Amazon (AMZN) is an extremely controversial stock to investors. The earnings have been disappointing over the last several years, but analysts are universally bullish on the potential. Here, I would like to analyze several bullish arguments to see if they are valid.
1. Amazon's international sales will accelerate and its margin will improve.
China is the second largest e-commerce market outside the United States. After eight years and hundreds of millions of dollars spent, Amazon still accounts for less than 1% of the Chinese market. The retail business is fiercely competitive in China, and the margin is even lower than in the United States. The high-margin items, like e-books or songs, for Amazon in the United States are not selling well in China. Most people can get those items for free or at very low prices (the average price for an e-book is $0.20). Despite heavy investments in China, it is difficult for Amazon to become a significant player. Alibaba currently is the leader in China with 75% of the Chinese e-commerce market.
The European market is working better for Amazon than the Chinese market. However, the growth rate is slowing down. In Germany, the revenue growth rate for 2010/2011 was 37%, and in 2011/2012 it was 21%. In the UK, it was 31% in 2010/2011 and 19% in 2011/2012. In addition, the higher fuel costs in Europe make point-to-point delivery less competitive. Recently, there have been outcries from several countries, including the UK and France, complaining that Amazon is dodging taxes, which has led to investigations. Eventually, Amazon will have to pay more taxes and hope that consumer bases won't be impacted by the poor image this tax problem has created.
Amazon may do better in other international markets, but that's insignificant if it cannot perform well in the two largest markets outside the United States.
2. Amazon is going to improve margins dramatically after some heavy investments.
Giving Amazon credit, it has been investing heavily in certain areas and will improve its cost structure. But by how much? That is a big question. I will examine three areas that Amazon has been investing in extensively:
a) Kindle. Amazon has sold millions of Kindles at or below cost, and it has depressed the company's margin. Amazon is planning on selling millions of e-books after people have their Kindles. An e-book's profit margin is higher than that of a printed book. There is no doubt that e-books are selling well. But how long will it be before competitors undercut Amazon's prices? If Amazon can sell songs and books for i-Tunes, then why not the other way around? Apple (AAPL), Google (GOOG), or Wal-Mart (WMT) can easily sell e-books for Kindle, and they all have deeper pockets than Amazon.
b) Warehouses (fulfillment centers). Amazon has invested heavily in new warehouses to bring them closer to consumers and to accommodate third-party sales. The new warehouses will reduce shipping costs but will increase other costs, including labor and real estate. Ironically, if overall costs are reduced, then it implies that brick and mortar companies like Wal-Mart have a cost advantage over point-to-point delivery companies like Amazon. Providing a platform and warehousing to third-parties is crucial to Amazon, and it generates a higher margin. However, at a certain point, conflicts will occur. Do you want to limit hot sales items by third parties? How do you control the qualities and reputations of third parties? In addition, Facebook (FB) and Google can easily become the platform for third parties.
c) Cloud computing. Amazon is a leader in cloud computing and has invested billions of dollars into it. However, the competition from Microsoft (MSFT) and Google has made margin improvement impossible. Amazon has cut its prices on cloud storage and services several times in the last year. The cost for retaining the talent in this area is also extremely high.
Overall, the heavy investments by Amazon may improve its cost structure minimally, but competition will prevent it from meaningfully increasing its margin and will force it to continue to spend.
3. After Amazon crushes its competitors, it can raise prices and improve margins.
This is the weakest argument. Amazon may have crushed Best Buy (BBY), but not Wal-Mart or Target. New competitors, like Google and Facebook, are coming in with deep pockets. Even the dismal performance of Best Buy was partly due to Amazon's unfair tax advantage. After California and Texas adopted sales tax for Amazon, there is evidence that Best Buy is performing better in that area. Competition is becoming stronger, not weaker, for Amazon.
4. Cash flow is positive and improving.
This may be true on the operative level. If you count all the dilutions and share buybacks, however, the cash flow for investors is negative. Over the last two years, Amazon spent over a billion dollars to buy back its shares and, at the end of last year, the share account was higher than it was two years ago. The increased total assets did not translate into higher shareholder equities on a per-share basis. In other words, all the cash flow, plus some debt, went to employees' pockets, not shareholders. But the worst part is that Amazon cannot stop giving stock and options to its employees because of the competitive pressure to retain talent. Looking at a long-term discounted future cash-flow model, there is little evidence to support a long-term investment case for Amazon on a cash-flow basis.
Competition will prevent Amazon from increasing its margin meaningfully. Amazon has to continue investing heavily to compete. The advantage of sale taxes is disappearing state by state. The Chinese market has been tough and will likely remain so for Amazon. Most of the money Amazon has made went to insiders and employees, not shareholders. So when hurrahs for hope in Amazon's future are heard, we may just need to ponder once again, is the emperor really wearing anything?