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Introduction

Amazon's (NASDAQ:AMZN) unwarranted stock valuation creates an excellent shorting opportunity. Amazon is priced at a P/E ratio of 2964: a multiple that is 180 times higher than that of the current market multiple of 15. Because Amazon is priced at a significant premium, investors are betting on dramatic earnings growth. However, it is highly unlikely that Amazon will expand earnings enough to justify its price because there are monumental challenges surrounding all of Amazon's businesses. Amazon's e-commerce business faces tax enforcement from states and competition from new online marketplaces. The Kindle, Kindle Fire, Amazon Instant Video, and Amazon Web Services are in highly competitive markets and have razor thin margins. Finally, Amazon will not be able to reduce its expenses to achieve the increase in earnings that many analysts expect because its high spending is not temporary; Amazon's expenses are structural and critical to support its businesses. Since Amazon's earnings will not increase enough to justify its valuation, Amazon's stock price will decline significantly until it returns to the point at which it has a fairly priced multiple. For that reason, Amazon is an excellent long term shorting opportunity.

Amazon E-Commerce

The enforcement of Internet sales tax will be detrimental to Amazon's e-commerce business. On Amazon's website and at a local Best Buy in California, the Samsung 60" Class Plasma 1080P 3D HDTV is sold for $1919.99. Previously, Amazon was not responsible for collecting sales tax, so many consumers avoided paying the additional $134.39 of sales tax that they were forced to pay at Best Buy. This pricing advantage has popularized Amazon so elimination of it threatens a significant portion of Amazon's e-commerce business. In a study performed by Wells Fargo analyst Matt Nemer, it was determined that 33% of Amazon customers would shop less on Amazon with enforced sales tax. As these customers are cost conscious consumers, without Amazon's pricing advantage, they will flock to cheap mega-stores like Best Buy or Wal- Mart. According to the Wall Street Journal, this has already occurred in Texas where Best Buy has experienced a considerable increase in sales since Amazon began collecting sales tax. Since the majority of Amazon users will be subject to sales tax in the next year, it is likely that Amazon's e-commerce business will begin to contract.

In addition, new online marketplaces from eBay and Wal-Mart threaten Amazon's e-commerce business. Both eBay and Wal-Mart have created online applications that connect consumers to local stores with real time inventory data, which function as warehouses. eBay, which uses Best Buy and other partners' stores as warehouses, and Wal-Mart, which uses its 4,000 locations as warehouses, already have efficient delivery networks in place. These services have a larger warehouse network than Amazon, and as a result they will be able to offer cheaper and faster delivery than Amazon throughout the country. This newfound competition, coupled with the enforcement of sales tax, will likely reduce Amazon's sales volume.

Furthermore, due to increasing shipping costs, it is probable that a significant portion of Amazon's E-commerce business is unprofitable. Amazon Prime, Amazon's retail membership program, was designed to increase Amazon's volume of sales by enticing shoppers with free two day shipping on all purchases. Since Amazon initially priced Prime membership at $79 a year in 2005, UPS shipping costs have risen 46%, so shipping costs have likely risen beyond its stagnant E-commerce margins. Subsequently, because Amazon probably pays more to cover the two-day shipping than it receives from the profit on each order, it is very likely that Amazon loses money on each E-commerce sale to Prime members. Because Amazon Prime members use Amazon around 3 times more than regular customers, it is unlikely for E-commerce to boost Amazon's bottom line.

Kindle, Kindle Fire & Content

As the tablet market develops, Amazon's Kindle may find itself obsolete. Recently, tablets have begun to offer e-reading options analogous to the Kindle's, which have made the Kindle replaceable. In the same way that versatile smart phones replaced MP3 players, tablets that have greater functionality will replace e-reading devices like the Kindle.

In addition, the optimism surrounding the Kindle Fire is unwarranted. Unlike the iPad or Nexus 7, the Fire is merely a gateway to Amazon's entertainment; practically all of its features are designed to consume Amazon's content. The Fire possesses neither the application ecosystem, integration with other devices, or productivity features that all other tablets do. Since its features are essentially limited to Amazon content consumption, the Kindle Fire will only appeal to Amazon devotees looking to maximize their Prime membership, a small user base. Consequently, it is doubtful that the Fire will drive revenue for Amazon. Even if the Kindle Fire becomes a top selling tablet, it will not generate the profit investors expect because it is sold around breakeven in order to drive the sale of Amazon's content.

But unfortunately for Amazon, it is likely that Amazon Instant Video is no longer profitable because studios have substantially increased the price of licensing video content. According to Michael Pachter, an analyst from Webush Securities, the competition between Amazon, Hulu, and Netflix has driven up licensing costs ten times in the past two years. While Amazon's licensing expenses have dramatically increased, its selling point for content from Amazon Instant Video has remained the same, so numerous analysts have estimated that Amazon Instant Video does not contribute much to Amazon's bottom line. According Atul Bagga, a senior analyst from Lazard Capital Markets, "the cost of content is going to go up" even more, so it is highly doubtful that Amazon Instant Video will expand Amazon's bottom line.

Amazon Web Services

Furthermore, analysts are overestimating the potential profit contribution of Amazon Web Services, Amazon's cloud-computing venture. Amazon Web Services, or AWS, is a product that rents cloud infrastructure services to companies that have not built their own. AWS's story is reminiscent of Netscape. Netscape was the first sophisticated web browser so it dominated its sector. But because Netscape did not have proprietary architecture, it lost market share as superior competitors emerged. Just like Netscape, Amazon Web Services started off unopposed but recently companies such as Oracle, HP, IBM, Rackspace, CSC, Microsoft and Google have been investing billions of dollars in products to compete with Amazon. Since AWS does not have proprietary architecture, Amazon did not create binding contractual agreements with its customers and Openstack allows users to port their data on AWS onto other IaaS products, it could lose its customers to superior competitors.

The new IaaS ventures threaten Amazon because each emulates AWS current services and takes it a step further in some regard. Oracle's IaaS offering has increased security. HP's product provides additional business oriented capabilities. Amazon's greatest threat, Google's compute engine, offers better reliability and value than AWS. Google has extremely dependable infrastructure: for the past decade it has powered all of the Google services without many flaws. Google's consistency is especially threatening to Amazon because the AWS has been struggling with spotty service. In addition, Google claims it will offer 50% better value than other leading cloud providers, namely Amazon. Since companies use IaaS to reduce unnecessary expenses, Google Compute Engine's value will be very appealing to these low budget companies. Just as superior services displaced Netscape, it seems as if the newfound competition in the IaaS market will do the same to Amazon.

Even if AWS is able to oust its competitors, it may not be the profit generator investors expect. Morgan Stanley analysts Scott Devitt, Andrew Ruud and Nishant
Verma claim that AWS has a profit margin of about 10%, which will decrease as
Amazon faces more competition. Now that there is competition arising in the IaaS market, Amazon will cut its price even further, which will limit its earnings potential. Thus, should AWS survive, it will be another slim margin endeavor for Amazon and will not boost Amazon's bottom line at the levels investors expect.

Expenses

Finally, many analysts are ignoring Amazon's overvaluation because they are convinced that once Amazon stops building fulfillment centers, its expenses will disappear, which would increase earnings enough to support its current valuation. However, this is not true because the cost of building fulfillment centers is a mere fraction of Amazon's expenses, as seen in the charts below.

Table 1: The Expenses Related to Building Fulfillment Centers. (In Millions)

The costs of building fulfillment centers, along with Amazon's other long-term investments, are written as capital expenditures so these investments can be depreciated over time.

Q3 2012Q3 2011Q3 2010
Capital Expenditures$716$529$315

Table 2: Amazon's Other Significant Expenses.
(In Millions)

SG&A fulfillment expenses, as seen in the table below, do not include the cost of building fulfillment centers. Rather, fulfillment expenses are the costs of maintaining Amazon's E-commerce business. Total SG&A costs represent the added expenses from fulfillment, technology & content, marketing and other expenses that are not included in the chart.

Amazon SG&A ExpensesQ3 2012Q3 2011Q3 2010
Fufillment$1,450$1,090$657
Technology & Content$1,080$694$386
Marketing$524$360$234
Total SG&A$3,260$2,440$1,370

Chart 1: Amazon's increasing SG&A expenses.

As seen in this chart, SG&A expenses are increasing, so even if Amazon cuts all capital expenditures it will still be overvalued.

Even without the extensive building of fulfillment centers there are still capital expenditures, as seen in Q3 2010. So if Amazon stops investing in fulfillment centers, it will still be overvalued because of its immense SG&A spending. Since the SG&A expenses are critical to support Amazon Prime, Instant Video and Amazon Web Services, these costs will continue to impact Amazon as long as it engages in these ventures.

Conclusion

Because Amazon's ventures are revenue drivers, not profit drivers, it will be very hard for Amazon to increase its earnings enough to justify its price. E-commerce is a low margin industry and it is highly unlikely that Amazon profits from sales to Prime customers because it must cover the cost of free two-day shipping. The Kindle Fire is sold around breakeven and it is doubtful that Amazon's content selling business will increase Amazon's earnings because its costs have risen exponentially. With new competition, AWS's margins will continue to decrease and it will become another slim margined endeavor. Finally, contrary to analysts' beliefs, it is very unlikely for Amazon's earnings to expand from a decrease in expenses because Amazon's expenses are structural. Subsequently, it is very unlikely that Amazon will increase its earnings to justify its price, so Amazon's stock price will need to fall for it to return to a fair valuation. However, should Amazon somehow quadruple its earnings in the upcoming years, its stock would need to drop $221 a share to justify its valuation. Should it octuple its earnings, its stock would still need to go lose $216 a share to justify its valuation. Clearly, Amazon is an excellent long term short.

Source: Short Amazon: Its Businesses Face Monumental Challenges