Is Amazon.com Set Up for a Crash?

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Amazon.com (NAS: AMZN) , probably the hottest Internet company on the NASDAQ, seems to have shrugged off a bad quarterly report in October and is poised to hit new highs going into the holiday season. There is certainly a lot of reason everyone is getting excited about Amazon, especially with its entry into the booming tablet market with the Kindle Fire line, but alarming factors like the company's lack of profitability could eventually send the shares into a death spiral.

Mixed signals from the bottom line
One of the more recent things that should irk you about the stock's behavior is the way it virtually shrugged off the bad data in Q3 2011, when Amazon's net income decreased an ugly 73% relative to 2010, despite huge revenue growth. The company has said it will continue to pursue strategies that expand its market share at any cost, and it expects a high chance of an operating loss this quarter.

A lot of the company's more recent expenditures can be attributed to the rapid expansion of its fulfillment centers. In expanding its warehouse network, Amazon is looking to reduce costs through the streamlining of its shipping routes. The likely result is that Amazon will continue to offer rock-bottom prices while keeping revenue growth strong, and since costs will be reduced, the company should be able to grow earnings more rapidly than usual. There are huge problems that shareholders seem to be forgetting, though, like the assumptions that the company is making while investing so heavily in its network.

These fulfillment centers are leased for long periods. And much as with brick-and-mortar stores, there is no exiting the contract once it's made. If revenue doesn't grow at least as quickly as Amazon is expanding its network, the company will begin to lose money quickly from the upkeep costs on the warehouses. On top of rent, the high costs of employees and shipping are considerable expenses that should be factored in, too.

The Kindle Fire: a new product, a huge gamble
On top of fulfillment-center expansion, the new Kindle family represents a more aggressive front of Amazon's business model. By pricing the new Kindle Fire at $199, Amazon is just breaking even on the components inside the device, and after factoring in shipping, warranties, and other costs it's losing an estimated $50 per Kindle, all in an effort to sell the product more aggressively. CEO Jeff Bezos has long had a history of moving into markets as early as possible, and this is no exception -- he's trying hard to grab a stake in the tablet market. While it's good to see that there is finally some viable competition arising for Apple (NAS: AAPL) , the aggressive pricing model that Amazon is approaching can backfire.

By selling the Kindle Fire at a $50 loss, Amazon obviously needs to make at least $50 on every Kindle's software just to break even. That's a tall order, given that the e-reader market has already been tapped to a large extent. Then there's the foregone opportunity of putting that huge pile of money into alternative investments, or actually selling the product at a profit. While it always costs resources to move into a new market, the company may have overextended itself here. It's certain that the low pricing model will draw more customers than usual, but the long-term prospects for the Kindle Fire aren't nearly as exciting.

Apple makes a hefty profit on every iPad sold. It has no problem increasing its sales volume in every consecutive quarter, even with much cheaper tablets and smartphones on the market. Apple never had to buy a fan base through artificially low prices but instead developed one through its innovation. Amazon seems to be taking the opposite approach, by focusing on pricing and buying a temporary customer base. In the long run, how is Amazon going to recoup the losses? Apple essentially got to keep its cake while eating it, yet it's trading at a price-to-earnings ratio of 14 while Amazon is trading well above 100.

We've seen "invulnerable" stocks before
Remember that not too long ago, Netflix (NAS: NFLX) was the bulletproof Blockbuster-killer with the invincible CEO. That company never needed a huge budget to increase market share, and it had huge momentum behind the stock. Eventually, when the pressure came to boost earnings, the subscription fees increased and people began dumping the service -- and fast. The share price got sliced in half in the next two months as a result and are down nearly 80% from their 52-week highs.

Those who are optimistic about Amazon can always point to the company's incredible revenue growth, which is impressive, but the company simply hasn't been able to generate enough money to justify the share price. When the company has to start focusing on earnings, the incredible revenue can disappear overnight, as Netflix investors learned the hard way.

Despite all the hidden flaws in the company's business model, Amazon needs a catalyst to cause the shares to collapse to more reasonable levels. It's tough to figure out when that will happen, but if anything can be said at this point, it's that there is a bloodbath just waiting to happen. At these levels, Amazon's shares are priced to absolute perfection and are essentially constructed almost solely on investor confidence in Bezos. If you spot smoke, get out, because there's going to be a fire.


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At the time this article was published The Motley Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of Amazon.com, Apple, and Netflix and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days.Fool contributor Brian Wilson owns shares of Apple and no other company mentioned in the article. You can email him at brian.wilson@hyperioncapitalresearch.com. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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