Is Amazon.com Set Up for a Crash?

Amazon.com (Nasdaq: AMZN  ) , probably the hottest Internet company on the NASDAQ, seems to have shrugged off a bad quarterly report in October and is poised to hit new highs going into the holiday season. There is certainly a lot of reason everyone is getting excited about Amazon, especially with its entry into the booming tablet market with the Kindle Fire line, but alarming factors like the company's lack of profitability could eventually send the shares into a death spiral.

Mixed signals from the bottom line
One of the more recent things that should irk you about the stock's behavior is the way it virtually shrugged off the bad data in Q3 2011, when Amazon's net income decreased an ugly 73% relative to 2010, despite huge revenue growth. The company has said it will continue to pursue strategies that expand its market share at any cost, and it expects a high chance of an operating loss this quarter.

A lot of the company's more recent expenditures can be attributed to the rapid expansion of its fulfillment centers. In expanding its warehouse network, Amazon is looking to reduce costs through the streamlining of its shipping routes. The likely result is that Amazon will continue to offer rock-bottom prices while keeping revenue growth strong, and since costs will be reduced, the company should be able to grow earnings more rapidly than usual. There are huge problems that shareholders seem to be forgetting, though, like the assumptions that the company is making while investing so heavily in its network.

These fulfillment centers are leased for long periods. And much as with brick-and-mortar stores, there is no exiting the contract once it's made. If revenue doesn't grow at least as quickly as Amazon is expanding its network, the company will begin to lose money quickly from the upkeep costs on the warehouses. On top of rent, the high costs of employees and shipping are considerable expenses that should be factored in, too.

The Kindle Fire: a new product, a huge gamble
On top of fulfillment-center expansion, the new Kindle family represents a more aggressive front of Amazon's business model. By pricing the new Kindle Fire at $199, Amazon is just breaking even on the components inside the device, and after factoring in shipping, warranties, and other costs it's losing an estimated $50 per Kindle, all in an effort to sell the product more aggressively. CEO Jeff Bezos has long had a history of moving into markets as early as possible, and this is no exception -- he's trying hard to grab a stake in the tablet market. While it's good to see that there is finally some viable competition arising for Apple (Nasdaq: AAPL  ) , the aggressive pricing model that Amazon is approaching can backfire.

By selling the Kindle Fire at a $50 loss, Amazon obviously needs to make at least $50 on every Kindle's software just to break even. That's a tall order, given that the e-reader market has already been tapped to a large extent. Then there's the foregone opportunity of putting that huge pile of money into alternative investments, or actually selling the product at a profit. While it always costs resources to move into a new market, the company may have overextended itself here. It's certain that the low pricing model will draw more customers than usual, but the long-term prospects for the Kindle Fire aren't nearly as exciting.

Apple makes a hefty profit on every iPad sold. It has no problem increasing its sales volume in every consecutive quarter, even with much cheaper tablets and smartphones on the market. Apple never had to buy a fan base through artificially low prices but instead developed one through its innovation. Amazon seems to be taking the opposite approach, by focusing on pricing and buying a temporary customer base. In the long run, how is Amazon going to recoup the losses? Apple essentially got to keep its cake while eating it, yet it's trading at a price-to-earnings ratio of 14 while Amazon is trading well above 100.

We've seen "invulnerable" stocks before
Remember that not too long ago, Netflix (Nasdaq: NFLX  ) was the bulletproof Blockbuster-killer with the invincible CEO. That company never needed a huge budget to increase market share, and it had huge momentum behind the stock. Eventually, when the pressure came to boost earnings, the subscription fees increased and people began dumping the service -- and fast. The share price got sliced in half in the next two months as a result and are down nearly 80% from their 52-week highs.

Those who are optimistic about Amazon can always point to the company's incredible revenue growth, which is impressive, but the company simply hasn't been able to generate enough money to justify the share price. When the company has to start focusing on earnings, the incredible revenue can disappear overnight, as Netflix investors learned the hard way.

Despite all the hidden flaws in the company's business model, Amazon needs a catalyst to cause the shares to collapse to more reasonable levels. It's tough to figure out when that will happen, but if anything can be said at this point, it's that there is a bloodbath just waiting to happen. At these levels, Amazon's shares are priced to absolute perfection and are essentially constructed almost solely on investor confidence in Bezos. If you spot smoke, get out, because there's going to be a fire.


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The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Amazon.com, Apple, and Netflix and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Brian Wilson owns shares of Apple and no other company mentioned in the article. You can email him at brian.wilson@hyperioncapitalresearch.com. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On November 30, 2011, at 11:54 PM, JokerJoey wrote:

    Brian, you are correct in your assessment.

    Amazon would have been better off just increasing its pricing on shipping to cover its costs

    and keep the operation streamlined with maybe between one and three hubs. Why? Because of the forgotten factor.

    The forgotten factor in all this is not so much the cost of keeping up all those warehouses and staffs and support structures. That's a given. The forgotten factor is that it also costs money to ship physical product TO each location in the first place.

    It's especially important in the case of books, because books are absolute dead weight for shipping purposes, and I don't care how much you negotiate, there are limits to what it costs to run a truck profitably from printer to warehouse, and you just can't get below those costs if you expect a trucking company to deliver the goods...unless of course Jeff wants to start his own transportation infrastructure and run trucks all over G-d's half-acre. That's a nightmare that you wouldn't even want to dream of in terms of costs: equipment, drivers, repairs, downtime, route efficiency, insurance, depreciation, and on and on and on and on. And I'm probably missing a few things!

    Maybe the goal is to convert everyone to digital downloading and give up on physical books altogether. Guess what: AIN'T GONNA HAPPEN! Check the data: physical book publishing actually INCREASED by 5.6% over the last year, and most (nearly 76%) of downloading books is for those titles that are technical or text types, and NOT recreational reading. That isn't likely to change, because eventually the bloom with casual downloading a book will fade. It isn't the same as music, the having of which is a passive activity once you get it the first time. You listen to it. It's passive. To read a book you have to engage the page (there's a nifty slogan....hmmmm), and frankly it;s not the same thing on a tablet (yes, even the iPad) as holding a physical book in your hand.....especially if you're in the bathtub, sauna, or spa! You want to relax and read, not worry about dropping your device!

    Seriously though, people used to say that Steve Jobs had a distortion field around him that would cause people to believe anything he said. At the multiple that Amazon's stock is trading at, I would say that Jeff Bezos' distortion field beats Steve's all hollow, because it just plain ordinary doesn't make sense in the smallest iota of a degree! When people wake up to this fact as they have figured out with Netflix, then watch out scout, 'cause it's gonna get mighty ugly mighty fast!

  • Report this Comment On December 02, 2011, at 3:54 PM, monkeywrenchgirl wrote:

    State sales tax collection imminent, Kindle users' privacy violations being addressed on a congressional level, sweatshop allegations and boycott threat, disgusted customers may allow Prime memberships to lapse, in a better labor market amazon.com would not be able to staff their godforsaken warehouses, they are bullies who threaten just about everyone they deal with (customer returns nearly impossible, third-party vendors must fight for due remittance), Google is looking to compete ... and, amazon.com's arrogance is staggering. Bad publicity is finally beginning to stick, and amazon.com is engaging in risky business practices at a time when their authority is being successfully challenged. Hubris is a killer. Bezos is mad, and I can tell you that it is a soulless, unsustainable operation because I work there. I would not recommend amazon.com to anyone for any reason.

  • Report this Comment On December 03, 2011, at 12:52 AM, Oldfool103 wrote:

    Hey mwg, that is an analysis that is invaluable. I hope your work situation improves. Thanks for the tip.

  • Report this Comment On December 05, 2011, at 6:41 AM, monkeywrenchgirl wrote:

    @Oldfool103

    The bad new keeps coming... "Amazon's Special Deals With States Unconstitutional, Law Profs Say"

    http://www.forbes.com/sites/janetnovack/2011/12/04/amazons-s...

    Also, amazon.com has been rather coy in media reports regarding sales of their Kindle Fire. Amazon.com is a numbers-obsessed corporation and I am certain they know exactly how many units have been sold -- why aren't they releasing concrete data?

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