11/1/2011 11:30 PM ET|
Is Amazon about to catch fire?
Investors have punished the online retailer for investing in its future, making the stock look like a bargain. Particularly since projects like the Fire tablet are about to start paying off.
Amazon.com is the "go to" website for bargains on almost anything. At the moment, the retailers' own stock is a deal as well.
After getting beaten up following an earnings report, Amazon.com (AMZN) stock is trading about 15% below recent highs. To understand why that makes it a compelling buy, you need to consider what I will call the "forever clock rule."
This rule, espoused by Amazon founder Jeff Bezos, may sound whimsical, and not something to risk your hard-earned dollars on. But if you get this simple concept, you'll understand Amazon 100% better than the crowd in the market that dumped the stock last week.
Buy at these prices and you'll get:
• An early piece of the Fire, Amazon's soon-to-be hot gadget.
• A chance to make lots of money as the stock regains ground and keeps going.
• A lesson in why long-term thinking is as important in investing as it is in life.
If you believe in forever . . .
Here's the idea. In a remote Texas mountain, Bezos is building a clock designed to last 10,000 years, at a cost of $42 million. His forever clock. (I wrote about it recently in "Billionaires chasing big, bold dreams.")
His point? He hopes the clock will teach people the value of long-term thinking.
This long-term approach, the forever clock rule, is the rule Bezos has used to run Amazon since he founded it in 1994. It explains why Amazon survived the tech bubble and went on to thrive while so many competitors blew up.
And it explains why investors dumping the stock were making a big mistake.
After all, they were upset that Amazon's operating margins tumbled almost 3 percentage points to 2.4%. But this wasn't bad news; it was good news. It was good news because of why margins fell. Amazon is investing heavily in its long-term future, pouring money into stuff like infrastructure, digital-content rights and new devices like the Kindle Fire tablet, due out Nov. 15. (Pre-orders are being taken now.)
"Amazon has always invested in infrastructure years in advance. And they were always criticized by analysts, and the analysts were always wrong," says Howard Davidowitz of Davidowitz & Associates, a retail consulting and investment banking firm.
Indeed, while other tech stocks shot up in the tech bubble and then flamed out, Amazon's stock is higher now than it was back then. It's also posting revenue growth of 39% a year. Why? It's because of the forever clock rule -- the willingness to sacrifice near-term profit margins for long-term dominance. This strategic thinking is why shortsighted investors were punishing Amazon stock.
Davidowitz says a key differentiator of most successful retailers, like Bezos, is that they believe market share comes first, over profit margins, at least in the near term. "I worked with (Wal-Mart Stores (WMT) founder) Sam Walton for 20 years and he never said, 'How much margin can we get?' He always said, 'How much business can we get?' He knew if he got the business the margin would follow."
OK, so what exactly is Amazon investing in? After all, companies make investments all the time, and a lot of them don't work out. Why should we think Amazon's big investments will pay off?
The short answer is that Amazon has a long history of making investments pay off for shareholders. I don't see any reason to think that's changed.
More specifically, Amazon is pouring money into everything from its order-fulfillment centers, data centers and video content, to basic research and development that will create the devices it needs to deal with big threats from Apple (AAPL) and others.
To simplify things, I'll break out the investment strategy into two areas, basic infrastructure, and dealing with the Apple threat.
Infrastructure built for customers
Above all, Amazon is investing heavily in keeping customers happy. A big part of why Amazon is popular is that its site is so easy to use. Your stuff arrives on time and usually in good shape. And if it is broken, or you want to exchange it, the process is fairly painless. You don't even have to pick up the phone, a real blessing in this era of highly annoying and time-wasting phone trees.
With Amazon growing so rapidly, posting sales growth of 39% a year and customer growth of 20% a year over the past four years to hit 152 million in October, the company needs to invest heavily in infrastructure just to stay ahead of all those customers.
"We're seeing the best growth which we've seen since 2000 . . . . And so with this strong growth, we're investing in a lot of capacity," finance chief Tom Szkutak said in Amazon's Oct. 25 conference call. "We remain heads down, focused on driving a better customer experience...We believe putting customers first is the only reliable way to creating lasting value for shareholders."
Amazon is adding 17 fulfillment centers to its base of 52 centers where people package and ship orders. And it may well add the same number next year, believes Deutsche Bank analyst Jeetil Patel, who has a buy rating and a 12-month price target of $246 on the stock. Indeed, Patel takes the aggressive investment in capacity as a very bullish statement by Amazon that "future prospects look solid, especially internationally, where a majority of these centers were opened."
Morningstar analyst R.J. Hottovy predicts Amazon sales will grow 28% a year, on average, over the next four years.
A bite of Apple's action
For Amazon, investing for the long term isn't just about keeping customers happy. To put it bluntly, it's about keeping them away from Apple.
Consumers love Apple devices, of course, because they're cool and easy to use. But from a competitive perspective, they're also a trap, as well. For all Steve Jobs' affable alternative aura, we learn from Walter Isaacson's just-published biography that he was also a bit of control freak. This is reflected in the Apple ecosystem.
Apple customers load their stuff into an iTunes library, then download tons more stuff from iTunes store. Customers with a variety of Apple gadgets tend to stay inside the virtual iTunes mall, and Apple controls who can sell there and who can't.
Amazon risks getting shut out of the digital content shopping mall as consumers increasingly migrate from desktops and laptops to tablets, a segment currently dominated and controlled by Apple. And it can't let that happen, says Eric Johnson, a professor at Dartmouth College's Tuck School of Business, and the director of the Glassmeyer/McNamee Center for Digital Strategies. "The strategic consequences are way too high."
So Amazon has invested heavily in a line of tablets meant to challenge the iPad -- starting with the Kindle Fire.
To date, Amazon has sold e-readers, Kindles that let users read books on a black-and-white screen. In contrast, the Fire has a color LCD display and will provide access to streaming movies and TV shows. Users also get access to downloadable songs, books and magazines, all of which can be stored in Amazon's cloud, a vast network of computers accessed via the Web.
The Fire's Silk browser pushes computing tasks to the cloud, making it run faster. And here's the kicker: The browser naturally makes it very convenient to buy digital content, and other stuff, from Amazon.
Given how big a hit the iPad has been, will consumers go for the Kindle Fire? I think it's a no-brainer.
First off, Amazon has a great record with its Kindle e-readers. Growth has been great. Amazon is secretive about device sales data, so I turned to IDC, which makes sales estimates based on intelligence gathered from supply-chain contacts. As of the end of June, Amazon had shipped 6 million of the devices this year. So the company already was well on its way to beating last year's shipment total of 6.9 million. In the second quarter, Amazon sold 52% of all e-readers, says IDC. In short, Amazon clearly knows how to sell devices.
And with the Kindle Fire, Amazon is following its forever clock rule, which will virtually assure good sales. It's almost giving away the device. The Fire's price, at $199, is well below the $499 starting price for the iPad. It is also as much as $55 below what it costs Amazon, when you include manufacturing and marketing, says Deutsche Bank's Patel.
That's fine with Amazon, because it thinks it will be able to sell enough books, magazines and music to cover its costs and earn a profit over the lifetime of the device. "Amazon is, in effect, seeding the market with their devices," says Danielle Levitas, vice president of IDC's consumer, broadband and digital marketplace division.
"This is typical Bezos," says Davidowitz. "He is buying market share. Isn't that his record with everything he does?"
Essentially, Amazon's approach is the flip side of Apple's. Apple makes money via premium prices on devices, and not so much on content. In contrast, Amazon is selling devices at a loss, with an eye toward making money on content.
JPMorgan Chase (JPM) analyst Doug Anmuth thinks Amazon will sell 5 million Kindle Fires in the fourth quarter. For context, Apple shipped 11.1 million iPads in the third quarter, according to IDC. In other words, in a single quarter Amazon will vault into the position of being a serious iPad competitor.
To be clear, the Fire is no iPad substitute. For one thing, the Fire has a seven-inch screen, compared with the iPad's 10-inch screen. But Tom Mainelli, a research director at IDC, thinks Amazon will roll out a Kindle Fire with a 10-inch screen in 2012. "I think Amazon ships at least half as many units as Apple, in 2012, if not more," he said.
Others burned by Fire
While primarily designed to take on Apple, Amazon's Fire is going to burn several innocent bystanders in the process. Things don't look too good for the Nook Color media tablet offered by Barnes & Noble (BKS). It costs $50 more than the Fire, and it doesn't offer such deep access to content or cloud storage. The BlackBerry PlayBook, the 7-inch tablet from Research In Motion (RIMM), also looks like a potential victim, given its now-absurd price tag of $450.
Amazon looks set to do even more damage to established players in digital streaming content, like Netflix (NFLX). This is a huge, early-stage consumer trend. There are currently 9 million households in the U.S. watching digital streaming content like movies, a twofold increase over last year, says Levitas of IDC. Watching streaming digital content, as opposed to DVDs, will continue to grow rapidly as people become more comfortable with it. The Kindle Fire will no doubt help that happen -- and put more consumers in the hands of Amazon, instead of Netflix, in the process.
All of this means Amazon is being punished by the market for investments that look to start paying off as soon as next year. Remember the forever clock rule, ignore the naysayers, and an investment today could pay off for years to come.
At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
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