Seeking Alpha
Long/short equity, long only, short only, growth
Profile| Send Message|
( followers)  

Two weeks ago, I published an article covering Amazon's (AMZN) fiscal Q1 earnings. The article, called "Skeptical of Amazon At These Levels", brought into question some of Amazon's struggles, and why I felt the valuation was just too high. Since then, I have had some time to review some company data again, and the new numbers only support my original conclusion. Amazon has a few problems currently, and shares do not reflect them.

To briefly summarize the quarter for those who missed it, Amazon beat on both the top and bottom line, when compared to analyst expectations. Gross margins were up, but sharp rises in operating expenses led to lower operating and net profit margins. Also, most of Amazon's actual net income was due to gains in their equity investments. Q1 net profit margins were at 4.2% in the 2010 period, and this year, they were under 1%, including the investment gain.

So let's look forward to Q2. Amazon guided to a revenue range of $11.9 and $13.3 billion, compared to $9.91 billion in the prior year period. Analysts currently are projection $12.93 billion, so they are towards the higher end of Amazon's range. However, Amazon guided their operating income from a loss of $260 million to a profit of $40 million. Last year produced an operating profit of $201 million. Last year's earnings per share came in at $0.41, and analysts are currently projecting just a two cent profit. A loss may be possible.

So here is the concerning part. We already know that some of Amazon's margins have been coming down in recent years. However, as you can see from the following table, Q2 gross margins are generally higher than Q1 margins.

Q1 Margins2009201020112012
Gross23.48%22.86%22.82%23.95%
Operating4.99%5.53%3.27%1.46%
Profit3.62%4.19%2.04%0.99%
     
Q2 Margins2009201020112012
Gross24.36%24.51%24.09%????
Operating3.42%4.11%2.03%????
Profit3.05%3.15%1.93%????

So let's review Amazon's guidance. A revenue midpoint of $12.7 billion, and operating income midpoint of a $150 million loss. Now in the past two quarters, Amazon has been at the high end or even above their operating income guidance, so let's give them a little benefit of the doubt. For argument's sake, I'll say Amazon will have $13 billion in revenues and an operating profit of $100 million. That works out to operating margins of just 0.77%, well below the 2.03% in the prior year period. And again, I'm giving a high number, it could be even lower. If Amazon produces operating margins of say 0.5%, or maybe even a loss, it seems very logical that a loss is possible. Unless, of course, they have more investment gains that distort reality.

Now, the second issue I'm worried about is their balance sheet. It is getting worse, as you can see from the following table.

Financials3/31/093/31/103/31/113/31/12
Current Ratio1.401.531.461.16
Debt Ratio58.19%53.35%56.48%64.25%
Working Capital$1,365$2,771$3,558$1,666

After improvement from 2009 to 2010, the current ratio and debt (liabilities to assets) ratio have worsened over the past two years, and dramatically in the past year. Working capital also took a plunge from the end of Q1 in 2011 to the end of Q1 this year.

Also, Amazon has built up a large amount of inventory. Inventory levels at the end of Q1 increased from $2.89 billion last year to $4.26 billion this year. That might explain part of the drop in cash and marketable securities, which fell from $6.88 billion to $5.72 billion over that time. But what worries me more is the trend. Here are a few other facts I find concerning:

  • Over the past two years, inventories as a percent of current assets have risen from 22.85% to 35.01%. Over that same time, accounts receivable have risen from 10.23% to 14.92%. Combined, they have gone from 1/3 to a 1/2 of current assets.
  • Over that same time period, cash and marketable securities (as a percentage of current assets) have declined from 63.57% to 47.02%.
  • Over the past two years, Amazon's Q1 revenues have increased by 85%. However, end of quarter inventories have increased by 134% and accounts receivables have increased by 122%.

So why am I so concerned? Well, think about it this way. Cash is cash. Generally speaking, $1 billion of cash should be worth $1 billion going forward (ignoring inflation because it is irrelevant for this argument). Marketable securities should be very safe assets that shouldn't really gain or lose too much value. But what about inventories? Amazon's more than $4.25 billion of inventories, if too large, might cause Amazon to drop prices. $4.25 billion at the end of Q1 might only get sold for $4 billion. That will impact margins. Also, accounts receivable rising faster than revenues usually isn't a good sign, especially when they are rising 1.5 times as fast as revenues. That means Amazon is relying on customers paying down the road, and in this uncertain environment, will those customers pay? Amazon had more than $1.8 billion of accounts receivable at the end of Q1. If they can't collect it all, they will have less cash than expected going forward.

I also have been concerned with Amazon's Kindle Fire. When the product initially came out, there were more than a few people saying that the Kindle Fire could be a legitimate competitor to Apple's (AAPL) iPad. In fact, research firm IDC has reported that Kindle Fire's market share dropped 75% in the first quarter. Yes, it is about 4% of the tablet market now. Apple is roughly two-thirds of the entire market. I can remember in the fourth quarter when I was seeing 2 to 3 commercials per day for Amazon and the Kindle. Before Tuesday, when I actually saw one, I can't remember the last time I saw a commercial for it. If Amazon wants to take some market share, they might want to release a new version soon. Apple released a new iPad, sold 11.8 million iPads in the calendar Q1, and I am expecting Apple to sell about 15 million this quarter.

Also, I need to remind you of the following piece from my most recent article comparing Apple and Amazon.

Another hit came this week as well when Target (TGT) announced it would no longer sell the Kindle. Target, like many other retailers, is looking to prevent the "showroom" effect. That occurs when customers go into the store, look at an item, like the Kindle, and then buy it elsewhere, perhaps online directly from Amazon. The above mentioned report even suggests that Best Buy (BBY) could even dump the Kindle. Don't forget, we found out last year that Apple would launch some mini stores inside select Target locations. Target is making the smart move, going with the company that is doing well.

Target is eliminating Kindle sales, and will soon have the Apple mini-stores, allowing even more iPad sales to take place. We've even seen rumors of Apple considering mini-stores inside Wal-Mart (WMT). Just think about Amazon and Apple this way. In calendar Q1 (Apple's fiscal Q2), Amazon produced net income of $130 million, including the $89 million investment gain. That was in the entire quarter. Apple produced net income of nearly $128 million per day!

Another thing to mention again, involving the deal between Microsoft (MSFT) and Barnes and Noble (BKS). Microsoft invested $300 million in a new partnership that will expand Barnes and Noble's e-reading efforts. Microsoft will own approximately 17.6% of the new company. Do you think this will have any impact on Amazon? I sure do. Why else would Microsoft make this kind of a move? Just remember this. How many people said that Microsoft was crazy when it invested $250 million in Facebook (FB) at a "crazy valuation of $15 billion". Facebook's IPO will price this week at about a $100 billion valuation, and probably will trade much higher than that once trading starts. How many people are laughing at Microsoft now? Now, I don't think that this Microsoft/Barnes and Noble partnership is going to increase in value as much as Facebook did. But if the partnership just doubles in value over the next couple of years, it should be enough of an effort to create some issues for Amazon. Even Apple is trying to take on Amazon in this space. It sure will be fun to watch going forward.

I said in my last article that I thought Amazon shouldn't trade for more than about $228.50 or so this year. For most of Tuesday's trading, we were above that level. There are just too many issues with this company, and at some point, the lack of earnings will catch up with them. Amazon continues to be a very good short candidate, especially when it is above $230 and challenging its 52-week highs.

Source: Amazon: More Problems Than We Thought?