Amazon’s Smoke And Mirrors Are Fading December 21, 2012Posted by Ishmael Chibvuri in Latest Articles!!!.
Over the past year or so, I’ve detailed one of the most unusual occurrences in the stock market today. A company that’s growing revenue at a tremendous pace, but seeing earnings decline at an even faster pace. While that may not seem unusual, you have to consider that this stock is up nearly 44% over the past year, and nearly hit its 52-week high on Tuesday. That, for a company that can’t turn a profit, just raised a ton of debt, and loves to sell products at a loss. If you haven’t figured it out already, I’m talking about Amazon (AMZN). Amazon’s latest race toward new highs is even more surprising than the last. Unfortunately, this company is in worse shape than many realize, and eventually, the stock seems destined to drop. Amazon might have been great for longs in the past, but the smoke and mirrors surrounding this company seem to be fading.
Can we make any money?
I used the following chart in my last Amazon article, and it is one worth showing again. I’ve put together a chart showing the trailing twelve month operating and net profit margins for Amazon. This is not an average number. It is a combination of the quarters, the total operating income for the previous four quarters divided by the total revenue for those four quarters. So for example, the Q4 2009 number below is actually the margins for the entire year in 2009, whereas the Q3 of 2012 number is the four-quarter period from Q4 of 2011 to Q3 of 2012. These numbers are based on the GAAP results, and do not take out any adjustments, such as any gains or losses from equity investments that are always discussed when it comes to Amazon.
Over the last twelve months, ending with its most recent third quarter, Amazon has generated $57.26 billion in revenue. How much of that made it to the bottom line? A paltry $40 million. Yes, that’s million, not billion. If Amazon’s Q4 net income drops more than $40 million over last year’s Q4 result of $177 million, trailing twelve month net income will go negative.
Now, how possible is it that net income drops? Well, let’s consider a few items. In Q4 of 2011, Amazon produced operating income of $260 million. Amazon does not provide net income or earnings per share guidance, but it does provide operating income guidance. You can find company guidance in any of its earnings reports, found here. For Q4 of 2012, the current quarter, Amazon guided to operating income in a range from a loss of $490 million to a profit of $310 million. That means a midpoint of a $180 million operating loss.
Current analyst estimates call for Amazon to have Q4 revenue of $22.24 billion, which is toward the upper end of Amazon’s $20.25 to $22.75 billion provided range. At that current estimate, analysts are looking for 27.6% revenue growth, year over year. But here’s the surprising thing. For the quarter, Amazon analysts are expecting a profit of 29 cents, which still would be down from a 38 cent profit in last year’s period. A 29 cent profit would make it close on that $40 million net income drop. But here’s the thing to question. If Amazon guided to an operating loss, had basically zero profit in Q2 and a huge loss in Q3, why are analysts expecting this quarter to be so rosy?
The unusual philosophy:
There are two companies out there that seem to care about revenue growth tremendously, even at the cost of earnings. Amazon is in the first, and a competitor of Amazon’s, Netflix (NFLX) is the second. I’ll have more on Netflix later, but Amazon’s efforts to compete with Netflix in the streaming space may be one reason why profits have dwindled in recent years.
Amazon is known for selling things very cheaply. That’s why people love the site. But at what point is Amazon selling things too cheap? Consider the following example. For my birthday, I recently asked for seasons 2 and 3 of one of my favorite television shows. I already own season 1. For my birthday, I was given seasons 1, 2 and 3. The person who gave it to me told me the following. It was actually cheaper to order all three seasons together than it was to purchase just seasons 2 and 3. I understand that Amazon sometimes runs extra special deals, but how profitable can it actually be?
How odd is this phenomenon of selling items as a loss? Well, one analyst recently cut his Kindle Fire sales estimates for Amazon. Pac Crest’s Chad Bartley said that channel checks aren’t as great as previously thought. He cut his 2012 estimate to 6 million units this quarter of the Fire, down from 8 million previously, and 10.5 million for all of 2013, down from 12.5 million previously. His reasoning behind the move was two fold. First, he thinks the 7-inch HD version is selling better than the more expensive 9-inch HD model, and better than the $159 standard definition model. He also believes Amazon is facing stiff competition from both Apple (AAPL) and Google (GOOG). Apple just released the iPad mini, and has recently doubled orders for iPad mini units.
Now Amazon does not provide unit sales numbers for the Kindle, so we may never know what actually happened. But here is the best part of the analyst’s note. Despite the fact that he cut his revenue forecast for Amazon for both 2012 and 2013 as he cut his Kindle Fire numbers, he maintained his earnings forecast for 2012 and increased his 2013 earnings forecast! The reasoning behind this is simple. Since Amazon sells the device at a loss, selling fewer units means the company will lose less, or profit more. This usually is the opposite of Amazon’s strategy. So what should investors want? More sales growth and declining earnings, or fewer sales and more earnings? It’s a rather interesting question.
The big debt deal:
Recently, Amazon realized that its current cash position wasn’t where it needed to be. The company went out and raised $3 billion dollars. Why did the company do this? Well, as I mentioned recently, the company’s working capital balance has declined from $3.56 billion about 18 months ago to just over $500 million at the end of the most recent quarter. Where is the cash going? Well, Amazon is spending it to build up the current infrastructure. That includes not only warehouses and fulfillment centers, but the $1.16 billion dollar headquarters Amazon plans to open in the Seattle area. Amazon isn’t using the money for a special dividend, and it probably won’t use any of the funds on its buyback plan, but that could be an option.
I mentioned before that Amazon is currently dueling with Netflix when it comes to the streaming video space. That requires a lot of investment. Content costs can be in the hundreds of millions, perhaps billions per year. Amazon recently announced a new deal with Time Warner (TWX) to bring even more content to its Prime platform. Last month, Netflix CEO Reed Hastings said he believes Amazon is losing between $500 million and $1 billion dollars on Prime. Content expenses aren’t broken out directly, but Amazon’s "technology and content" expenses in the first 9 months of 2012 rose 57% to $3.219 billion, up from $2.047 billion in the prior period. Netflix’s recent deal with Disney (DIS) will only turn up the heat in the streaming war, meaning Amazon will need to acquire even more content. This debt deal will help with that, but it also could boost Amazon’s losses if Reed Hastings is right.
The issue here is that this debt deal may not be the last. If funding the new headquarters takes out nearly 39% of the money raised, content expenses could take out another chunk. Add in Amazon’s other fixed asset purchases, and the $3 billion could be gone before you blink. Don’t forget, if Amazon starts losing money on a consistent basis, the cash position could dwindle further. Amazon’s working capital position had dropped until this debt raise artificially boosted the ratio (since long-term debt doesn’t count in the formula), but it will start dropping again as Amazon spends the cash. Amazon could need cash again rather soon, and if that is the case, it means increased interest expenses and a weakening balance sheet.
Is Amazon trying to copy Apple?
Right now, everyone wants to be Apple. Apple has three of the hottest products on the planet, and could produce close to $50 billion in net income during its current fiscal year. Amazon might have trouble producing $50 million in net income. A few years ago, Amazon launched its Kindle Fire tablet to enter the tablet space, in addition to the Kindle e-readers it already sold. Amazon was confident that it could sell the Kindle Fire at either a low margin or a loss, and that consumers would come back for higher margin books, content, etc. Amazon saw that Apple was dominating the tablet space, and it tried to get a piece of the industry. In Apple’s latest fiscal year, which ended in September, Apple sold more than 58.3 million iPads, as per the 10-K. With the addition of the iPad mini, that number is expected to grow even larger going forward. How many tablets will Apple sell in its current fiscal year? 70 million, 75 million, or more are all possibilities. While Amazon doesn’t release numbers, the analyst above noted that Amazon might only sell about 10 million. Apple is miles ahead, and that is not likely to change anytime soon.
If Amazon is trying to copy Apple, where would it be logical to go next? How about the phone space? Well, it appears that may be coming true, as rumors of an Amazon phone launching during 2013 have really picked up lately. Sources say that Amazon is looking to launch a $100 to $200 phone during the second or third quarter of 2013. Now that $100 or $200 could be the subsidized price, kind of like how an iPhone 5 starts at $199 but Apple is getting roughly $650 a phone (on average).
Apple has been extremely successful with the iPhone, as it sold over 125 million iPhones in its most recent fiscal year. That number is expected to increase at a nice clip this fiscal year, even if Apple doesn’t strike a deal with China Mobile (CHL). The iPhone is very high margin, coming in around the mid to high 50s or low 60s, percentage wise. That’s well above Apple’s gross margins, running around 40% right now.
So why does Amazon want in? Well, it seems to want in to everything, especially if it is something Apple does. But the second part has to do with margins. Even if Amazon develops a phone with just a 40% gross margin, it would be significant to Amazon’s financials. As you can see from the following table, Amazon’s gross margins lately have rivaled Apple’s net profit margins. Yes, Apple is making more on the bottom line than Amazon is making on the gross margin side (percentage wise, not dollar wise). The quarters presented below are calendar quarters. Apple uses a September end for its fiscal year, so Apple’s fiscal Q4 is the calendar Q3 number presented below.
If you can remember from above, Amazon’s operating and net profit margins have been declining steadily over the past few years. I don’t see Amazon rivaling Apple in terms of gross margins anytime soon, but if Amazon could get gross margins back to the 30% level, it would be a huge help. A smartphone could be the way to do it, which is why Amazon may be trying to duplicate Apple’s success. The problem is that Amazon is entering a very crowded space, and one that has some well established products. It will need to be a good phone, otherwise it won’t sell well against the iPhone, Galaxy, Lumia, or any other of the top-selling phones.
Conclusion / Recommendation:
Amazon’s spending keeps increasing, more so than the company seems to be able to afford at this point. Amazon loves to focus on revenue growth, even at the cost of earnings. At some point, that will catch up to it, and recently, it has started to. Amazon reported a huge third-quarter loss, and its fourth-quarter guidance may be hinting to another loss, despite analyst projections for a profit.
Even when Amazon reports bad numbers or gives soft guidance, the stock rebounds almost right away. Amazon is not being held to the same high standards that other top names like Apple and Google are. But if Amazon starts losing money on a more consistent basis, margins continue to contract, and the excessive spending causes it to need more money, expect Amazon to be held to a higher standard. Amazon’s smoke and mirrors are fading, and trying to produce a smartphone in a very competitive space seems to be its plan going forward. Amazon made a valiant effort into the tablet space, but it appears that Apple’s latest creation, the iPad mini, is clearly impacting Amazon’s Kindle Fire.
Given all of the issues surrounding Amazon, you would think this name would be a great short candidate. There in lies the problem. The stock is a short candidate, but has not been a very good short, except for the few minutes right after earnings are reported. Over longer time periods, Amazon has just rallied higher and higher, burning short after short. Eventually, if Amazon’s problems continue, the shorts will win out, but trying to figure out exactly when that will be is the million dollar question. But if Amazon continues at its current pace, that day is coming closer and closer.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.