Sorry, I Don't Buy It
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I know that there are going to be many people that disagree with this post. However, I honestly believe that sometimes investors get so enamored with what they assume will happen, that they forget to look at real results. This appears to be what's happening with Amazon.com (NASDAQ: AMZN). The company's most recent earnings report reminded me a lot of what we used to see near the year 2000. A company would report much higher sales and very little earnings and be applauded for “investing for the future.” The problem is, similar to the year 2000, investing for the future does little good if the future doesn't turn out the way investors and the company expect.
Distribution Matters, But That Isn't The Big Problem:
One of the key issues most people see at Amazon is that the company is spending a tremendous amount of money to set up new distribution centers. In theory, these additional locations will allow better shipping times in the future. The most recent example is an article by Brian Stoffel who actually said, “without these expenses, I wouldn't be investing in the company.” His assumption is that the cost for building out these distribution centers will subside eventually, leading to much better earnings. While at some point this assumption could prove true, there are issues at Amazon that are not connected to the cost of building out this distribution network.
Growth In Revenues And Many Red Flags:
In the most recent quarter, net sales increased 29%, and North American segment sales grew 36%. The main issue that I see with assuming that this revenue growth will continue in the future is, there are multiple red flags that show that Amazon's strategy may not lead to the huge earnings expected. The first issue is within the North American division.
With revenue up 36%, what has been lost is the fact that the majority of sales growth came from consolidated electronics and other general merchandise. This category actually showed 38.46% growth in sales compared to media sales, which increased just 12.54%. There are two problems when you think about these numbers. One of the arguments for buying Amazon is that the company should be able to sell an increasing amount of digital content. That is not happening, as the percentage of electronics and general merchandise sold has increased from 62% just five quarters ago to 66% today. When you consider that Amazon has introduced multiple new Kindle devices hoping to drive digital sales growth, this is particularly troubling. The second issue is that the growth rate in electronics and general merchandise is dropping sequentially. Just over a year ago, the growth rate was 56%; in the most recent quarter this dropped to 38.46%. In addition, investors should be concerned that Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) have higher operating margins at 5.65% and 7.62% respectively, versus just 0.83% at Amazon. In plain English, Wal-Mart and Target can both afford to cut prices to compete more effectively if they need to. Amazon, on the other hand, has major challenges with its international division that are significantly harming the company's financial results.
What Is Going On Internationally?
On the surface, international segment sales increasing 22% would seem to be good news. However, the company saw a massive drop in operating margin from 3.82% last year to just 0.29% this year. This was a huge factor in Amazon reporting net income down 96% year-over-year. Amazon has virtually no room to cut prices further without reporting losses in this division. What was equally significant was the company's expense growth which led to such a small profit on a massive amount of sales.
Expenses Are Growing And It's Not Just Distribution:
Amazon reported that operating cash flow increased by over 40%, but capital expenditures increased 51.73%. The combination of these two factors led to negative free cash flow of $63 million. Two of the major contributors to this expense growth were: Fulfillment expense increased 44.1%, and technology and content expense increased 55%. While the fulfillment expense could drop in the future, technology and content expenses will likely rise if the company continues on its current path. One of the differentiating factors that's driving Amazon Prime is the ability to stream instant video for more than 18,000 movies and TV episodes.
Bad For Netflix = Bad For Amazon:
In a recent Motley Fool video, Lyons George talked about the Amazon Prime service. His commentary suggested that Amazon is growing its streaming library into a serious threat to Netflix (NASDAQ: NFLX). He said that the offering represents a real value at just $79 a year, giving members both free two day shipping and unlimited streaming. However, Netflix's content library, even though it's much maligned, is far better than what Amazon Prime offers. Second, the Netflix experience is light years ahead of what Amazon members have to deal with. Amazon offers no queue, no ability to stop watching the video and then pick it back up where you left off, and is available on fewer devices. Longer term, Netflix and Amazon face the same challenge. As more people watch the videos, higher licensing fees will be required. The company is making a choice to lose money to try and gain customers, but there are only so many ways the company can lose money before these losses become unacceptable.
Losing Money To Grow To What Point?
Proponents would suggest that greater distribution leads to greater satisfaction. However, many customers are already making a trip to Wal-Mart or Target once a week basis to pick up necessities. These necessities are not sold through Amazon such as items like meats, vegetables, frozen foods and the like. Unless Amazon is going to enter the grocery market, customers will still have to make this trip to restock their pantries. It's much easier to pick up a few extra items while getting groceries than it would be to buy the groceries, go home, sign on to Amazon, buy the other items and wait for them to be delivered. In addition, how many ventures can the company lose money on? The increased cost of content for the Prime service, more distribution centers, losses from the Kindle lineup, and free two-day shipping, all equal a much less price-competitive Amazon.com. Any company selling at over 80 times next year's earnings carries with it risk. Missed opportunities or operating issues could cause Amazon to slip into the red, which is what the company is forecasting in the next quarter. If you add it all up, I just don't buy it.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.If you have questions about this post or the Fool’s blog network, click here for information.