For the last year and a half, every Amazon.com (AMZN) earnings report has been followed by a severe cut in guidance. And each time, the company has claimed that it was investing heavily in the future, and that was the reason why near-term earnings were impacted. There are, however, a great many reasons why one can and should doubt such a theory.
I’ll start with the obvious. The guidance given by the company is based on an internal budget, and although market-related variables are very difficult to predict (namely, it’s hard to gauge demand, distribution costs, etc., as these fluctuate), it is much easier to predict the costs you will have with any investment initiative – since it is you who decides when, how, and how much to invest. So, when the company misses its own guidance, that means it got blindsided by variables outside its control, not variables within its control (investment).
Also obvious, most investment in infrastructure (fulfillment centers, data centers) gets capitalized and expensed over time, so the near-term impact on earnings is much lower. This is the reason why hundreds of other profitable retailers do NOT get a huge earnings impact from their own decisions to expand.
Furthermore, a careful analysis of Amazons’s 10-Q also shows something curious – the investment being carried out is mostly in the USA, yet the severe margin compression is most evident in its International operations, where segment operating profit got cut nearly in half. Again, this argues against the theory that the margin compression is happening because of investment.
Also from the 10-Q, we learn that the mix of sales is leaning towards EGM (Electronics and General Merchandise) and towards third party sellers, and guess what? That same 10-Q states that such a change in mix is unfavorable for fulfillment costs. Again, this has nothing to do with investment.
But it doesn’t stop here.
There is reason to believe that Amazon has done some blunders in the past that are catching up to it right now. One of those blunders was the free 3G with the experimental browser. This is being used by customers to check e-mail, some browsing, etc. Now, there is no such thing as “free 3G,” Amazon is picking up the tab for that use. And even if the cost is low per customer, multiply it by tens of millions of kindles and 12 months, and you rapidly get a figure that is a percentage of Amazon’s earnings. Again, this is not investment, and indeed, speaks directly against the “lifetime value” Amazon just a few days ago dazzled the analysts with. Just think about it, if the first few tens of millions of Kindles brought no discernible value to Amazon’s bottom line, what makes one think that the next few tens of millions will do so? It is perhaps no surprise that the Kindle 4 no longer allows for free 3G browsing.
Another blunder was the free video for Prime customers. The problem here is not whether Amazon Prime will turn into a Netflix (NFLX) competitor or not. The problem here is that this free video was offered to existing members. Now, those members are speculated to be around 1/4th the subscribers Netflix has. And that video is not free to Amazon. What does this mean? It means that from one day to the other, Amazon committed itself to paying content costs for 1/4th the subscriber base of Netflix without receiving any additional revenue from it! Again, this was not an investment – at most it had a marginal effect on preventing Prime churn. (5 million Prime members in 2011 out of 121 million customers estimated by Piper Jaffray's Gene Munster.)
Having arrived here, it should be perfectly clear to anyone that the reason being advanced for Amazon.com’s margin compression is bogus. And it being bogus means it will persist. Which brings us to another conclusion – since margins will continue to compress during Amazon’s most important quarter, it will be very hard for these same margins not to turn negative as soon as a seasonally less favorable period comes. This means that Amazon will be showing losses as soon as Q1 2012.
And yet, even after having suffered cuts in estimates of around 70% for 2011 and 50% in 2012, and even after seeing earnings plunging by 50% in 2011 to levels last seen during 2004 (so no earnings growth for a full 7 years), this is a large capitalization stock that trades at a huge premium to the market. Indeed, it trades a full order of magnitude (10x) more expensive than the market, at a 169 PE for 2011 (given present EPS consensus estimates of $1.28).
Disclosure: I am short AMZN.