Plays With Fire, But It's The Tech Industry That Gets Burned

by: NakedValue (NASDAQ:AMZN) unveiled a new suite of products earlier this week. Among them was its headline grabbing $199 7" tablet, the Kindle Fire. This turn of events reminded me about a wonderful scene from Godfather 2, where Hyman Roth opens up to Michael Corleone about his anger over the murder of Roth's friend, Moe Green. Up until then, Roth was portrayed as an even tempered, mild mannered gangster. But during this exchange, even as he tells Corleone that he understood the murder because "that is the business we have chosen," his anger seethes into his dialogue and contradicts his claim of understanding. This almost reminds me of the current tablet environment. Up until now, even amid the rabid competition between Apple (NASDAQ:AAPL) and other tablet manufacturers, there seemed to be a complicit agreement to hold the line on pricing. Well, with a $199 price tag, Amazon broke past the crowd and established itself as a viable threat to the industry even if its technology and platform prove to be below average. Like Hyman Roth, other tablet manufacturers must be quietly seething even though this is the industry they have chosen. While they may publicly acknowledge that technology is driven by creative destruction, and that competition and innovation are great for consumers, deep down they must be disgusted by's market share grab because this ultimately pressures margins for the entire industry.

Here are some notable companies that could be affected by the Kindle Fire.

Apple Inc (AAPL) - Perhaps this is the most obvious candidate because it is the dominant (some would say the only) force in the tablet computer market. Its entry-level tablet costs $499 compared with $199 for the Kindle Fire. They're not quite the same because among other things, they operate on different software and have different sized screens. Still, Apple investors and fans a like would be foolish to dismiss the Kindle Fire like they rightly did with previous iPad wannabes. Amazon has already displayed a patience that other Apple competitors have lacked and as such, we should assume that the Kindle Fire would not have been released unless the company was satisfied with the functionality. In addition, pricing matters and as such, there will be a price to pay for Amazon's aggressive pricing. This price may not be initially obvious. The Kindle Fire and iPad are different enough that they could both succeed, but even if iPad sales continue to grow, this does not mean that Amazon has not grabbed some of their potential sales. One additional point. Only a few years ago, the iPod was the driving force of Apple's resurgence and now demand is already on the decline. While the tablet market appears to have significant runway, Apple investors need to be cautious here and remember that the stock's success is built on a small handful of products and that there is no promises of another blockbuster product once iPhone and iPad sales and margins decline.

In the case of Apple, we own shares because we think that much of the risks are mitigated by the company's current dominance in the tablet market and its low stock valuations. AAPL's trailing P/E is 15.45 and the forward P/E is 11.96. Once you strip out the excess cash and investments on the balance sheets, the adjusted trailing P/E is 12.37 and the adjusted forward P/E is 9.67.

Microsoft Inc (NASDAQ:MSFT) - Amazon's relatively low priced tablet hurts Microsoft on two fronts. First, this puts additional pricing pressure on a traditional PC market, which MSFT is directly exposed to. Also, Microsoft should be considered a tablet competitor. It has not introduced a tablet based on its software, but its recently announced relationship with mobile device giant Nokia Corp (NYSE:NOK) is a major testament to its commitment. So despite the fact that the Microsoft tablets are not expected to hit the markets until next year, the margin compressions caused by the Kindle Fire will surely ripple through the industry and be felt in Redmond, WA., and beyond.

Netflix Inc (NASDAQ:NFLX) - Not too long ago, the content rental company's stock price seemed to be unbreakable. The stock was capable of rallies on good news and shrugging off bad news. In the last few weeks though, the gravity of stock fundamentals have set in and the stock price has dropped to a third of the 52-week high. Now every headline, seems to have the same bearish effect on the stock price even when the implications are unclear. We think the Amazon news is a clear example. Today, the content rental company's stock price took a major hit after analysts dismissed an Amazon acquisition. We think the truth is that the Kindle Fire is a disruptive force and that it adds uncertainty to the marketplace but the ultimate consequences for Netflix are uncertain. On the one hand, the more affordable Kindle Fire should meaningfully increase the number of mobile devices on the market that will demand video content. This is bullish for Netflix. On the other hand, Amazon already has a substantial subscriber base and content library so the introduction of the Kindle Fire could just be an extension of ambitions that will trample and hurt the Netflix business model. I don't think the answer is obvious at this point, but I do think that NFLX's stock is being rightfully adjusted following valuations that did not include any margin of safety.

PowerShares QQQ Trust (NASDAQ:QQQ) - Even based purely on structural factors, when something involves behemoths like Amazon, Microsoft and Apple, it will affect the industry index just because of their index weighting. But fundamentally speaking, no company is an island and as such, any margin pressures at the technology giants will trickle down to component vendors like OmniVision Technologies (NASDAQ:OVTI), which supplies camera components for mobile device manufacturers like Apple and Nokia Corp., which abandoned its own operating system to develop Microsoft-based products.

Sirius XM Radio (NASDAQ:SIRI) - This may seem like a surprise member of the list. The satellite radio company is only tangentially related to the tablet wars but what makes it vulnerable is the continuing decline in the upfront cost of mobile devices capable of streaming video and audio. On the margins, this trend will make SIRI less competitive versus imperfect substitutes like tablets and smartphones assuming that SIRI holds costs constant.

But of course, satellite radio and streaming music and video are not perfect substitutes. Even if the cost of hardware like tablets and smartphones continues to decline, bandwidth costs have actually increased, effectively driving up the cost of satellite radio alternatives. In addition, because SIRI generates much of its own content and controls its own distribution infrastructure, the cost structure advantage is proportional to the subscriber growth. Subscribers have grown and as long as they continue to grow, the advantage will expand over streaming music providers whose variable content acquisition costs and distribution costs restrict economies of scale.

SIRI is a levered company and as such, stands to produce outsized gains or losses based on successes and missteps. We do not think that the news will adversely affect the company (at least not in the short term), but investors should pay close attention to the subscriber churn rate following the upcoming price increase. For the first time since the merger between Sirius and XM Satellite, the combined company will be able to flex its pricing power.

Disclosure: I am long AAPL and may initiate a long position in MSFT, OVTI or SIRI over the next 72 hours. I receive no compensation to write about any specific stock, sector or theme.