Amazon

Amazon (AMZN) is the world’s biggest e-commerce retailer which has been growing revenues at a tremendous rate over the last decade. Amazon has not restricted itself to e-commerce, but has branched out to a number of other hardware and software segments. The company was one of the first ones to enter the tablet and e-reader market with its Kindle product. Amazon was also one of the first technology companies to realize the potential of cloud computing and is now one of the leading companies through its Amazon Web Services (AWS). The Jeff Bezos led company has also cleverly exploited the open source weakness of Google’s (GOOG) Android operating system to build its own software layer over Android.

Though Amazon has been diversifying, the company still depends on online retail segment for the vast majority of its revenues. The other problem is that the company’s profit margins are extremely low. The company operates in the highly competitive retail industry where net profit margins are in low single digits. This means that Amazon generates a fraction of the gargantuan free cash flows generated by its principal competitors like Microsoft (MSFT) and Google. This makes us think that Amazon is stretching itself too thin by expanding into too many markets without having the money to sustain these efforts. I think this strategy weakness coupled with Amazon’s sky high valuation makes it a good short.

Amazon’s new Ventures and the Risks

1. Cloud Computing

Like tablets, Amazon saw the potential size and growth of the cloud computing market quite early. Amazon starting providing a number of cloud computing services and it is one of the leaders in this space. Google and Microsoft are now eyeing this rapidly growing industry. Both companies have tremendous strengths that Amazon lacks. Google has got the biggest data centre capacity in the world as it spends billions of dollars each year to strengthen its computing infrastructure. Microsoft has almost three decades of experience as being the undisputed leader in the enterprise software segment. It’s Windows operating system and Office productivity suite is universally installed in almost every big corporation in the world. Microsoft has decided that it is time to move to the cloud computing space and has launched the cloud computing variant of its popular Office software. ValueAct Capital Management purchased a $2 billion stake in MSFT as they think that Microsoft will become the No.1 player in the cloud computing industry. Amazon is outmatched by Google and Microsoft both in intellectual and money power. At best, it can hope to become the No.3 player in this industry. Amazon is already feeling the pressure as AWS has lowered prices 31 times since it launched in 2006, including 7 price reductions so far in 2013.

Read about Cloud Computing Companies in India.

2.Tablets and E-readers

Amazon was the first company to understand the potential of the e-reader/tablet market and came out with its very successful Kindle product. However, the market has undergone a sea change with the iPad totally transforming the market. E-readers have become obsolete with tablets taking their place. Seeing the tremendous success of the iPad, hundreds of competitors have entered the tablet market to capture a slice of this massively growing market. Technology giants like Google , Microsoft , and Samsung (SSNGY.PK) are focusing their massive resources into the tablet market. Given the level of competition, I don’t think that Amazon will remain a top player in the market. At best, it will become one of the many niche companies in the market.

3. Smartphones

After tablets, Amazon wants to launch a smartphone and rumors have been floating around about a new Amazon smartphone. The smartphone industry is seeing severe competition with top companies trading in low single digit P/Es. Smartphones have become the most important segment in the computing industry and every Tom, Dick and Harry wants a piece of it. This has led to tremendous competition which is putting pressure on the weaker players. To enter the smartphone industry at this point of time looks foolhardy.

4. TV Set Top Box

Amazon continues to surprise me with new product announcements despite its thinly stretched resources. The company now plans to release a television set-top box that would stream video over the Internet into customers’ homes. Note Intel (INTC) which is the world’s biggest semiconductor company (and one of my top picks in the technology industry) has also announced plans of building a similar product. Google and Apple (AAPL) are also planning to come out with new TV products. Microsoft already has a presence in the living room though its Xbox game console.

5. Online Advertising

Amazon is positioning itself to compete with Google for a slice of the massive online advertising market. Google is the undisputed king of online advertising with almost every big online publisher using Google Adwords network. Amazon sells the ads on its websites through its in-house ad network. Now the company plans to expand this division to sell ads of 3rd party publishers. Amazon has an edge as it has information about the buying behavior of millions of consumers. I think this is one of the better expansion opportunities for Amazon as it will allow the company to enter a large market without spending too much money.

Read about Indian Online Advertising Market – Advantages, Problems, Statistics & Types.

Amazon’s e-commerce model is also under attack

Amazon’s e-commerce segment growth has slowed down in recent quarters as competitors have started becoming more aggressive. Its biggest online retail competitor eBay (EBAY) is starting to show an improved performance after lagging Amazon for a long time. eBay also has much better margins than Amazon. Other technology companies like Google and Apple are also getting into the e-commerce industry. While Apple is not explicitly competing with AMZN, its iTunes stores sells millions of digital products like songs and eBooks every quarter. Google Shopping is now directly competing with AMZN for e-commerce dollars. Brick and mortar retailers like Wal-Mart (WMT) are also becoming better in selling stuff online.

Amazon Stock Price Action

Amazon’s stock touched an all time high of ~$285 before reporting it quarterly earnings results. The stock has continued to trend up confounding bears that have been shorting it based on the company’s sky high valuation. Shorting Amazon has been one of the worst trades in the past few years as the stock keeps going up despite the company reporting meager profits. The company’s stock fell sharply by ~8% after the company reported results which did not meet buy side expectations. The stock has traded in a ~$205 to ~$285 range over the last year.

Valuation is too expensive

Amazon has one of the highest valuation multiples amongst large cap technology stocks. The company has a market capitalization of more than $115 billion with a forward P/E of ~60x and P/CF of ~28x. I fail to understand how the company is being given such a high valuation despite the competitive risk that the business faces. Bears have tried and failed at shorting the stock for a long time as Wall Street loves Amazon.

Summary

Amazon is trying to compete with technology giants like Microsoft , Google and Apple (Apple). However, the company lacks the massive free cash flows and margins generated by these companies. Its e-commerce business does not generate the kind of cash that Google’s Search or Microsoft’s Windows business does. The luxury of billions of dollars in operating cash flow every year allows GOOG and MSFT to enter many new segments. Amazon does not have the capacity to match them. If the company fights the technology war on too many fronts, it might collapse. Amazon has a much higher valuation compared to other big technology stocks which means that the company will fall long and hard if it fails. I would advise investors to avoid Amazon due to its high valuation.