Amazon (AMZN) is only 7% off its all-time high, but a closer examination suggests the company is facing far greater risks than the market is factoring in.
In 2011 Amazon's EBIT margin was 1.8% (inclusive of relatively higher margin Cloud business). EBIT margin estimates for 2012 are currently around 0.25% whilst Q2's estimated operating margin is 0.0%. To highlight the margin freefall, the EBIT margin only two years ago was 4%, 16 times higher than the current figure. The company is trading at a P/E ratio of 190 actual earnings and 95 times future earnings (9th highest P/E in the S&P 500). Both forward P/E and P/TBVPS are trading at their highest percentile historically.
Amazon's Q4 results missed analyst estimates, reported a 57% decline in profit (due to increased shipping costs - read oil, and the money-losing Kindle Fire) whilst lowering guidance on all major metrics. Q1 results at the end of April beat guidance with a rise in gross margins and a very strong media showing (benefited by closures of international competitors). The disastrous performance of entertainment software stocks over the last few months suggests this was nothing more than a seasonal blip. Amazon's share price has appreciated 32% since its Q4 results.
The introduction of Amazon Prime (offering unlimited two-day shipping for a year) shows the company is prepared to sacrifice margins for growth but with shipping costs on the rise such a short-term income generative scheme looks a high risk strategy likely to negatively impact numbers as the year progresses (most subscribers signed up last holiday season).
The Kindle Fire, retailing at $199, looked like a good value against Apple's (AAPL) twice-as-costly iPad, but looks poor in value against Google's (GOOG) recently announced and more flexible Nexus 7 tablet, priced at $199 and ready to be shipped in weeks. Google's new tablet seems to have been targeted directly at Kindle Fire customers which, if successful, could lead not only to a fall in tablet sales but also negatively impact Amazon's eBook revenues.
At the end of April, Amazon agreed for the first time ever to collect customers' sales tax in states where it hasn't built distribution centers. The lack of requirement to collect sales tax from its customers has always placed Amazon at a competitive price advantage versus its brick-and-mortar competitors, such as Barnes & Noble (BKS). From July 1, Amazon will have to collect sales tax in 12 states making up approximately 40% of the US population. This could have a tremendous impact on their value offering. In California, for example, where sales tax is one of the highest in the country, Amazon customers are now facing 9% higher prices.
Amazon also potentially faces legal challenges from individual states attempting to reclaim uncollected sales tax. Texas has already claimed the company owes it $269M, and although it unclear how many states will pursue this course of action, it represents a potentially significant downside risk going forward.
Faced with declining margins, reduced market share, migration from physical to digital media, increased shipping costs, falling tablet sales and loss of price advantage, Amazon has been prudent to position itself as the major player in cloud computing and holds the majority of federal contracts.
Both Microsoft (MSFT) and Google have lagged in this space, though both have recently announced that Cloud is central to their future strategies. Google upped the stakes last week with its release of 'Google Compute Engine', opening up the company's servers to almost any application for the first time to go head to head with Amazon's 'Elastic Compute Cloud'. Google says the service will undercut its rivals by offering 50% more computer power for each dollar spent, thanks to its vast data centers.
Amazon's Cloud margin forecasts may have to be lowered to reflect increased competition in this sector, whilst market share will become harder to maintain and grow. Recent cloud outages and Groupon's (GRPN) launch of a 'Groupon Goods' retail website further highlight the pressure Amazon faces in every area of its business.
The market appears to be over-valuing the company significantly, and I expect to see widespread downgrades this quarter.