Will Amazon Ever Be Able To Open The Earnings Floodgates?

Oct. 3.12 | About: Amazon.com, Inc. (AMZN)

There are no shortage of bear cases that are being made these days against Amazon (NASDAQ:AMZN), with recent articles here on Seeking Alpha pointing out their dwindling earnings, low margins, and high revenue growth hurdles. However, none of these issues has slowed the dizzying ascent of Amazon's stock price, which is up almost 50% year to date. Therefore, there must be something attractive about the future of the company, because after all the current price of a stock should be a reflection of all their future cash flows.

Basically, the bull case is this: Amazon is going to continue to invest in their core business to further their dominance in online retail and leverage that platform to enter other desirable markets, eventually become a one-stop-shop for anything you could ever want, including eBooks, streaming video, and cloud storage. It doesn't take much imagination to picture Amazon as a future juggernaut, and the theory goes that once they have built an ecosystem with a wide enough moat they will be able to throttle back on spending and open the floodgates to earnings.

I would use the name-appropriate analogy that Amazon is building dams on rivers of future income and will eventually be able to open the floodgates and generate significant earnings power. However, it's not going to be easy, since besides their flagship position in online retail, Amazon is also trying to displace current heavyweights in many of these areas. This is equivalent to building dams downstream of current ones that are already restricting the flow of potential profits, so Amazon is forced to operate unprofitably with only the overflow just to gain a foothold in that region, selling Kindles at cost to compete with Apple or spending billions on online content to try to woo Netflix customers.

I've often wondered why Amazon insists on doing it on their own, considering that they could easily buy Netflix (NASDAQ:NFLX) or Zynga (NASDAQ:ZNGA) for less than they'll ultimately end up spending to develop their own platform, again preferring to build their own downstream dam rather than just buying an existing one. If Amazon simply bought Zynga for $3B (of which ZNGA already has about half that on their balance sheet), the over $1B increase in revenues would be valued at about $2.5B at Amazon's current price to sales ratio. I guess buying $4B for $3B doesn't really suit their "investment" style, not that I necessarily fault them since it seems the more they spend the more the stock goes up. Investors seem to assume that Amazon's clout will overwhelm those companies, so there's no need to buy them out to remove them as competition.

Seemingly not satisfied with fighting over scarce resources with dominant players in those markets, Amazon is also spreading itself even thinner with forays into developing a movie studio, with rumors of the company even joining the mobile payment fray. All these areas seem to fit with the company's recent strategy of investing in the future with seemingly no regard for current profits. While some of these may pan out, there's no guarantee that they will be lucrative enough to justify the current spending.

Amazon is also spending billions to build more distribution centers. While this will improve customer service with faster shipping times, it's not clear how it will contribute to earnings since Amazon already offers free shipping to Amazon Prime members. Furthermore, having more physical locations will strengthen states' arguments that Amazon should have to charge sales tax, lessening their competitive advantage over bricks and mortar stores.

In conclusion, Amazon undoubtedly has a great core business model in online retail that has provided a reservoir of revenues that theoretically eventually could be turned into earnings if they can ever rachet down infrastructure spending. However, their current efforts to dam insignificant tributaries or already overcrowded rivers unprofitably just to gain the necessary revenue increases to support the overinflated stock price could turn out to backfire.

When these dams start to spring leaks in the form of rampant spending it will further erode margins and profits, which it seems we've already begun to see lately with Amazon's deteriorating fundamentals. Therefore, I would stay away from Amazon's stock until its price more closely reflects the reality of the company's position as a low margin online retailer with big dreams of ubiquity in the mobile marketplace but so far little concrete evidence to support that their other projects will ever generate enough earnings power to justify the continued spending or current stock price.

Disclosure: I am long ZNGA. 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.