After Amazon.com (AMZN) unveiled its new lineup of Kindle Fire tablets, priced at cost, the market once again turned to believe in the Jeff Bezos theory that Amazon.com will make its money when its customers use the tablets, not when they buy them. This is in stark contrast to Apple (AAPL), which makes most of its money from margins on hardware.
At face value, this seems like something believable. Readily, people imagine these tablets being sold at a $0 margin, and then the sheer volume of Amazon.com content making for nice profits. This thesis has just one problem. It's false, and indeed, a folly. This is so for many reasons. I will state the most important.
The tablets are sold at a loss
This happens for two reasons:
- First, the tablets seem priced for gross margins of zero, or having their bill of materials (including manufacturing) at close to the selling price. We gather this from the iPad 3's estimated BOM, which comes to $316 for a specification close to the Kindle Fire HD 8.9", which retails for $299. Even if the Kindle Fire is slightly cheaper to make -- which is dubious due to Amazon.com's much lower purchasing volume and lack of own CPU - it's still likely that its gross margin is close to zero. Now, the problem here is that the costs for retailing the Kindle don't end with its manufacturing. There are R&D, engineering, transport, distribution, advertising, warranties, support and other costs. This alone means that the tablet is already sold at a loss;
- But it doesn't stop there. Amazon.com will distribute the tablet through some physical stores such as Best Buy (BBY). Best Buy and other retailers are not in the business of distributing products at 0% margin. At least some 20% of the sales price is going to stay in Best Buy's hands. So each tablet sold outside Amazon.com will produce losses even if the sales price approaches the BOM on the device (and before all other costs).
This shows beyond any doubt that the Amazon.com tablets begin their life by showing a significant loss to Amazon.com. Indeed, this will probably be enough to, once again, drive Amazon.com's earnings even lower than they have already been, as the new devices seem good enough, spec-wise, to sell significantly.
Content is not very profitable
The market seems to believe Amazon's story that it will sell the tablets at a small loss or breakeven, and then mint money on the content. Now, one could dream that after Amazon.com sells 20 million, 30 million, 40 million of these things, this would really happen. But, wait a second. Someone has already gone down this road. Apple has some 400 million iOS devices out there in the wild, all pulling content from iTunes. iTunes now generates close to $2 billion in revenues per quarter because of this. iTunes is what Amazon.com expects to become, by selling all those tablets.
iTunes is, we might say it, the best case of what Amazon.com hopes to become. It has the volume; it has the margins on the content with few discounts (when compared to Amazon.com's content offerings). So does iTunes mint money like the market believes Amazon.com will, if it ever becomes like it?
We already know the answer. The answer is "No":
Cook then addressed the specifics of the question, noting that Apple has lots of content, "most everything" in the music business and around 40,000 movies and 70,000 TV shows, but that it "was not there for the profit," noting that the iTunes Store is targeted to run at break even as a convenience to users, not as a business.
iTunes, with all its obvious advantages versus Amazon.com today, in scale and less use of discounting, is targeted to run at breakeven. It produces little profit and will be run to produce little profit in the future. Now, Amazon.com is not known to price its wares well above its competitors, yet if one is to believe the market, Amazon.com would have to do so if it wanted to really profit from content on those "at-cost tablets". Amazon.com won't do it, so the profit will never show up.
As a side note, iTunes really gets 30% of the content's selling price in gross margins. It's just that payment handling, hosting and bandwidth, curating of the content (which Amazon.com also does) and other expenses end up eating the gross margin. Amazon.com is not exempt from any of these costs - and is likely to keep less in gross margins as well, since it discounts more often.
Since the tablets are sold at a loss and the content is just a bit over breakeven at best, this has some obvious consequences:
- One is that the recent gross margin improvement Amazon.com showed, due to the previous generation hardware's sales falling off, is going away. One should remember that most of this year's improvement in the Amazon.com share price was supposedly because of this gross margin improvement. This should go away in Q4;
- Another is that Amazon.com will once again guide earnings down, most probably for Q4, and most certainly over the course of 2013, due to the tablets being sold at a loss.
So again, here we have a stock selling at 336 times the forward 2012 earnings estimate of $0.77 per share, and with a significant likelihood of seeing this estimate fall even further. As for 2013's consensus estimate now sitting at $2.38, one just needs to remember that less than 2 years ago, 2012 was estimated to come in around $5.50 … the $2.38 estimate has nowhere to go but down.
Amazon.com remains a clear bubble with incredible downside.
Disclosure: I am short AMZN.