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With decreased revenues and a P/E reaching levels bordering on the ridiculous, here is why the smart money is bearish on Amazon (AMZN).

Amazon, in the past, has consistently beat the brick-and-mortar retail business model, and as a result, it comes as no surprise that the Internet retail giant has ranked as the top E-Retailer in customer satisfaction for eight straight years as ranked by Foresee E-Retailer Consumer satisfaction index.

What is surprising is how Amazon's share price continues to reach new highs, even while the company's core business model is contracting along with its revenues.

Increased Competition Is Problematic

Amazon, as we mentioned, consistently beats the brick-and-mortar retail business model, leaving a wasteland of dead or dying businesses in its wake: Radio Shack (RSH), Circuit City, Blockbuster, Borders Books and Barnes & Noble (BKS) just to name a few. However, in killing off its smaller niche retail competition, Amazon is now facing what appears to be an insurmountable problem. Amazon is now faced with competing head to head with retail giants that dominate its market share: I am speaking of course about Wal-Mart (WMT), Target (TGT) and Costco (COST).

Case in point, Amazon was expected to earn over $62 billion in revenue for 2012 with $22 to $23 billion of that coming in on the fourth quarter. Wall Street was further predicting 27 cents a share earnings. Remember, that predicted 27 cents a share earning is down from 38 cents per share from the same time last year. In fact, Amazon's net income is down a staggering 45%! This equates to only 21 cents per share or $97 million net. When you consider that Amazon posted total net income of $177 million in 2011, the numbers speak volumes about Amazon's ability to generate revenue with its current business model.

Of course, those that are bullish on Amazon will spark the argument that Amazon still has plenty of room for growth. There are two key facts that the bulls are ignoring; the first is that Amazon's total annual revenue is only about 12% of Wal-Mart's staggering $500 billion in sales. The second is that their argument relies on the fallacy that the competitive edge Amazon has held on to for so long will continue indefinitely.

Amazon's revenues are decreasing, and its competitive edge is slowly, but surely, disappearing.

The Changing Business Landscape

One of the greatest competitive advantages that Amazon has enjoyed for years was the ability to sell its products without having to charge a state sales tax to its customers. This advantage is disappearing at an alarming rate, as California, Pennsylvania and Texas have already passed legislation requiring Amazon to begin collecting sales tax. With the state of our Country's economy and individual States facing severe budget shortfalls, look for more and more States to come after the "cash cow" Amazon can provide. Further eroding Amazon's profits are the added costs incurred by Amazon for implementing and administering the collection and distribution of these sales taxes.

Bulls will also argue that, as an online retailer, Amazon does not have to contend with all of the added expenses that the traditional brick-and-mortar business does. What they fail to realize is that Amazon does in fact have to contend with brick-and-mortar expenses because it is dealing with the large costs of staffing and maintaining massive warehouses loaded with its inventory. Amazon incorporates this into its business model with the specific intent of packaging and shipping its products to its customers in as short a period as possible. This is one of the reasons for its excellent customer satisfaction. But, this landscape is changing as well.

First of all, Amazon offers free shipping on many of its products, but it still costs Amazon money to ship these products. Postage rates are continuing to rise and as energy costs are likely to continue to rise in the foreseeable future, you can bet that FedEx (FDX), UPS (UPS) and the bankrupt United States Postal Service will continue to push their costs onto Amazon, further eating into Amazon's already razor thin margins.

When Amazon first began, it had the distinct advantage of being one of the only large retailers selling online. It gave the company a distinctive marketing edge, but that is now changing at a rapid pace. The fact is that the brick-and-mortar giants that Amazon has not been able to kill off are advancing rapidly in the online retail business. With its razor thin profit margins, I do not believe that Amazon will be able to lower its prices enough to continue to draw in its record number of customers.

Secondly, there is much that can be said about human nature and in this instance, we need to address the issue of instant gratification. Even if Amazon's major competitors never get into a pricing war with Amazon, they still have a "nuclear option." They can simply match or beat Amazon's online prices when the customer comes into the store. Match that with the inherent need for instant gratification and you can see why I call it the "nuclear option." When customers can simply get a price match guarantee and they don't have to wait on shipping times, what is the incentive for shopping at Amazon?

Think it can't happen? Sorry to report that Target is already offering its customers a price match guarantee. Not only did they target Amazon, but they have targeted all of its rivals by guaranteeing to match any online price regardless of who is selling it.

Business Expansion Challenges

Amazon decided to wade into uncharted territory with the Kindle. Now, I will be the first to concede that the Kindle is a super product and has in fact chipped away at Apple's (AAPL) market share. The only problem is that it comes at a severe cost to Amazon.

Having no idea what the reception would be for its Kindle product, Amazon had to take drastic steps entering into this market that is loaded with fierce competition. In order to be competitive and have a chance at market penetration, Amazon gives away its product. In other words, Amazon is making no money on its Kindle sales. In fact, according to a recent article in Forbes, Amazon has confirmed that it makes no profit on Kindle sales, hoping instead that its product will drive people to its online store where they hope to make a profit by selling its online content. Further compounding the problem is that Apple still controls an estimated market share that is 10 times that of Amazon's. Apple, in my opinion, fired back at Amazon's introduction of the Kindle with its iPad mini; if you need confirmation, just compare the price points for the iPad, the Kindle and the iPad mini and then ask yourself why. I am sure you will come to the same conclusion that I did.

Amazon, like many other businesses, is looking to expand into China in order to fuel more growth. But that's the problem, Amazon is venturing into uncharted territory with heavy competition at every turn. Granted, taken as a whole, the Asian market is huge. In fact, the tablet PC market alone grew by over 60% in just the third quarter over the previous year. Apple's iPad dominates that market however, holding on to an incredible 70% market share. But here is where Amazon's business model breaks down; Amazon does not have a dominant online presence in Asia as it does in North America. Remember, they are practically giving away the Kindle, making no profit, with the hope that it drives people to its website where they will make purchases. While this might work in North America, it is just not happening in Asia. Amazon just does not have that dominant online presence.

Now there is even more bad news for Amazon. While most people in North America have never heard of this company, they are huge in Asia. In fact, according to a recent report by the Euromonitor International, this company, based in Asia, will overtake Amazon to become the largest online retailer by 2016; the company I am referring to is Tmall.com.

Having already killed off the smaller competition Amazon is now dealing with some very large and dominant competitors in every area of its business model. While Amazon is making some headway into new territory, its competition is as well. All of Amazon's current strategic moves are facing severe competition, increasing costs and a changing landscape.

Then there is the issue of Amazon's profit margins. As I discussed before, they are razor thin. Consider the following:

  • Amazon's net profit margin: 0%-3%, currently it's 0.7%.
  • Wal-Mart: approximately 4.20%
  • Target: approximately 3.5%

The bottom line: 90% of Amazon's profitability comes directly from its online retail sales. As Amazon's competition increases and its cost increases, look for Amazon's profits to decrease. Which brings us to a glaring question; how in the world does Amazon have a P/E of 3,286?

A P/E OF 3,286

Who in the world invests into a stock that has a price to earnings ratio of 3,286? Well, apparently, everybody, based on what the market is doing.

Amazon is trading just over $262 as I write this, which is an increase of over 46% from this same time last year. But why? Amazon is posting terrible numbers. Earnings per share have been consistently declining; FY 2010: $2.53, FY 2011: $1.37, FY 2012: $-0.3. That is not a typing error, their earnings per share in 2012 were a negative. Here is an Excel spreadsheet I put together. I ask you; am I the only one that sees a problem?

There is no way that the numbers above justify buying into Amazon; Amazon just posted another year-over-year decline in quarterly earnings and unfortunately, this is now becoming the rule rather than the exception. This is slowly but surely, in my opinion, working its way to becoming a "bubble." Amazon operates on razor thin margins that are going to continue to be eroded as Amazon spends billions expanding into new areas, upgrading its infrastructure, rising costs and increased competition.

Furthermore, with an average daily trading volume (10 day trailing) of over 100,000,000 shares, there is a lot of potential for volatility. In my opinion, many shaky investors will sell their shares at the first hint of trouble. Case in point, remember the Dot Com era fiasco; looking at my spreadsheet, I am reminded of that: Skyrocketing P/E, ultra high stock price, large volume trading, and no solid numbers to support it. Just take a look at the yearly chart below and you can see incredible trading volumes and a stock price that has been skyrocketing since 2009.

Currently, Amazon seems to be trading more on "hype" than on fundamentals and as a result, I won't risk it.

Bottom line: look to exit at a good price point, or short the stock on the next earnings report, or better yet, avoid it altogether.

Source: Amazon: When Will This Bubble Burst?