Amazon Ready To Plunge On Margin Squeeze

| About:, Inc. (AMZN)

Amazon (NASDAQ:AMZN) is expected to release the Kindle Fire 2 this month. According to sources, the next generation Kindle Fire is scheduled to launch on July 31. The device will feature a camera and volume-control buttons as there were complaints that its predecessor, the original Kindle Fire has only on-screen volume controls. Furthermore, it has Bluetooth connectivity, increased storage capacity and expansion capabilities. Amazon will also introduce a new Kindle e-reader with an integrated light. It will maintain the $200 pricing as the original Kindle Fire, although there are reports that the original Fire would be offered at $150. The lower pricing is in line with its strategy to outperform its competitors in the tablet market space.

Incidentally, Google (NASDAQ:GOOG) is also scheduled to launch its Google Nexus 7 a couple of weeks before the Kindle Fire 2. The Nexus 7-inch tablet will also have a $200 price tag and will run on quad-core Nvidia Tegra 3 processor. It will also have a 1 gigabyte of RAM. These are high-end specs are steal given its expected selling price.

Industry pundits are somewhat bullish on the Nexus 7. They believe that it would be an instant success once it hit the stores. If this is the case, then it would be difficult for Amazon to make a big splash on the Kindle Fire 2 debut. The competitive landscape of the tablet market is intense as pricing war looms. I bet that Apple's (NASDAQ:AAPL) iPad will also cut its prices in the long run once it sees that consumers are starting to look for non-Apple tablet alternatives.

Based on the recent ComScore data, the original Kindle Fire has doubled its share in the Android-based tablet market. It cornered more than 50% of the Android market, beating Samsung Galaxy Tab (market share of 15.4%), Motorola Xoom (market share of 7%), Dell (NASDAQ:DELL) Streak and HP (NYSE:HPQ) Lenovo Ideapad. The main driver for its market shares gains is price. It can sell at lower prices relative to competitors as it lures customers to purchase content from the company. This essentially builds its own ecosystem, similar to Apple's iCloud and iTunes. In contrast, Samsung and Motorola have instead relied on Google's platform. This means that Google has bargaining power over these tablet manufacturers.

Good for Sales Growth, Bad for Margins

The market share gain of Kindle Fire is a good reason for Amazon to celebrate. In a span of months, it has basically outsold other Android-based phones. This has translated to better than expected topline growth. It reported sales of $13.18 billion for the first quarter of this year, beating analyst estimates of $11.9 billion to $13.3 billion. However, net income for the quarter dropped by 35% to $0.28 earnings per share. This is lower compared with earnings per share of $0.44 last year. It seems that the bottom line has been affected. I believe that Amazon is sacrificing near-term net profit gains to create an Amazon ecosystem for its clients. Amazon's operating margins have been steady at 4% from 2008 to 2010. Last year, operating margins have fallen to more than 1%. Amazon is finding it harder to find newer revenue sources that have better margins. In addition to that, its international expansions have operating margins below 1%. Going forward, the lower-priced tablets will definitely have an impact on margins. I expect operating margins to be in the region of 1% as it rolls out its strategy to develop low-priced tablets to beef up its content ecosystem. If we compare this to other companies that invest money for its content, this is definitely lower. Yahoo! (NASDAQ:YHOO) has operating margins of 16%. AOL (NYSE:AOL) has similar operating margins at 2% although the latter is still in the investment phase as it has been aggressively buying content-based websites.

Heads up Match: Kindle versus Nexus

I believe that the main advantage of Kindle over Nexus is cheaper content. Google Play Store is relatively expensive over Amazon's libraries. In the long run, this will lure clients to the Amazon's platform. Unless Google plans to drastically change its pricing, Kindle will have edge over Nexus. It could also lower the price of its tablet to effectively compete with the $199 Nexus tablet. Premium pricing for the Kindle will be disastrous as Nexus has high-end specs at cheap pricing. Meanwhile, Nexus 7 will run on a new updated operating system called Android OS 4.1 or also known as the Android Jelly Bean. This will also increases switching costs for the current Android tablet users.

Overall, Nexus has advantage in terms of specs and pricing. However, the best chance for Kindle is that Amazon could offer lower priced content libraries to attract current and prospective customers.


Analysts expect the company to earn $2.57 per share next year. This is more than double than the estimated earnings of $1.23 per share this year. This translates to a price earnings ratio of 88 times. In terms of price-over-growth ratio, the stock trades more than 5 times.

This is definitely higher than its peers. Google trades at 11 times earnings and Yahoo! is valued at 17 times earnings. The companies' price over growth ratios are 0.75 times and 1.25 times, respectively. It seems that the market has focused on Amazon's revenue growth and future profitability. Over the next 5 years, it is expected to grow its earnings by 32%. This is better than the industry's growth of 13%.

Moving forward, I expect a multiple contraction as investors will be disappointed with the company's results. The recent first quarter result is a prelude to how the market will react to successive quarters. If you will notice its past financials, costs have increased dramatically. Operating expenses have doubled more than 3 times from 2007 to 2011. The trailing expenses are already at more than $10 billion, higher than the $9.9 billion posted last year. In my view, Amazon's lofty valuation clearly does not reflect a margin squeeze in the future. This is a perfect recipe for investor disappointment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.