Amazon Investors Should Wait Out the Storm

Kindle Fire is pinching profits now, but it's a necessary evil

   

Here’s the dirty little paradox about Amazon (NASDAQ:AMZN); the reason investors often are unhappy with the online-retailer’s management, even while they value the stock at 90 times its forecast 2012 earnings: To compete aggressively in the long run, Amazon has to risk a lower near-term stock price.

Of course, competing successfully can secure profit growth that can keep the stock rising for years. Amazon’s playbook always has been to keep costs as low as possible, even if it means razor-thin profit margins. Amazon’s net profit has long been below 5% of revenue as the company sells goods at prices below its rivals and introduces loyalty programs like Amazon Prime, which increases sales per customer but requires Amazon to eat a lot of shipping costs.

For the past couple of months, investors once again have been bracing for a decline in profit margins at Amazon, thanks to the introduction of the Kindle Fire tablet. After Amazon announced the $199 tablet, it soon became clear the price tag was below what it costs Amazon to make it. And so, as InvestorPlace’s Anthony John Agnello pointed out last month, “Amazon might burn a hole in its pockets with the Kindle Fire even if it’s a success.”

That’s worrisome to investors. Because during the past six quarters, Amazon’s net profit margin has fallen from 4.2% to 0.6%. Some of the more bearish analysts are forecasting that Amazon will post a net loss as high as 26 cents per share this quarter, compared with a 14-cents-per-share profit last quarter.

The fourth quarter, of course, is Amazon’s busiest quarter by far, with nearly 40% of its annual revenue. A loss in the fourth quarter would be especially disconcerting. Amazon’s stock has fallen 27% in the past two months on these concerns, closing at $180.21 on Wednesday.

For its part, Amazon doesn’t seem troubled by this outlook. While Kindle Fire sales will weigh down margins in the next couple of quarters, it could boost revenue and profits of content sales for years as Kindle owners buy not only e-books, but movies, music and games to enjoy on the tablet.

Of course, investors and analysts might be underestimating the hurt that the Kindle Fire will put to Amazon’s earnings next year. On Tuesday, Goldman Sachs analyst Heather Bellini said she expects the gap between the Kindle Fire’s launch and the eventual increase in digital content sales to give Amazon a 2012 EPS of $1.42. That figure is not only significantly below the Street’s consensus estimate of $2.02 per share, it would be Amazon’s lowest EPS since 2007, when it posted $1.12 per share. It also would mean that Amazon is trading at a forward P/E ratio of 127.

Investors dreading a short-term swoon in profits might understandably be taking heart in recent reports of the clumsy launch of the Kindle Fire. Some users are discovering the tablet doesn’t work right out of the box. Others find it so awkward to use that one usability expert declared “the Fire is going to be a failure.” Then there were reports that the Kindle makes it easy for children to “charge up a storm.”

But even that development could hurt one of Amazon’s most cherished assets: its image as a consumer-friendly brand. If the Kindle Fire does fail, Amazon’s status as a tech innovator would be harmed, and it could open the door to other digital content portals such as Apple‘s (NASDAQ:AAPL) iTunes or a music/video/app store from Google (NASDAQ:GOOG).

Amazon’s best hope is for the Kindle Fire to be a big hit; to reach the broad base of consumers who want a tablet but find an iPad too costly. That will mean a lot of discomfort for AMZN investors focused on the next few quarters. But for investors with a longer-term view, it could strengthen Amazon’s role as the place where many of us buy stuff online.

As of this writing, Kevin Kelleher did not hold a position in any of the aforementioned stocks.


Article printed from InvestorPlace Media, http://investorplace.com/2011/12/amazon-stock-kindle-fire-amzn/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.