After Amazon's (AMZN) earnings announcement, its shares dropped over 12 percent; the company had badly missed estimates. Before the announcement, I expected Amazon to miss earnings, but since shareholders have been OK with the company sacrificing margins for revenues, I was not sure if the stock would drop. In addition, I felt the jury was still out on whether the company would meet its expected growth. After this earnings announcement, a second look at Amazon's Kindle strategy, and a comparison to its competitors, I believe that this is just the beginning of a long-term drop in Amazon's stock price.
Apple (AAPL) has such a high market cap because of its high profit margins on hardware driving earnings. With Amazon selling the Kindle Fire at a loss and attempting to recoup its loss by selling digital media, the company is making a big mistake. Music stores have struggled to be profitable. In addition, the majority of the first Kindle Fires will be given as gifts during this holiday season. Someone getting a Kindle as a gift is far less likely to spend significant money on downloads.
This strategy mirrors that of video game systems, where the console is sold at a loss, but the games are sold at high margins. However, console video games can only be played on the consoles and have no substitutes, while there are dozens of substitutes when it comes to digital media. I believe the product itself will meet its lofty expectations, but I do not believe that it is a very profitable venture.
Barnes & Noble has failed to be profitable for four of the last five quarters and the future of the company looks dim at best. The book retailer has experienced a 36.6 percent increase in revenue from FY 2009 to FY 2011, where its revenue was almost exactly $7 billion. Despite increasing its sales, lower margins have caused Barnes & Noble to move into the red. Amazon's revenue growth has been about twice as high, with net profit margins of around 3.5 percent that it achieved in the past have dropped to about 2 percent in recent quarters.
The company's gross margins have remained the same, due to an increase in operating costs. Amazon's warning that it can potentially report a loss in the fourth quarter can mean a potential to struggle with profitability in future quarters as well. If this is the case, its $50 billion to $70 billion in expected annual revenues will not justify a market cap of over $90 billion. Overstock.com has annual revenues of over $1 billion, yet its market cap hovers around $250 million.
Right now, Amazon's stock price has a lot of room to drop and little room to gain. Value in any company is ultimately derived from its earnings. Regardless of revenue, cash flow, or investments, the bottom line is that if a company cannot consistently achieve high earnings, it will lose substantial value. Despite Amazon having a business model that is considered to be revolutionary, online retailing has become more of a way to stay in the game rather than a way to get ahead as it was in the past.
Selling Kindles at a loss is still a bad strategy, in my opinion, and Netfix's recent performance and antics have shown that Amazon will lose substantial value and market share if it tries to change its sales strategy now. Despite its significant drop in price, I believe shorting Amazon is still a good position to take. From looking at its competitors, I could see share prices potentially dropping as low as $140 per share by the end of 2011.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.