Amazon's Financials Show That A Move Into Smartphones Is Unwise

Jul. 7.12 | About: Amazon.com, Inc. (AMZN)

The newest rumor in the world of technology is that Amazon (AMZN) is set to launch its own smartphone, to compete with Apple (AAPL). While Amazon has historically been a fierce competitor in all the markets it plays in, we think that this time, the company has stretched itself too far. The nature of the smartphone market is not one where Amazon's traditional strengths, namely price, will work as well as they have in the past. And the company's financials, in our view, serve as an even stronger indicator that such a move would be unwise (for purposes of disclosure, we hold no direct position in Amazon. We do, however, hold shares of the company via a mutual fund). Before delving into Amazon's financials, we feel it is prudent to first address why the smartphone market will be different for Amazon.

The Smartphone Market: Not Amazon's Friend

The smartphone market is far different than what Amazon is used to, and the company's main competitive edge, price, will not be of much help in this case.

The reason for this is that in the postpaid smartphone market, OEM's compete mainly on features, not price. To beat the iPhone, a company cannot simply price their handset below $199. It must offer users something more, something that they cannot get with the iPhone. Samsung, Apple's main competitor, understands this, which is why it seems to be the only company of being able to at least challenge Apple in the smartphone market. That is why the Galaxy S III is priced at the same level as the iPhone (at least the $199 model). Samsung knows that to win over customers, it must offer more than just a cheaper device. It must offer a better device and experience.

Amazon, despite its pretenses, is not a device company. It is a service company. What we mean by that is that Amazon sells its Kindle devices to draw in users to its ecosystem. It is widely believed that the Kindle line is a loss-leader for Amazon. And while that strategy may work in tablets, we doubt that it will work in smartphones. To be able to take on the iPhone, an Amazon smartphone would have to have features and specifications on par with it, while at the same time being priced aggressively to account for the fact that it is not an Apple or Samsung product (those are the only 2 companies that seem to be able to successfully price their products at a premium). Amazon has a history of selling its devices at a loss, and then generating its profits from selling content to those devices (apps, books, etc...). So couldn't the company just repeat the process and enjoy the same success it has with its Kindle line?

The smartphone market is different than the tablet or e-book market. Why? Carriers. With the Kindle line, Amazon is able to control the experience its customers have. But with a smartphone, Amazon would at least have to work with carriers. That will require not only time and effort, but money as well. To gain traction in the smartphone market, Amazon would likely have to boost its advertising greatly, in order to differentiate itself in the marketplace. Given the fact that an Amazon smartphone would be running on the Android platform, it will have to not only beat iPhone, but its Android peers as well.

But doesn't the success of the Kindle Fire show that Amazon can differentiate itself? The evidence doesn't support such an argument. According to IDC data, Amazon's share of the tablet market crashed to 4% in Q1 2012, down from 16.8% in Q4 2011. The Kindle Fire launched just in time for the holidays, which seem to have artificially boosted its sales. In our view, the most concerning feature of IDC's report wasn't the fact that Amazon's share slipped. It was the fact that Amazon is now in third place in the tablet market, behind Samsung. In order for Amazon to succeed in smartphones (and tablets), the company needs to become the leader within the Android ecosystem, something that is very difficult. In order to differentiate itself and stand out, Amazon will not only have to build a great device, it will also have to spend huge sums to market it (simply featuring it on Amazon's website will not be enough this time). And it will need carrier support in its promotional efforts. Carriers such as AT&T (T) and Verizon (VZ) want an alternative to Apple (and to some extent Samsung), for it would give them leverage in negotiations with Apple. That is one of the primary reasons carriers are so enthusiastic about Windows Phone. However, one of the central complaints carriers have with Nokia (NOK) and Microsoft (MSFT) is that the companies are not spending enough on marketing Lumia handsets. We feel that Amazon would face the same demands. And while Nokia and Microsoft can easily boost marketing spending (Microsoft would be doing the actual spending), we think Amazon would have a much tougher time. The reason lies in Amazon's financial profile.

Amazon's Financials: Spread Thin, Spreading Thinner

Jeff Bezos is a believer in investing for the long-term, and so far his vision has paid off. When Amazon was first starting, he kept the firm on track, not shying away from making necessary expenditures to grow the firm and strengthen the brand. And he has maintained that vision as Amazon became a larger and larger force in retail. In the last few years, however, Amazon has begun expanding into new markets, such as web services, payments, and devices (Kindle). And it has done so all while continuing to not only invest in its traditional retail business, but accelerate that investment.

Amazon is investing across all of its business lines, and that strain is showing up in the company's financial statements. In its last quarter, the company's operating income fell by 40.37% to $192 million. Its operating margin fell to 1.456% from 3.267% in the previous year. On its own, those figures do not paint the picture of a company that is financially strained. Rather, Amazon's guidance and balance sheet serve to do that. For the second quarter of 2012, Amazon has guided for operating income to range between a loss of $260 million and a profit of $40 million, which would represent a decline of at least 80% from the previous year's results.

What concerns us most, however, is Amazon's balance sheet. The company's aggressive investments in its business have resulted in large outlays of cash, and that is a trend that is likely to accelerate, not decline. Amazon ended its latest quarter with $5.715 billion in cash and investments, a drop of $1.166 billion from the prior year period. And with the company set to spend $775 million on Kiva Systems, that cash balance will be dented even more (Amazon's operating cash burn was well north of $2 billion in Q1, but that is due to seasonality). In the past 12 months, Amazon's cash outlays for fixed assets and business investments jumped almost 67% to $1.899 billion over the previous 12 months.

Given the fact that Amazon has committed itself to spending even more on its various business lines in the next year (and likely the years behind it), Amazon's cash balance will likely be put under increasing pressure. And there is Amazon's $2.58 billion of debt to take into account as well. While Jeff Bezos certainly has vision, it is important for him to remember that Amazon cannot afford to spread itself to thin. Google (GOOG) may have even more business lines than Amazon does, but Google has the luxury of billions in quarterly operating cash flow and growing profits. Google can invest in all the new businesses it wants. Amazon, however, does not truly have that luxury. In the past 12 months, Amazon had $3.051 billion in operating cash flow. But the company spent $2.514 billion on acquisitions and business investments. With the company's spending set to rise, we think that a move into the smartphone market will put increasing pressure on the company's balance sheet. Related rumors that Amazon is looking to acquire wireless patents bring the possibility of even further spending increases, as those patents are unlikely to come cheap.

Conclusions

Amazon has a history of entering new markets successfully. It has done so in books, retail, e-readers, and web services. But the smartphone market is different. Amazon's core competitive strengths are unlikely to be of much use to the company, and to truly be successful in this market, Amazon will have to spend large amounts of money. Given the company's present investment needs, we think that this will prove challenging for the company, and think that it would be much wiser for Amazon to spend its cash on strengthening its existing business units, not launching new ones.

Disclosure: I am long AMZN, AAPL, GOOG, MSFT.

Additional disclosure: We are long AMZN, GOOG, and MSFT via a mutual fund that assigns them weightings of 1.08%, 2.21%, and 0.95%, respectively.