. Apple has already signed up five publishers to sell e-books for its iPad. "There's clearly competitive risk," says Mark Mahaney, a managing director at Citigroup.

Ostrofsky believes Amazon will have to revamp and upgrade the Kindle to stay competitive. "My guess is that Jeff [Bezos] is going to have to come out with a color version darn fast — probably faster than he wanted to — because the iPad is going to take market share away," he says. On Feb. 4 the New York Times reported that Amazon had purchased Touchco, a start-up company specializing in touchscreen technology.

For now though, analysts aren't expecting a mad rush to the iPad since the Kindle's $259 price tag is far cheaper than those of the iPad, which will range in price from $499 for the cheapest version to $899 for a model with 3G capability for Internet access anywhere.

Some analysts speculate Amazon will ultimately have to purchase a major player in the digital universe, like Netflix, to prevent falling behind in the movie and book digital transformation as it did when Apple snatched control of the digital-music industry.

Adding to the iPad threat is a dispute over e-book pricing. Apple signed deals that allow publishers to set the prices in Apple's iBooks store, and new e-book best sellers are expected to be priced at $12.99 to $14.99 — which is considerably higher than Amazon's $9.99 price. Publisher Macmillan is already pressuring Amazon to offer similar pricing. It demanded the right to set prices on Amazon, causing an angry Amazon to pull all of Macmillan's books from its site. However, two days later, amid a firestorm of debate, Amazon indicated that it would agree to Macmillan's demand.

Analysts worry that higher e-book pricing could eat into demand for Amazon's Kindle. "They're trying to build the iTunes for books with their Kindle, so they're particularly sensitive about market share for books," says Sebastian.

That said, the higher e-book price could actually benefit Amazon's bottom line. "At $9.99, Amazon wasn't making any money," says Hamed Khorsand, an analyst at BWS Financial. "So for Amazon to be forced to sell a product at $12.99, they're basically being allowed to make a profit." If prices continue to escalate higher though, it could be a problem, analysts say.

Amazon's stock took a hit in the wake of the iPad launch and book-pricing dispute, falling 9%, although it has since partially recovered. Some analysts believe the sell-off was overblown. "I think the Street is making a bigger noise out of it than it really is," says Khorsand.

Even if the Kindle does lose market share, it only accounted for about 2% to 3% of Amazon's total revenue in 2009, and is only projected to represent 6% in 2010, says Douglas Anmuth, a director at Barclays Capital.

Instead, many analysts see Amazon's biggest growth coming from its international operations, expansion into new merchandise and the addition of more third-party sellers. Its November acquisition of online shoe giant Zappos, for example, contributed $200 million of revenue to the company's fourth quarter. The number of active third-party sellers rose 27% to 1.9 million, and revenue from international sales climbed 49% to $4.56 billion in the latest quarter.

Some see Amazon's biggest growth coming from further expansion into electronics, apparel and consumer products, ranging from shampoo to groceries. Amazon's ability to cross-sell products to existing customers is powerful. "When you've got an account opened at Amazon and they have your credit-card information and they also happen to have some of the lowest prices, it's very easy to start buying on Amazon items that may be outside people's traditional products that they buy online," says Sebastian. "I've been buying diapers from Amazon — not just the books that I would have bought 10 years ago."

Still, Amazon isn't without risk.

Up until now, online retailers have been reaping the benefits of not having to charge customers state taxes in all but about four states. However, a movement is afoot to change that through a streamlined sales tax. "If successful, you'd lose the pricing advantage they have vis-à-vis the bricks-and-mortar stores," says Sebastian.

Then there's the free shipping that's often offered, which experts believe cannot be offered forever. "If energy costs go up and transportation costs continue to rise, that's got to get paid for," says Bill Martin, co-founder of ShopperTrak, a research firm that tracks shoppers.

Amazon's shares recently traded at $115.85 a share. Anmuth has a 12-month price target of $165 on the stock while Khorsand is even more bullish with a $200 target. "I think there's considerable upside from here," says Khorsand. "They have a level where operating margins are tracking above 5% in 2010 and that provides them with a level of cash flow and earnings that would support a $200 stock price."

• Janet Morrissey
• Blockbuster earnings and a nimble response to market trends keep online retailer Amazon in favor on Wall Street, even as competitive threats grow