The Truth About Amazon's Drones

BALTIMORE ( Stockpickr) -- The day before Cyber Monday, ( AMZN) CEO Jeff Bezos announced that his company was working on delivery technology that would disrupt the industry: autonomous drones that fly your Amazon orders right to your door.

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Amazon shareholders should be thrilled about the announcement -- but not because Amazon Prime Air could change how customers receive packages from Amazon. Instead, shareholders should be thrilled because Bezos & Co. generated some incredible buzz for Cyber Monday just by showing off some pricey toys.

The truth is, that's just about all Amazon's drones really are at this point. And for Amazon, that's probably a good thing; after all, introducing drone delivery introduces a host of problems.

I'm not just speaking as a stock analyst here; I'm also an active, licensed pilot. From both a regulatory and a practical viewpoint, Amazon Prime Air doesn't add up -- at least not the way that it was shown to us on TV.

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So today, I'll show you the truth about Amazon's drones. More important, I'll show you why Amazon has a much easier path to disrupting the delivery business after all.

Regulatory Hurdles

The most obvious barrier to drone delivery is regulatory. Recall, it took about two decades for the Federal Aviation Administration to OK the use of Angry Birds during all phases of flight on airlines. The FAA is probably the slowest-moving government agency -- and it's by design.

The FAA doesn't want any surprises when it enacts a new rule.

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That means that any big changes to the Federal Aviation Regulations are drawn out. While the FAA is mandated to integrate unmanned aircraft into the national airspace system by 2015, the agency is behind schedule, and most of the focus has centered around remotely controlled UAVs, not autonomous ones like the ones Amazon is touting.

The amount of additional testing required to demonstrate that Amazon's octocopters can safely self-navigate to the FAA's standards is going to be immense -- and very costly. Couple that with the fact that many of the more densely populated U.S. cities are blanketed with restrictive Special Flight Rules Areas (in New York and Washington D.C.) and heavily trafficked Class B airspace, and suddenly the regulatory challenges increase.

The best example probably comes from Amazon's Prime Air promo clip shown on 60 Minutes: Amazon and the FAA both confirmed that Amazon's drones are currently illegal here at home, so the firm had to shoot its video clip overseas.

Will the System Work?

All of the regulatory challenges assume that Amazon's Prime Air will work as advertised in the first place.

Amazon's presentation gave us a pretty good idea of the niche that Prime Air would be used for: shipping small items under five pounds within a 10-mile radius of a distribution center within 30 minutes. It certainly sounds like an attractive service, especially when you consider the fact that it covers around 86% of the items Amazon delivers.

But the logistics seem a little questionable.

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For an Amazon drone to make the 10-mile trek one way in 30 minutes, it would need to be traveling at a brisk 20 miles per hour, and that assumes a direct flight path from the distribution center to the destination. If the FAA allows drones to fly "highways in the sky," it could add significant mileage to a trip. That also doesn't factor in shipment preparation times. If it takes 10 minutes for Amazon's teams to prepare an order, we're talking about a 30 mile-per-hour ground speed to make a 30-minute delivery.

For a two-foot-square aircraft, that's a scale speed of around 300 miles per hour for a full-scale helicopter. On a breezy day, scale speeds of 500 miles per hour may be necessary to hit that same 30-minute delivery time.

We don't know how much Amazon's drones are going to cost. Package delivery firm DHL is testing drones of its own that currently run $54,900 each -- and that's for a vehicle with half the payload of Amazon's octocopters. It's reasonable to think that Amazon will be able to acquire a fleet of octocopters in a few years for much less than that -- until you amortize R&D costs for FAA certification across each aircraft.

Because Prime Air can only carry one item at a time, Amazon needs at least one aircraft for every order that it receives from the time one drone gets sent out to the time it returns for another pickup (longer if we add recharging to the equation).

The costs will be material, and so will the load on the airspace system; it would take around 1,500 drones to replace every semi trailer that comes out of an Amazon distribution center.

That means that margins are also a consideration. While AMZN's five-pound payload covers the majority of its shippable offerings, it doesn't cover the majority of the offerings that have the most margin available to cede to a costly new shipping method. Amazon's highest-margin products are things that don't get delivered at all, such as eBooks and Amazon Web Services.

Capture the Drone

We shouldn't forget about the challenges along the trip.

Some drones will be intentionally damaged and stolen. Weather will ground others. And accidents will take out more of them.

When drones reach their destinations, will Amazon be on the hook for maiming children and animals with eight sets of spinning rotors? Or will it add cost and decrease payload by adding guards to its octocopters?

Since Amazon Prime Air will be marketed toward customers who live in densely populated areas (10 miles from a distribution center), what happens when someone who lives in an apartment on a busy street makes a Prime Air order? Does it get dropped 10 yards from the door to the building?

A System That Works

All of the drone talk seems even crazier when you consider the fact that Amazon is investing huge amounts of money in its own present-day delivery infrastructure. Amazon Fresh, a grocery delivery service, sports a growing fleet of trucks making same-day deliveries to customers in Los Angeles, San Francisco and Seattle.

We already have a mature road infrastructure in the U.S., with increasingly fuel-efficient trucks that can carry hundreds of packages in a single run. Better yet, by keeping delivery in-house with its own trucks, Amazon can also handle hassles (like returns) more easily than ever before. If Amazon is thinking about moving its distribution centers closer to cities, cutting out the middleman with Amazon Fresh makes far more sense than drones ever did.

In fact, if the firm is so bent on cutting humans out of the delivery process, autonomous delivery trucks make a lot more sense than drones do too. After all, our road system is meticulously mapped, road conditions are far more predictable and consistent than air conditions are, and trucks don't need to return home after every delivery.

But autonomous vehicles, like drones, aren't investible right now. They're too pie-in-the-sky to be on your radar as an Amazon investor. In the meantime, it makes sense for Amazon to continue to build on its Amazon Fresh service in additional markets, human drivers and all.

There's no question that Amazon is a "castle in the sky" stock. It hasn't had a P/E ratio under 100 since 2011, and less than 2% of the firm's market cap is covered by cash on its balance sheet. Translation: AMZN isn't cheap by any stretch of the imagination. But momentum is still very much intact, and that means that the time is right for Amazon to make meaningful investments while costs of capital are low and its valuation is rich.

Don't expect to see drones making dropoffs at your house by 2015 -- but same-day delivery still looks like a promising enhancement for AMZN.

-- Written by Jonas Elmerraji in Baltimore.


Follow Stockpickr on Twitter and become a fan on Facebook.

At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to
TheStreet . Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily , and on Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

Follow Jonas on Twitter @JonasElmerraji

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