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On January 6th, 2013 Morgan Stanley analyst Scott Devitt upgraded Amazon.com to Overweight on the thesis the company would gain e-Commerce sales market-share and grow revenue by around 30% annually in the next 3 years (2013 +31.2% y/y, 2014 +30.3% y/y, 2015 +27.3% y/y).

This bull thesis went out the window weeks later when Amazon.com reported Q4-2012 sales growth of only 22% y/y missing the average sell-side sales estimate by $1 billion with an epic 700bps ex-FX y/y sales deceleration from Q3-2012. The Morgan Stanley analyst quietly lower his sales estimate by 1/3 to around 20% y/y annual sales growth over the next 3 years after the report.

Yesterday the same Morgan Stanley analyst came up with a new bull thesis. In a new sell-side note citing a U.S. consumer survey they did of 1108 owners of eReaders and tablets, Scott Devitt concluded the 2012 eBook market is 50% larger than they previous estimated.

Using his assumptions of EBooks sold per hardware device tie-ratios, e-Reader/tablet hardware market growth, and market-share, his Amazon.com’s eBook operating profit estimate ballooned higher 3 years out.

Investors giddily bid up Amazon.com shares by +4.16% on Morgan Stanley’s revised higher EBook market analysis. The problem is his methodology is seriously flawed.

Morgan Stanley asked e-reader and tablet owners how many EBooks they bought per month. Then they multiplied the number by 12 and took a "finger in the air" 40% discount due to "annualizing" it and also guessing there probably is a lower International tie ratio.

The end calculated results were 13.3 EBooks purchased per e-reader device and 6.4 EBooks purchased per tablet in the year of 2012. He then used these same ball-park tie ratios as a base case along with device growth to extrapolate EBook market-size and Amazon EBook revenue & profit over the next few years.

If Morgan Stanley was going to annualize the EBook purchased per device number, why didn’t they just ask how many EBooks each consumer bought in whole year of 2012 instead of per month? Wouldn’t a consumer who actually bought 0.25 EBooks per month likely to say 1 instead of 0? Doesn’t this introduce large rounding error issues? Isn’t this a serious flaw?

What’s with the made-up 40% discount number which comes arbitrarily out of thin air?

Why would tie ratios stay in the same range 13-14 Ebooks a year per e-reader device and 6-7 Ebooks a year per tablet device over the next 3 years? Wouldn’t the tie ratio change as the market matures?

Also the final tie ratios of 13.3 and 6.4 EBooks sold annually per each and every hardware device didn’t pass the smell test to me either, so I did a survey of my readership.

I actually asked the right question of how many EBooks they bought in the entire 2012 year instead of the errant per month method Morgan Stanley used. I got 85 responses for my survey. The 2012 EBooks bought per eReader device tie ratio came out to 4.8. The 2012 EBooks bought per tablet device tie ratio came out to 1.4.

My reader base demographic is probably more affluent and more educated than the average American and E-reader/tablet owner. The tie ratios are LESS THAN HALF AND A FRACTION of Morgan Stanley’s number, who used less accurate survey methodology.

Morgan Stanley’s assumptions and methodology garbage in = garbage out, just like Scott Devitt’s original Amazon.com 30% annual sales growth bull thesis. Investors beware.

One of the most successful fundamental hedge-fund portfolio managers, Roberto Mignone of Bridger Management, once said, “When a position moves against you, don’t panic. Research.” The more I research Amazon, contrary to the recent price movement in the stock, the more I find the fundamentals are getting worse.

From Microsoft’s $605 million life-line to Barnes & Noble’s Nook business to new developments in state sales tax collection to even the temporary margin improvement in the Q1 quarter to the recent and future launches of low cost Android 4.0 (Samsung/Google/ASUS) and Apple iOS tablet competitors; all point to a weaker long-term fundamental positioning of the company.

Microsoft Giving $605 million to Barnes & Noble’s Nook Business is Bad for Amazon

Before today if you told me to give you top 5 list of news events that would be most detrimental to the fundamentals of Amazon, Barnes & Noble getting a deep pocketed strategic partner for its Nook business would have been number 2 on that list.¹

And that is exactly what happened with the news of Microsoft’s investment agreement with Barnes & Noble.  If you read the SEC 8-K filing [Link], you will find Microsoft is paying $300 million for a 17.6% stake of the NewCo business (digital Nook business+College bookstore business) and an additional $305 million over the next 3-5 years for revenue sharing and technology development.

The consensus was Barnes & Noble without a strategic backer would be bankrupt within 1-2 years and be especially vulnerable to a “scorched earth” ebook price war from Amazon with the “agency” pricing model likely going away as a result of the recent DOJ actions against the publishers and Apple.

What was Amazon’s biggest legitimate opportunity to win back digital media market-share by driving Barnes & Noble out of business is now a lost cause as Nook will have the dry powder to match any price war and develop new products to compete for several years. In fact if Amazon does lower prices, all it will do is lower profit margins for all the players in the market.

One of the most interesting competitive developments in the last 2 years is on a “level pricing playing field” Barnes & Noble has been able gain significant market-share in the ebook business by out executing Amazon and simply making better products.

The company went from 0% ebook market-share to 27% in 2 years, while Amazon went from above 90% to 60%.

”Amazon is going to have a tough time holding on to the 90 percent share of the e-book market it currently claims.” Source: CNET 2/17/10 [Link]

”Mr. Lynch said Barnes & Noble now held about 27 percent of the market, a number that publishers confirm gleefully. Amazon has at least 60 percent” Source: NYTimes 1/28/12 [Link]

“company claims about 27% of U.S. e-book title sales today, with Amazon holding 60%” Source: WSJ 4/30/12 [Link]

Amazon ironically became what Microsoft was to Apple, a lame copy-cat of Barnes & Noble’s superior engineering.

In November 2010, Barnes & Noble launched the Nook Color [launch review Link], the first successful low-cost color IPS screen tablet with a forked Android OS. It did so well that Amazon basically had to copy the device with the Kindle Fire launch in November 2011.

In June 2011, Barnes & Noble launched the Nook Simple Touch with its revolutionary infrared beam touch screen technology. It won great reviews [Link] and Amazon quickly copied it with the Kindle Touch in November 2011, finally giving up Jeff Bezos’ decree that all Kindles must have physical keyboards due to the verdict of the market-place.

And this month Barnes & Noble launched the Simple Touch GlowLight [launch review Link], which Amazon will surely copy in the months ahead. Do you see a pattern here?

The clear take-away is against a fully funded Nook business, hardware engineering innovation, prime position as the digital book-store of Windows 8 operating system, and simply being a maker of “better products,” Amazon will have a tough time re-gaining market share in the ebook business against Barnes & Noble, not even mentioning the Apple iPad iBooks store and the ramping digital self-publishing book eco-system of Apple’s iBooks Author [Link], which enables authors to create multi-media ebooks with ease.

¹My number 1 on the Top 5 “bad for Amazon” list is the launch of a low cost $249-299 7-inch Apple iPad, which will probably happen later this year.

New Developments in State Sales Tax Collection

Last Friday Amazon announced [Link] it will start collecting state sales taxes in Texas starting July 1st, 2012 as a settlement of dispute from last September. This is a new near-term development. Amazon is already slated to collect sales taxes in the big states of California and Pennsylvania in September 2012 [Link] with many more states looking to legislate in the coming year. It’s only a matter of time before Amazon will lose its state sales tax non-collection advantage across the whole country.

Texas, California, and Pennsylvania alone are 24% of the U.S. population that Amazon will be forced to collect state taxes in the next 5 months. This will raise effective pricing by at least 6-8% for Amazon customers in those states. Econ 101 tells us if a company raises effective pricing 6-8%, it will hurt sales.

On the last earnings call, Amazon’s CFO was asked directly by a sell-side analyst TWICE on whether starting to collect state sales tax in New York State slowed sales. The CFO conveniently would not comment on “any specific geography” like New York State, but repeated the same refrain from the past that for 50% of Amazon’s sales the company collected some kind of VAT tax (Europe) or sales tax and the company was able to grow in the past few years.

No-one is saying Amazon will stop growing as it starts collecting state sales taxes in more states, but there is no doubt in my mind it will hurt sales growth.  Common sense tells me if a customer has to pay 6-8% more for a product, maybe he or she would be willing to pick up the product at Walmart or Target later in the day vs. waiting 2 to 5 days to get the product delivered through the mail if the pricing delta is smaller.

If a customer is ordering electronics and lives in Texas, on a level sales tax playing field, ordering from Dell.com which is based in Texas suddenly becomes a much more competitive option, along with the potential for quicker local warehouse shipping. The same can be said for NewEgg.com customers in California or B&H Photo [www.bhphoto.com] and J&R [www.jr.com] customers in New York State, all solid reputable online retailers that get a new lease on life to compete for their local in-state customers.  To say 6-8% effective increase pricing won’t impact sales growth for these reasons above, doesn’t pass the common sense test.

It’s All about the Kindle Fire and the Fundamental Prospects are Still Poor

Last week Amazon reported Q1-12 financial results. Sales growth decelerated 100bps from Q4 from 35% y/y to 34% y/y in Q1.  The company guided Q2 revenue growth to 27% y/y at the mid-point of guidance, which would be 700bps of deceleration. Operating income was –40% y/y and Electronics+General Merchandise business decelerated from 48% y/y growth in Q4 to 43% y/y in Q1.

On the positive side, World-wide media segment accelerated from 15% y/y growth in Q4 to 19% y/y in Q1. Gross margins also improved 120bps y/y from 22.8% in Q1-11 to 24% in Q2-11.

As this table from Amazon’s 10Q clearly shows all the profitability came from the North American business and the International business’ margins plummeted even further.

There are two drivers to the better margins in the North American business.

1) I believe for the first time in the history of Amazon, the company decided to NOT delight customers and raise prices 50-100% on select items in their Subscribe & Save business. This customer message board [Link] is filled with these pricing examples through-out Q1-12.

Also during Q1-12 I noticed Amazon adopted the Gamestop’s shady practice of increasing videogame prices significantly couple days before a “Buy 2 Get 1 Free” sales promotion.

The simple fact is raising prices 50-100% on customers who have subscriptions isn’t likely to lead to long-term margin improvement. There will be a short-term lag as customers see the higher pricing on their credit card bills and cancel their subscriptions.

2) The second more important driver of better margin was digital media purchases by new Amazon Kindle Fire owners [Note: Kindle Fire was only released in North America]. By triangulating data-points, I estimate Amazon sold 5 million Kindle Fires in Q4-2011.² Please read my previous article [Link] for reasons why the Kindle Fire sold well initially.

I did a survey of 10 Kindle Fire owners and asked them how many ebooks they bought in the first 3 months of ownership. The average was 3.4 ebooks. Using a blended average of $9.99 and $12.99 ebook prices from Amazon’s Kindle store I calculate an $11.49 ASP X 3.4 ebooks sold X 5 million Kindle Fires = $195 million of additional digital media revenue. That number nicely coincides with the upside in the media business vs. street expectations. Ebooks are also high margin as there is little to no cost other than bandwidth.

So the Kindle Fire is driving digital media sales and improving margins, that’s great news right? Not so fast.

In my same survey of 10 Kindle Fire owners, I asked them how many ebooks they intend to buy in months 4-6 after ownership. The average was 1.3 ebooks. The take-away is after a Kindle Fire owner first purchases the tablet, they populate it with a few ebooks in the first 3 months, but additional purchases taper off afterwards. That would be fine and dandy if Kindle Fire sold like the iPad quarter-after-quarter (Apple sold 15.4 million iPads in Q4-11 and 11.8 million iPads in Q1-12), but all the data-points show Kindle Fire sales slowed dramatically in Q1-12. I estimate Kindle Fire sold a paltry 1-1.5 million units in Q1-12.² Again read my previous article [Link] for reasons why Kindle Fire sales slowed.

Since Amazon takes a loss on every Fire sold, the irony is drastically lower Kindle Fire sales in Q1-12 also helped Amazon’s North America margins in Q1-12.

For the reasons given above, over-extrapolating Q1-12 y/y margin improvement as something sustainable is fool’s gold as it is dependent on the continued sales success of the Kindle Fire.

Furthermore all the arguments I laid out in my March Amazon article – “Kindle Fire Conundrum” section [read it again - Link] on the weak current and future competitive positioning of the Kindle Fire are equally valid, if not more so today.

In addition to the $199-$249 7-inch Google/ASUS Android 4.0 OS tablet which is slated to come out in July and the 7-inch Apple iPad which will probably come out in the Fall, a surprising entrant I did not realize a few weeks ago is Samsung. Samsung already released  7-inch Android 4.0 $249 Kindle Fire killer on April 22, 2012.

Kindle Fire “difference in performance noticeable..much rather own [Samsung]” TechCrunch review [Link]

“fuller version of Android.. more capable device” Verge review [Link]

“Samsung Has A Tablet That’s Better Than The Kindle Fire…Ice Cream Sandwich makes a much better tablet OS than Amazon solution” Business Insider review [Link]

It is highly unlikely with greater low-cost SKU tablet competition in 2H-12 with full-featured tablet operating systems like Android 4.0 “Ice Cream Sandwich” and Apple’s iOS (there’s a reason why dumbed down Microsoft Bob software failed and we don’t use Smith Corona word-processors anymore) that Kindle Fire sales will improve. And as Kindle Fire sales stay low, you can kiss long-term digital media sales and margin improvement good-bye.

Written by @firstadopter. Follow me on Twitter [Link]

² I estimate Kindle Fire sold 5 million units in Q4-11 and 1-1.5 million units in Q1-12 triangulating from the following data-points:

-Digitimes on 2/20/12 reported Kindle Fire shipments in Q1 fell to 1.5 million units.
-Taiwanese Economic News on 3/27/12 reported Amazon moved 5 million units in 2011 [Link]
-Texas Instruments mid-quarter conference call on 3/8/12 comments regarding new product Q4 OMAP product launch which was clearly the Kindle Fire: “customers are now rationalizing both their expectations for ongoing demand as well as the associated inventory”
-Supply chain checks from Pacific Crest and OTR show 75-90% q/q decline in component orders for Kindle devices
-Pro-rating USA Today Kindle Fire to iPad app download numbers comes out to 5-6 million Kindle Fire units [Link]
-Pro-rating ComScore’s recent 1 Kindle Fire to 10 iPad in use ratio also comes out to 6 million units if you take account some run-off in iPad 1 devices.
-Frequent sales for used Kindle Fires from Amazon at $139-179 and even Best Buy at $150 speaks ill of the demand and the return rate. Walmart also had $50 gift card sales promotion
-Barnes & Noble on a 2/21/12 conference call said their largest competitor (obviously the Kindle Fire) had a return rate of 15-25%

UPDATE: 1) IDC releases Q1 tablet report showing Kindle Fire shipments went from 4.8 million units in Q4-2011 to 700K in Q1-2012 [Link]

2) Target, the country’s second largest discount retailer, announced it will phase out and stop selling Amazon Kindles and Kindle Fires this spring [Link]

3) Ad firm Chitika issues a report showing Apple iPad has 95% market-share of tablet web-traffic vs. Kindle Fire’s 1% [Link]

4) Paulo Santos has an insightful article on how Amazon’s black & white Kindle e-reader business sales are collapsing [Link]

5) Digitimes on 5/10/12 reports according to their Taiwan sources Amazon will ship 6 million e-reader units in 2012 vs. Goldman estimate of 19.6 million [Link]

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.

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

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.

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)

______

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)

Proven Track Record of Blowing out Street Estimates the Last 4 Quarters

Source: Motley Fool (Link), Yahoo Finance

U.S. Store Rollout up More Than Triple-Digits Year-over-year to 9550 stores

Source: Ad Age full article link

1100 new Target stores, 1140 new Staples stores, 240 new Costco stores all rolled-out in the past month. The CEO was quoted on CNBC with Herb Greenberg that Walmart “is coming”. The CEO also said at J.P. Morgan conference on 11/30/11 “retailers like Trader Joes and Whole Foods.. You will start seeing things like that in the next year or so”

U.S. Store Growth led to Triple-Digit Sales Growth in Past and Likely the Future with Recent Store Add Acceleration of +45% q/q

New Un-penetrated Countries Will Drive Years of Future Growth
SodaStream household penetration in Sweden is over 25% with several European countries in the range of 17-25%. Household penetration in the U.S. is negligible. The company just launched in Japan (press release link) in October 2011 and announced it will launch in Brazil in Q1 2012 (press release link). Changes in the corporate presentation also strong imply an upcoming launch in India (my analysis link).

CEO quote from J.P. Morgan conference 11/30/11 on U.S. business trends: “bottom-line sales are triple digit growth in the U.S. Consumables are going through the roof. So we are very excited about the prospects of a strong holiday and strong long-term growth in the U.S.”

It’s a Great Product that Saves You a Ton of Money
I use my SodaStream to make me sparkling water and soda about 3 times a day. If you drink sparkling water, buying a Sodastream is a no-brainer. Read my article (link) on how you can get an amazing 16.6 cents per seltzer liter. It also helps save the environment with less plastic bottles wasted (link), costs less (link), and is better for you nutritionally (link).

The following are some reviews on the Sodastream model I own – the Genesis. You can read all 46 customer reviews here: (Bed Bath Beyond link)

Consumables Growth is Strong and Average Spend per U.S. Consumer Bodes Well for Future

U.S. consumable growth is stunning (look above at CO2 refills y/y etc.). The CEO said on 11/30/11 that average spending per U.S. consumer is $65/year much higher than world-wide average of $34/year, which bodes well for the future as the U.S. is only 30% of SodaStream’s revenue and growing at triple-digit annual rates.

Awesome Business Model and Barriers of Entry
Not only does SodaStream make money up-front selling soda-makers, the awesome part of the business model is the 80% gross margins (DB analyst estimate) it gets from CO2 refill exchange canister business.

Along with the 9550 stores in the U.S. that sell SodaStream sodamakers, 50% of them (4785 stores) participate in the CO2 refill exchange business. Stores love this as it drives repeat customer traffic. This distribution network is a huge barrier of entry for competitors as stores are unlikely to offer a second CO2 re-fill brand at their customer service desks. Moreover SodaStream has 5 million CO2 re-fill cylinders in circulation manufactured at $10 a piece, which represents a significant capital investment. The CO2 re-fill valve is also patented.

In developed markets where there is well-financed competition such as Sweden, SodaStream still dominates at over 80% market-share due to its brand, first-mover advantage, and distribution network.

Europe Revenue Risk

I believe the developed European market macro risk is over-stated. The developed markets in Europe (look above) are primarily 75%+ consumable revenue streams for SodaStream. Even if the macro situation worsens, it is high unlikely a family will cut down on $15 consumable CO2 re-fill every few months when in fact SodaStream saves them a ton of money vs. buying bottles. It’s a stretch to say any family will stop drinking sparkling water and go back to tap water to save that $15.

Europe growth has been overall strong, but even if it goes down to flat or single-digits, the triple digit growth in the U.S (already 30% of revenue) and new markets such as Japan and Brazil still give the company years of 20%+ growth runway.

Valuation and Short Interest
Most of Wall Street estimates for 2012 EPS are around $2.00 in USD earnings (Note Yahoo Finance estimates are in euros). Using the $2 number, the stock at today’s close of $29.85 is trading at 12.8Xs 2012 EPS ex-cash growing sales at 39% y/y in the last quarter.

Using the latest Nasdaq 11/15/11 short-sale data (link), short interest has increased 12% in the previous 2 weeks to 7,478,030 shares. That means roughly 54% of the float is short. High short interest to float numbers such as this have preceded massive short covering squeezes of 50-70% upward stock price moves in as little as 4 weeks (Examples: OCZ and BKS in the past 2 months).

Long-term annual targets

Summary
I believe SodaStream is the best “early innings” rollout growth story in the market. They make a great product that saves people money and is a proven household penetration winner world-wide. 

The company has blown out Wall Street estimates the last 4 quarters, accelerated U.S. store distribution 100%+ y/y +45% q/q, launched in Japan in October, and will launch in Brazil in Q1 2012. For all these reasons including the CEO repeatedly being quoted on Bloomberg, CNBC, and at Wall Street conferences about being “very excited about the strong holiday” I believe it’s highly likely SodaStream will post strong Q4 results.

Moreover the company will likely give strong 2012 guidance of at least 20% revenue growth and EPS growth of 25% as the CEO repeats those long-term annual growth targets on a monthly basis and in corporate presentations everywhere he goes.

Research Links
1. Official company Powerpoint presentation September 2011 (link)
2. J.P. Morgan conference 11/30/11 Powerpoint presentation (link)
3. My metrics financial model spreadsheet (link)

Sodastream CEO presentation on September 8, 2011 Link

Notice on “Slide 39” during a presentation the SodaStream CEO gave in September 2011; there is nothing on Target, Staples, and Costco.

Using the “Where to Buy” feature on the SodaStream website (Link), I find the product is now available in about 1/2 of Costco locations (a rough sample estimate) and every Target and Staples store in my area (Note: this may not be the same across the country). 

A friend of mine in California said SodaStream was recently made available at his local Costco. My wife told me she saw SodaStream being demo-ed and sampled last weekend at our local Costco on the East Coast. I called that Costco up and an employee told me they had 100 units in stock.

I drove to my local Staples tonight and saw a huge end-of-aisle SodaStream display with 12 units right out in front when you walk in. It was right next to the Green Mountain Keurig display. I talked to an employee who told me he set the display up TODAY and they have one more box of inventory in the back. I estimate this Staples store got 20 units shipped-in.

I drove to my local Target and found the SodaStream display in the home kitchen area next to the microwaves and water filters. There was shelf space for 20 units. It looked like about 5 units were sold. I used the inventory checker with one of the units and found there was no more stock in the back. A Target employee told me it was a recent launch.

In previous SodaStream conference calls, management talked about a small 12 store test trial at Costco, which we now know had a large roll-out ramp up in the past week to more locations. Management also talked about testing at a big box mass-market discount retailer in the past year. Now we know that was Target with a massive roll-out this quarter. The Staples roll-out today is another positive surprise.

Costco has 432 stores in the U.S. Target has 1767 stores in the U.S. Staples has 1575 stores in the U.S.  I do not know the exact store roll-out numbers, but from a dozen zip code searches on the Sodastream site’s “Where to Buy” feature it looks pretty significant across the board.

If you do the shipped-in math of 20 units per added Target and Staples stores and 100 units for 1/2 of the Costco stores for $80-120 per unit, it is easy to see upside vs. the Wall Street estimate for U.S. SodaStream revenue this quarter. Please note this is U.S. revenue only. I have no visibility on their sales in Europe.

If you look at today’s SODA chart you can see a little after 2PM there was a big dive in the stock and a big increase in trading volume. After an initial bounce, the stock proceeded to sell-off the rest of the day.

Reuters reported around 2:08PM that Coca-Cola said their Freestyle Fountain Machine should be in 80 markets by year-end.

As you can see, this led many people on Twitter to imply Coca-Cola was now “competing” with Sodastream. The action on the stream even got @StockTwits to tweet about SODA’s move to all 125,000+ followers on StockTwits. Even @Benzinga, a leading financial news site with 11,800+ followers, tweeted about the SODA move.

The only problem is if anyone did any basic research at all you would have found the following:

1) The Coca-Cola Freestyle Fountain machine is not new. It’s been around since 2009. Link

2) The Freestyle machine is huge and is primarily marketed to restaurants. Link

3) The Freestyle machine costs 30% more than a regular soda fountain and leases out for $320/month. Link

4) And it costs $18,000. Link

So does a product that was introduced in 2009 primarily for restaurants like Subway with ingredients that cost 30% more, and costs $18,000 per machine compete with a $100 Sodastream product sold to consumers at home? Really?

It’s clear the Coca-cola is “now competing with Sodastream” innuendo all over Twitter and the trading news sites today is complete and utter bunk.

Even CNBC’s Herb Greenberg, a noted skeptic of Sodastream in the past, agreed that SODA traded on a “false rumor” today.

I love Twitter. I love StockTwits, but let’s try to do a little bit of leg-work and research before we tweet and re-tweet information. That’s all I ask.

Disclosure: At time of writing, the author is long Sodastream stock which he scaled in on today’s misinformation driven afternoon dip.

In this post, I will lay out my response to the two most serious claims in Copperfield Research’s OCZ report. Then I will show why the current and future fundamentals of this AMERICAN company are strong with real revenue and real products, nothing like the Chinese reverse mergers with phantom revenues and vapor-ware products that Copperfield Research compared OCZ to. Moreover I will also show why OCZ will “highly likely” post fantastic financial numbers and guidance on their May 3rd, 2011 earnings report.

1) Copperfield Research is “shady, suspect, and deceitful” in manipulating the media

On March 22, 2011 Copperfield Research issued a report on EBIX with the title “Not a Chinese Fraud” to get attention. Using the sensationalistic keyword “Chinese Fraud”, even though it had nothing to do with the substance of the report, it got the publicity they wanted to drive down the stock and profit from their short position.

On April 20, 2011 Copperfield Research did the same saying OCZ “may just be the American version of the story above [a Chinese reverse merger stock implosion example]. This time Copperfield Research never uses the word “fraud” anywhere in their post or report. However that didn’t stop the media, bloggersphere, and Twitterati from using the “fraud” word over and over again spreading the Copperfield Research OCZ report story WITHOUT DOING ANY ANALYSIS on the veracity of the report’s claims.

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2) Irreconcilable Financials Claim

10Q Filing – 1/14/11

8-K Earnings Press Release – 1/10/11

Amended “Fixed” 10Q Filing – 4/21/11

Copperfield Research noted that the November 2009 quarter revenue segment table category numbers in the 8-K earnings filing and the 10Q filing did not match up and appear flipped. Instead of accepting the easy explanation of a typographical error by some poor first-year accountant who couldn’t copy/paste correctly, Copperfield Research alleged OCZ is deliberately trying to mis-lead investors by over-stating 325% y/y SSD growth because obviously the 10Q filing number has to be correct right? Wrong. [of course Copperfield Research insinuates the worst possible scenario, they are short OCZ stock]

OCZ filed an amended 10Q Thursday afternoon fixing the “typographical error” in the 10Q filing to MATCH the 325% SSD growth rate in the 8-K earnings filing. Here’s a quote from the OCZ press release [Link]:

“This morning the Company filed an amended 10Q for the period ending November 30, 2010 that corrects certain typographical errors in line item data related to product group revenue… The totals in the historical financials as previously presented were correct and no restatement of the financials is necessary.”

Yes I will repeat “no restatement of the financials” is necessary. The OCZ bears will have you believe a simple typographical error of a revenue segment table [remember the revenue totals were accurate, it was just the segment categories with the 325% SSD revenue growth y/y number actually being CORRECT] is the same thing as a Chinese reverse merger company mis-stating revenue by hundreds of millions of dollars, that is like saying Roseanne Barr is as beautiful as a Victoria Secret super-model. That just isn’t right!

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3) CEO’s past criminal record

Copperfield Research’s alleges that the company withheld information about the CEO’s criminal background to investors during the recent equity secondary capital-raise. Here is Needham [one of the under-writers] analyst’s response:

“Information Withheld On CEO’s Past: FACTUALLY INACCURATE. The buyside was made known of the CEO’s youthful indiscretions many years ago through the filings as well as throughout the roadshow, and our own conversations suggest that investors were not concerned with something so old and irrelevant to current product roadmaps and the future of the company.”

And Craig-Hallum [one of the under-writers] analyst’s response:

Here are the facts. The OCZ CEO has publicly admitted that his only felony conviction was in 1998 for “trafficking in stolen property in exchange for marijuana,” which was later reduced to a misdemeanor.

SEC Rule 401(f) clearly states a company must disclose if an executive “was convicted in a criminal proceeding or is named subject to a pending criminal proceeding” in the past 10 years. It is clear the company has gone above and beyond their legal obligations from the responses above.

That being said, it isn’t great that the CEO of OCZ tried to exchange stolen property for pot when he was younger even if it was many years ago. One must remember though when Steve Jobs was younger he once built and sold “blue box” whistles that let you steal from the phone company and make calls for free.

Steve Jobs also lied and basically stole money from his partner Steve Wozniak over payment from the work they did in making Breakout for Atari. People makes mistakes, would you short Apple today just because Steve Jobs did some bad even criminal things when he was younger? Of course not, you would research Apple’s products, reviews, how products are selling, and future fundamentals.

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4) OCZ SSD Drives are the best reviewed products in the industry and are selling like hot-cakes

I recommend everyone to ask their computer nerd friends what is the best reviewed SSD drive on the market. If he or she knows anything, they will say OCZ Vertex 3.

Storage Review OCZ Vertex 3 Review [Link]:

“In one generation OCZ has managed to nearly double its speed in synthetic benchmarks and blow the socks off older drives in real-world scenarios. Given the intended market of performance enthusiasts, the Vertex 3 will no doubt be a huge success..”

“Puts other SSDs to shame in our real world benchmarks.. Pricing makes top-tier performance available for only a moderate premium.. The OCZ Vertex 3 spanks the competition with up to 69% faster speeds in real-world conditions and has firmly established itself as the fastest SATA SSD we’ve seen.”

Anandtech on OCZ Vertex 3 [Link]:

“If you were excited about the performance of the Vertex 3 Pro but were put off by the price, it looks like that’ll be a non-issue thanks to the Vertex 3. The performance of this second generation of SandForce based SSDs is nothing short of astounding.”

Sure the reviews are great for the new OCZ Vertex 3 SSD drives, but how is it selling? Newegg.com is OCZ’s largest customer. I have been checking OCZ Vertex 3 product listings on Newegg.com in recent weeks and have noticed EVERY TIME the product goes in-stock it sells out WITHIN HOURS.

I’m not the only one noticing this, here is an internet post on the OCZ Vertex 3 sell-out mania [Link]:

End market customers are also gushing over the performance of the OCZ Vertex 3. Read the customer reviews on Newegg.com with quotes like this:

“Absolutely mind-blowing load performance” “This type of speed will spoil you!” “Rating: 5/5 Very Fast – Best Hardware Purchase” “Blisteringly fast! Works flawlessly”

With great reviews, high demand, and happy customers, I am extremely confident that the newly released OCZ Vertex 3 SSD drives will sell like hot-cakes for at least another 2-3 quarters. SSD drives are definitely one of the hottest secular growth stories in technology for 2011 and OCZ is the leader of this tech sub-sector.

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5) OCZ will “highly likely” post fantastic financial numbers and guidance on their May 3rd, 2011 earnings report

On 3/7/2011 [Link]: OCZ pre-announces upside for Q4-2011 ending on February 28th, 2011. Revenue will approximately be $64 million up +97.5% y/y. SSD revenue will be +380% y/y and +40% q/q.

On 4/21/2011 [Link]: OCZ announces May 3rd, 2011 earnings date for Q4 earnings.

Why is it highly likely OCZ will post fantastic Q4 numbers and guidance when they report earnings on May 3rd, 2011? Because they ALREADY PRE-ANNOUNCED fantastic Q4 numbers and guidance. On March 7th, 2011 they pre-announced amazing +97.5% y/y revenue growth and +380% y/y SSD revenue growth. On March 28th, 2011 they guided FY2012 revenue growth to +60-75% y/y.

In the past when OCZ reports earnings, they report the quarter and give guidance for the full year. Both revenue for the quarter and guidance for FY2012 have already been announced in recent weeks, so I believe it is highly unlikely especially just after raising $94 million capital a week ago, the company would change full year guidance for the worse.

So after all this above let’s look at the current situation. According to Yahoo Finance, 19.7% of OCZ’s float is held short as of March 31, 2011. It is highly probable this short interest has increased significantly in the past 2 trading days in the after-math of Copperfield Research’s OCZ report by short-term term traders who haven’t done any in-depth research on the truth behind Copperfield Research’s misleading innuendo and claims. Do the shorts really know the fantastic fundamentals of OCZ’s “best in class” SSD products, how big demand is, and how fast Vertex 3 is selling out? I doubt it.

How many companies in the technology market have revenue growth of +97.5% y/y today? How many companies have a product segment like OCZ’s SSD that has had a revenue growth ramp of +27% y/y, +81% y/y, +325% y/y, and +380% y/y in the past 4 quarters [amazing accelerating growth]? Not many.

Even Copperfield Research admits OCZ may have potential design wins from the likes of IBM, EMC, and HP. Will the shorts really want to be short when those tier 1 customer names are revealed? Will the shorts really want to be short when OCZ continues to post blockbuster growth numbers?

I actually called OCZ on Thursday to ask them if they would defend themselves point-by-point against the Copperfield Research report. What OCZ said was very telling: “We will let our numbers do the talking.” I don’t know about you, but I wouldn’t want to be short OCZ on May 3rd, 2011.

If you want more details on the OCZ growth story, I highly recommend their PowerPoint presentation the company gave at the Roth Growth Stock conference in March 2011 which can be found here: [Link]

Disclosure: At time of writing, the author is long OCZ stock which he initiated during the sell-off on the April 20th.

Who says you can’t find good stuff on Twitter. Here are my 5 best fundamental tweets from my Twitter feed in the last 4 months.

1. GMCR on March 9, 2011

The Tweets: I tweet that the only logical move for Starbucks (SBUX) is to do a partnership or buyout deal with Green Mountain Coffee (GMCR). I then send out an FA Alert to buy GMCR to put my money where my mouth is.

Result: The next day Starbucks announces a partnership deal with Green Mountain Coffee and FA Alert subscribers make a 27% gain in one-day (Trade screenshot Link)

2. SINA on March 2, 2011

The Tweet: I tweet that SINA is the best public stock market vehicle to play the web 2.0 internet bubble due to their ownership of the Chinese Twitter.

Result: Although I wasn’t smart enough to buy it myself, the social networking valuation bubble went into over-drive with SINA moving up from $77.15 on March 2nd to $119.35 on April 8th for a +55% move in 5 weeks.

3. NVDA and MMI on February 7, 2011

The Tweets: I tweet that Nvidia Tegra 2 tablets will flop and Nvidia is a short as that flop news comes out. I also say Motorola Mobility’s Xoom tablet will flop hard vs. Apple iPad.

Result: Nvidia Tegra 2 tablets including the Motorola Mobility Xoom flop. Nvidia (NVDA) trades from $25.32 on February 7th to $17.55 on April 8th for a decline of 30.7%. Motorola Mobility (MMI) trades from $30.88 to $24.03 in the same time period for a decline of 22%.

4. Short BGP, Long BKS on January 28-31, 2011



The Tweets: I tweeted a prediction that Borders Group will declare bankruptcy in the coming weeks and BGP will go down and BKS will go up on the news.

Result: Borders Group did declare bankruptcy and their stock BGP got de-listed. Moreover BKS did go up on the BGP bankruptcy news and FA Alert subscribers were able to bank huge gains (Trade screenshot Link)

5. Buy oil, gold, farmers, and web 2.0 holding companies on December 5, 2011

The Tweets: After ranting against Bernanke money printing, I lay out the plan on how to play QE2. Buy oil, gold, farmers, and web 2.0 internet vehicles.

Result: From December 5th to April 10th, oil trades up 27%, gold up 4%, MOO up 8%, and web 2.0 private internet valuations go up a gazillion percent (Facebook, Zynga, Groupon, etc.)

If you like what you see above, be sure to check out my two paid services below as that is where you can exclusively find my fundamental trading idea flow now:

1) FA Alert – email trade alerts: http://www.firstadopter.com/fa-alert/
2) FA Chat – trading chat room: http://www.firstadopter.com/fa-chat/

I walked into my local Apple store around 3:30PM today. There was a line of 3-4 people waiting for the iPad demo station outside. It took about a 5 minute wait to get my hands on a store demo iPad. The store employees told me they were sold out of the 64GB model, but had plenty of the 16GB and 32GB SKUs in stock. This is good news for flash memory manufacturers like Sandisk as it looks like people are leaning toward using it as a media center for all their movies, music, and photos.

I got to play around with it for about 15-20 minutes. Here are my initial impressions.

Pros
-The screen is the BEST I have ever seen on a portable device, even better than the LED display on the MacBook Pro. Stunning clarity and colors. Steve Jobs made the right choice going with an IPS panel. This IS an amazing digital photo album device.
-The extra screen space makes huge difference over the iPhone in productivity apps such as the calendar and email. You can use a physical switch to lock in orientation, which is a great new feature.
-It’s fast. Felt like 50% faster than an iPhone.
-The Book reader app / store is as good as everyone says. Amazon should truly be worried about Kindle sales.

Cons
-It felt heavy after holding it a while. I recommend getting a case with a kick-stand because it is going to get tiresome holding it for long periods of time.
-iPhone apps do not look good on the bigger screen with ugly pixelation. Not a big deal as most widely used apps will be updated for the iPad.

Net-net
-I will probably buy the 3G version later this month.
-This is the ultimate web-surfing on the couch and digital media consumption device.
-It did seem like more people in the store were there to “check it out” than buy it. In my time there, I only saw one sale.

There’s a lot of conspiracy theories out there about how the government is manipulating the stock market upwards (I’m looking at you Zero Hedge) by buying stock futures, etc. However a light bulb went off in my head after I read this Time magazine interview with Pimco’s Bill Gross on how simple the explanation is.

But secondly, there’s a ripple affect. Just speaking about Pimco’s general portfolio strategy, we’ve sold our agency mortgage securities, Fannie and Freddie, in the billions to the willing check of the Fed. They’re buying a trillion dollars of them, or have over the past 9-12 months, and so we sold them a lot of ours. Now, what did we do with the money? We bought Treasuries, we bought corporate bonds, and so the bond markets in general have benefited, as have stocks because this available money effectively flows through the capital markets. So it’s a trillion-and-a-half dollar check that won’t be there as the Fed withdraws from the market. How that affects the markets, I just don’t know. I’m not eagerly anticipating the answer, but I think it holds some surprises in 2010, not just in mortgage securities but stocks as well.

So basically Bill Gross, the largest fund manager in the world, explains it to us. The Fed has been buying $1.5 trillion worth of securities from financial firms at unnatural supply/demand and some would say inflated prices, who then use this big pile of money they get from selling to the Fed to buy other stuff like corporate bonds and stocks. This is $1.5 trillion that did not exist before. It is printed money that is flowing through the financial capital markets lifting all boats. A simple explanation for the markets’ rise.

To prove this let’s look at the timing of Fed mortgage backed security buy program announcements. In 2008 the SP500 bottomed on November 21st, 2008. I remember things being very scary then. The Fed then announced their first $500 billion mortgage backed security (MBS) buy program on November 25th, 2008 (Link). The market then rallied 25%+ off the low and topped on January 6th, 2009.

The market then tanked again and bottomed on March 6th, 2009. I remember things being even scarier then. The Fed decided to add $750 billion to the MBS buy program to the original $500 billion and $300 billion of long-term Treasuries for a total over $1.5 trillion of buying power on March 18th, 2009 (Link). In time this $1.5 trillion of printed money worked its way through the system, hence the amazing 70%+ rally.

The lesson is the next time the Fed announces another $500 billion+ capital markets buy program buy the market hand-over-fist, although I doubt this will happen anytime soon given the political climate. And the $1.5 trillion of securities that the Fed bought? Here’s what Bill Gross says about that.

They won’t sell — it’s a near impossibility to unload what they’ve purchased over past 12 months.