2 Reasons Amazon Could Take A Hit

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

Wal-Mart Stores, Inc. (NYSE:WMT) announced last Thursday that it would stop selling Amazon.com (NASDAQ:AMZN) Kindle eReaders and tablets after it has cleared its current inventory. However, this does not mean that it will stop selling other tablets from other manufacturers such as Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Samsung (OTC:SSNLF) and Barnes & Noble (NYSE:BKS). In fact, Wal-Mart is hoping that the devices from other manufacturers will make up for the lost sales from Kindle.

This puts Amazon in the back seat compared to other tablet manufacturers, giving its competitors an advantage heading into the holiday season. The timing could also be wrong as Wal-Mart would definitely miss the newest line-up of Kindle tablets priced at $159 to $599.

Amazon CEO Jeff Bezos has decided to drop the price of entry-level Kindle Fire to $159 from the previous price of $199. This is significantly lower than the other tablets, as Amazon has introduced ad-supported tablets. This seems a good differentiator in a commoditized tablet industry. The company is planning to recoup its subsidy on its tablets through sale of its apps and services. These services include a fast-shipping annual Prime membership of $79. It features streaming movie content, as well as other offerings.

There are current reviews stating that the new Amazon tablet is better than before, but it is still no iPad. The positive reviews include improved access to cloud storage, additional of a physical volume button, and improved battery life. On the other hand, its flaws include the lack of fully stocked app store, lack of memory card, and the entry-level tablets include ads.

I believe that the main reason for Wal-Mart to pull out Amazon's tablet is its slim margins over other tablet makers. From this, it may not have much to share with the retailers. Earlier this year, Target (NYSE:TGT) announced that it will stop selling Kindle e-readers. Target has been trying to figure out how to stop its shoppers from visiting its stores to check out the Kindle, only to find out that most shoppers purchased their units online. In short, these retailers do not believe that it would be profitable to have the Kindle on their shelves.

For the last 10 years, Wal-Mart's operating margins have remained steady from 5.5% to 5.9%. This is lower than Target's operating margins. Target also maintained its margins from 7.4% to 7.5% for the same period. On a free cash flow basis, Wal-Mart has better track record at cash flow generation. Wal-Mart has increased its free cash flow from $3 billion in 2002 to $10.74 billion in 2011. Conversely, Target has negative free cash flow of $1.63 billion in 2002 to $1.06 billion in 2011. For retailers, a slight increase in percentage points has significant impact on its cash flow.

Impact on Kindle Sales Will Be Felt in 4Q

It is obvious that Amazon will see a decline on its Kindle hardware revenues from Wal-Mart's move. Given the scale of Wal-Mart stores, it would have to find other venues to make up for this loss. But, Amazon still has distribution partners in the likes of Best Buy (NYSE:BBY) and RadioShack (NYSE:RSH).

There are also rumors that Amazon will be forced to set up outlets to showcase its product lines. The truth is, it is in the processing of investing on its own distribution network to speed up its purchase deliveries and lower its shipping costs. I believe that this alternative will be costly for the company in the near term, but could be beneficial in the long run.

This would also impact its operating margins. Over the last 10 years, its operating margins have slightly improved from 1.6% in 2002 to 1.8% in 2011. This also translates to free cash flow of $135 million in 2002 to $2.092 billion in 2011. The investments in this network took a toll on its net profit in the second quarter. Net income declined by 96% to $7 million, lower than analysts' consensus estimates. It expects an operating loss this third quarter of $350 million to $50 million. In my view, the decline from Kindle sales will only be felt in the fourth quarter. Wal-Mart still has sizable inventory and purchase commitments of Kindle.

Investors should be vigilant about Amazon's higher-than-expected operating expenses. Operating expenses have increased by 31% to $12.7 billion. Amazon is pouring a lot of its resources into the Kindle Fire, which would allow it to sell digital books, movies and music.

Based on the latest IDC data, Amazon shipped 1.2 million Kindles for the second quarter. This translates to a market share of 5%. This means that its investments have somewhat paid off, but not enough to outshine market leaders Samsung and Apple. I also see that operating expenses running out of hand would not enhance its overall profitability. While analysts have touted this a topline story for Amazon, I still prefer to see solid cash flow to back up its growth.

Amazon Is Still Priced for Perfection

At the current price levels, Amazon trades at 87 times earnings. This is significantly higher than its 5-year average earnings multiple of 76 times. Its price over growth (PEG) ratio also appears high at 2.9 times. If we look at it as a revenue growth story for Amazon, its price over sales ratio seems high at 2.1 times.

In contrast, its peers are definitely trading lower. Apple is valued at 12.5 times earnings and has a PEG ratio of 0.5 times. What this means is that the price is relatively cheap to its future growth. On the other hand, Google trades at 15.9 times earnings and has a PEG ratio of 1.2 times.

I also believe that there are no catalysts for a possible re-rating of Amazon's stock. The risks are definitely brewing for Amazon. These include cut-throat competition in the tablet market and a higher-than-expected increase in operating expenses. Unless there are reasons for positive earnings surprises for Amazon, I prefer to stay on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.