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Amazon.com (AMZN) is the Secular Short of 2012

March 12th, 2012 21 comments

I believe the market is underestimating the deteriorating underlying business trends, the impact of the secular shift of physical media to digital media along with the competition risk from Apple and Google, and the weak positioning of Amazon’s hardware tablet strategy.

Uneconomic Revenue Goosed by Free Shipping Subsidization

The bull case for Amazon has always been it will continue to grow at rapid rates for the next 3-5 years and if you put some decent operating margin on the out year, you will get fantastic earnings power. However the problem with this argument is the wheels are starting to fall off the wagon.

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Back in the dot.com bubble there was a company called Kozmo.com that offered free 1 hour shipping of array of small goods like books, videos, magazines, etc. To my amazement, I tried the service and ordered a pack of gum. Within an hour someone was at my door to deliver it. The company reported amazing revenue growth. Obviously investors should have discounted that sales growth as it was an “uneconomic” business model.

Amazon is doing a similar thing by subsidizing free shipping. Anecdotally I am hearing customers who have Amazon Prime feel compelled to order small items to take advantage of the free 2-day shipping benefit. They are ordering batteries, Listerine (Link), toilet paper, water bottles, etc. all with free 2-day shipping, which is goosing Amazon’s revenue without helping their bottom line.

If you sell $1.00 of value for 99c, you will show amazing revenue growth. It’s all fine and dandy until your free shipping offering hits critical mass with take-up accelerating and the losses start ballooning. Over the past few quarters, Amazon’s operating income growth has plummeted and the % of revenue of net shipping losses (you can find these numbers deep in the 10Q) has accelerated higher from 3.8% to 5.4%. In other words, free shipping losses are increasing at a rapid clip from a loss of $562 million in Q4-2010 to $934 million in Q4-2011. In fact Amazon got stung with a stunning $2.4 billion in shipping losses in 2011.

The problem is this is an unstoppable trend as the more people use it, the more losses will pile up. To make matters worse, UPS raises shipping costs annually at the beginning of every year (+4.9% on 1/2/12). At some point, Amazon is either going to have to cut back on the free shipping benefit, which will hurt revenue growth or continue to face accelerating losses. Either choice will hurt investors’ portrayal of the economics of Amazon’s business.

Poorly Positioned in the Shift from Physical Media to Digital Media

One of the biggest trends in the past couple of decades is the shift from analogue to digital. In a similar vein, there is a huge secular shift today from physical media to digital media. People are moving from physical books, DVDs, videogame discs, and CDs to e-books, online video, digital videogame services, and iTunes.

Already the growth deceleration in physical media is showing up in the numbers. Amazon’s North America Media sales growth slowed to 8% y/y in Q4-2011. Amazon blamed poor sales of videogames as a factor. This isn’t going to get any better in Q1-2012 as NPD videogame sales were down 38% y/y in January (Link) and down 23% y/y in February (Link).

The problem for Amazon going forward is a significant portion of their current revenue is still from physical media, so they need to dominate the secular shift to digital. Unfortunately for Amazon, the elephant is the room is Apple.

In the CDs to digital music shift, the game is already over with the power of Apple’s iTunes/iPod ecosystem. Amazon has no chance to compete. In the DVDs to digital movies shift, Apple already has 75% market share of all movies bought online (according to a Hollywood source Link) and this is even before Apple has launched a true Apple branded TV which is slated to come out within a year.

Amazon doesn’t really have a digital gaming download strategy (other than a small PC games download business) and will be locked out in the future when/if Microsoft or Sony goes digital only with the next generation consoles. Also as more interactive game spending goes purely digital to MMOs, Facebook, and tablets, Amazon market share of videogame business will continue to decline.

In terms of e-books, Amazon has dominated this business due to the success of Kindle e-readers in the past few years. Unfortunately for Amazon, this too is now significantly at risk as the world is moving away from dedicated e-readers and to full featured tablets. Taiwan based E Ink Holding which provides black and white e-ink displays and counts Amazon as a large customer reported December 2011 revenue down 57% y/y (Link).

The Kindle Fire Conundrum

So if the world is moving to tablets to consume digital media, all of Amazon’s marbles are now put on the success of the Kindle Fire tablet. I was actually a day one buyer of the Kindle Fire. I was excited at the price point and entranced by the ultra-fast Silk web browsing marketing line-item. Within a couple of hours of using it, it was back in the box and on its way back to Amazon for a refund.

The Kindle Fire tablet is shoddily constructed, has no volume buttons, got uncomfortably warm after some use, and worst of all unenjoyable to use. I tried the web browser and it was very slow compared to iPad, Touchpad, and even the Nook Tablet I tried in the store. Netflix didn’t work well (Engadget review saying Kindle Fire Netflix app is choppy and worse than the Nook Tablet version Link). The operating system is a glorified app loader carousel and has a tiny sub-set of the functionality of Apple’s iOS and Android 4.0 “Ice Cream” sandwich.

I was not alone in my experience. 10 people I knew who bought the Amazon Fire tablet returned it within a week. 100% of people I know who have previously used an iPad in the past and bought a Kindle Fire wound up returning the Kindle Fire. That is an utterly damning data-point.

I believe that Kindle Fire initially did sell well in the first few weeks after release, but after word-of-mouth got around sales decelerated and imploded into Q1-2012. Many of the data-points that I triangulated from other companies and sources bear this out.

1. Apple’s CEO said on their earnings call and at conferences there was zero impact on the trajectory of their iPad sales after Kindle Fire was launched. He said “our customers won’t be satisfied with “limited function” tablet” and he has heard customers of a competitor [Kindle Fire] say “I got a good deal… but I hate it”

2. Barnes and Noble management on their conference call heard their biggest competitor [obviously Kindle Fire] “had returns rate 15-25%”

3. Sandisk management on their conference call pointed out weakness in the 8GB flash size product [the size of Kindle Fire’s flash memory].

4. Digitimes on 2/20/12 reported Kindle Fire shipments plummeted to 1.5 million units in Q1-2012. This is even worse 3 million units forecasted just 1 month before on 1/20/12 Link

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5. Walmart offered a $50 free gift card on Kindle Fire purchases 2/5-2/14 (Link) further supporting the inventory overhang theory. Staples did the same later in February with a $25 gift card promotion (Link). Moreover every time I visit my local Target there are piles and piles of Kindle Fire and Kindle e-reader inventory.

6. Texas Instruments on their mid-quarter guidance cut conference call on 3/8/12 (Link):

”whenever there’s a new product introduction by a customer, there’s also an associated one-time surge of revenue as those customers fill their channels with product. So although we had anticipated lower sequential revenue associated with that [non-recurrence] of the fourth quarter channel fill, demand for OMAP is lower than what we had originally expected as our customers are now rationalizing both their expectations for ongoing demand as well as the associated inventory.”

The most ballyhooed Texas Instrument OMAP app processor new product design win in Q4-2011 was the Kindle Fire. And now Texas Instruments is saying the channel got stuffed and needs to get “rationalized.”

And it’s going to get worse. Apple is reportedly going to launch a 7-8 inch tablet form factor iPad at a lower price point later this year. Google/ASUS is reportedly going to launch a 7” tablet in the coming months for $199-249 to compete directly with the Amazon Fire tablet. This new tablet will have a full-featured Android 4.0 “Ice Cream Sandwich” OS and an Nvidia Tegra 3 processor which will provide a much better user experience to consumers. I’ve been using Android 4.0 on my HP Touchpad and it’s fantastic, snappy, and pretty, all things I can’t say about the Fire.

In fact Amazon is stuck between in a rock and hard place as they built the Fire Tablet on top of Google’s Android OS. Building your device on someone else’s OS puts you at risk of being cut out in the future revisions and upgrades. A very precarious situation amplified by the fact Google is probably not happy Amazon cut out Google’s Android Market (now called Play) on their device.

If Amazon’s Fire tablet doesn’t catch on, tablet digital media sales will be dominated by Apple’s AppStore and Google’s Android Market/Play store. People like to have one device that has all their music, photos, videos, games, apps, and movies. Apple and Google hold the cards and will get the 30% sales commission tablet store spoils while Amazon withers in the dust.

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To add insult to injury the success of Apple’s iPad and iPhone products are taking large consumer electronics dollar market-share away from Amazon. iPad and iPhone sales have grown exponentially over the last few quarters while Amazon’s electronics and other revenue segment have suffered in comparison. Once again this is a trend that is not likely to reverse any time soon given the problems of the Kindle Fire and the high customer satisfaction and extreme stickiness of the Apple ecosystem (iCloud, iOS AppStore, iTunes, iPhoto, Apple TV, iPod, FaceTime etc.)

Amazon isn’t oblivious to the competitive issues at stake with the shift to digital media and the rise of tablets. Guess how many iPads and iPhones Amazon sells directly on their site (not third-party sellers)? Zero. That’s right, ZERO.

At the close of trading on Friday, March 9th Amazon stock price was $184.32 trading at a premium multiple of 143Xs 2012 earnings.

What multiple do you give a business that is goosing revenue with uneconomic free shipping subsidization?

What multiple do you give a business that is directly in the cross-hairs of Apple in the shift to digital media after what Apple did to Nokia, Research in Motion, HP, and Palm?

What multiple do you give a business that put its future on a shoddily built tablet that is failing in the market place?

My answer is: a much lower multiple.

Written by @firstadopter. Follow me on Twitter (Link)

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1. Many Amazon bulls keep saying “Don’t worry, Jeff Bezos plays long-term. He will figure it out.” This reminds me of what people used to say about Reed Hastings at Netflix last year as NFLX stock went from $304 to $62. No matter how great a CEO Hastings was before, it didn’t help the fact his content costs went from a sweet-heart $30 million a year deal with Starz where Netflix got quality Disney and Sony movies for a pittance to paying $1 billion for Gossip Girl. Similar perilous secular industry trends are facing Amazon, even great CEOs can stumble.

2. I didn’t even cover the long-term issue of state sales taxes. Currently analysts’ estimate Amazon has a 10% pricing advantage after no state sales tax and shipping vs. brick and mortar stores. This advantage goes to low single digits % over the next 1-3 years as states and/or Congress legislate and come to agreement with Amazon to collect state taxes. I’m of the belief this will help level the playing field and hurt Amazon’s revenue growth as there is some value to customers of having a store-front to try new products out, give service, and returns. The best example of this is Apple retail stores of course.

3. I also did not write about Amazon web services. Compared to the arguments laid out above for Amazon’s core businesses, web services is still a small single digit percentage of revenue (Link) and is suffering some issues of its own: 1) Zynga decides to compete after being Amazon’s largest web services customer (Link) 2) Sony switches some business away from Amazon to RackSpace after security breach (Link) 3) More price competition from Google Link 4) HP to compete in the coming months (Link)

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