Amazon (AMZN) has recently shown that in addition to a strong internet sales platform, it also has the know-how to produce consumer tech products (the quality of which are debatable). Mainly, its ability to create a seamless portal for buying and selling products online has made it a king in e-commerce. From 2006 to 2011, total annual revenue growth has never fallen below 28% and, as a result, its stock price has grown eightfold over the same time period.
Nevertheless, I'll explain why now is a good time to check into reality and consider AMZN as a good short hedge on a hot tech industry.
Amazon is Way Overvalued
Below is a graph of AMZN's stock price growth over the past five years.
This tremendous growth has been the result of multiple drivers, including: (1) outstanding annual revenue growth from Amazon's main online e-commerce platform, (2) the introduction of the Amazon Kindle in 2007, and (3) Amazon's entrance into the tablet market with the Kindle Fire in November 2011.
Let's start with (1). The issue with Amazon's revenue growth is that it has continually added little in terms of the bottom line (see first table). For whatever reason, Amazon doesn't see a need a make profits. If we look at a valuation table for Amazon, the trailing P/E of 285.49 implies some very absurd conclusions about Amazon's future earnings.
As Amazon's core market of e-commerce begins to saturate, it will begin to lose growth momentum and be priced according to a much less lofty multiple, such as what happened with Google (GOOG) and Microsoft (MSFT). If we assume that a nearing-saturation multiple of 20 is sufficient within the next 3-4 years, that implies a required net income of $5.4B, and, on a 2011 margin of 1.3% (margin ttm is even lower at 0.7%), that's a requirement of over $400B in annual sales.
Given that the entire World E-Commerce Market is projected to be over $1,000B by 2014, that means Amazon would need to supply the sales of almost half the world's online products and almost twice that of the United States. Currently, it only supplies around 5% of global e-commerce sales.
The implied growth here seems very farfetched in terms of the core market, which currently makes up around 93% of Amazon's revenue, excluding Amazon's e-reader and tablet product sales.
Amazon's Other Markets Will Not Add Value
Amazon showed it was more than just an e-commerce website and distribution center with the Kindle e-reader and its new tablet, the Kindle Fire; but if Amazon supporters are looking for historically similar growth through these new products, they should think again. In a mere few years, both of these markets have experienced heavy competition.
For e-readers, the Kindle has dropped from an 80% market share in 2008 to 60% in 2012. The resulting price drops over these years has destroyed margins ($400 price to $149-$199). The price drop of the Nook to $99 will be a key factor this Winter as the Barnes & Noble (BKS) and Amazon both fight for market share (right now BKS is in second place with around a 22% share). Additionally, the Kindle Fire will cannibalize some of these sales, not to mention the other competitor tablet sales.
Additionally, Amazon now joins the ranks of Google (Nexus), Motorola (Xoom), Samsung (Galaxy Tab), Apple (iPad), Sony (Tablet), and Research in Motion (Playbook), among others, in the tablet market. Unless a great deal of innovation is anticipated, the competitive advantage here is practically gone. Apple (AAPL) will continue to experience high margin sales with its $399-$499 price tag and 60% market share, but Amazon's 25% share will see much lower margins at less than half the price of Apple's tablets (Fire is now around $199-$230).
All in all, tablets and e-readers account for a mere 7% of Amazon's revenues, and though we can expect this figure to get somewhat larger as Amazon sells more of these products, margins will be low due to heavy market competition and little value will be added back into Amazon's business.
Another Red Flag
One more reason to fear for Amazon is a recent litigation involving potential antitrust violations. According to Bob Kohn, an attorney submitting an amicus brief for the DOJ investigation, Amazon is guilty of predatory pricing. Allegedly, Amazon lowered ebook prices to $9.99 with its publisher deals (against a cost to Amazon of $13/ebook) and was therefore losing money on the deal in order to gain market share. This practice is only illegal when the culprit is shown to reap profits as a result of the scam (in addition to Price<Marginal Cost). Many companies, however, are not able to achieve scale from the low prices and continuously lose money on a slow growing market share. Amazon, on the other hand, commands a 25% market share, and many of its deals with publishers have raised ebook prices from $9.99 to $12.99 and $14.99 in other cases. If it can be shown that Amazon's increased market share can be attributable to these lower ebook prices, then a settlement is on the horizon, albeit not for a potentially long, drawn-out period of time. This red flag is somewhat of a wildcard, but shows how tight the market has become.
A more prudent valuation of AMZN would take into consideration core market saturation and slower near term growth given the heavy amount of tech competition. That is, if we assume that Amazon reaches 10% of global e-commerce sales by 2014 (which is still an overly liberal hypothesis), that would imply roughly $100B in annual sales. At a 3% margin (the average of the past six year's profit margins), that gives $3B in net income, or an EPS of about $6.19. If we assume Amazon maintains some good growth well into 2014, that implies a multiple range of around 20-30x, and thus a per share price range of around $124-$185. It seems any way you slice it, this stock is destined to slide.
Disclosure: I am short AMZN.