Amazon.com’s (AMZN) third quarter earnings (including an $18 million gain from non-operating investment activity) beat the Zacks Consensus Estimate by 3 cents, or 6.3%. However, excluding this gain, results would have fallen a penny short.
Revenue clearly did not disappoint, beating the Zacks Consensus by 2.8%. Therefore, the lackluster earnings may be attributed entirely to Amazon’s continued investment in fulfillment centers and infrastructure build-out that should help drive growth going forward.
Although investors did not treat the results with enthusiasm (the shares dropped 3.86% in after-hours trading), we agree with management’s strategy and continue to believe that investment at this time will help meet the strong demand it continues to see.
Revenue
Revenue of $7.56 billion was up 15.1% sequentially and 38.7% year over year (at the high-end of management guidance).
Approximately 55% of sales were generated in North America, representing sequential and year-over-year increases of 14.9% and 45.1%, respectively. The balance came from the International segment, which grew 15.4% sequentially and 31.8% year over year.
The revenue growth was attributable to a 41% increase in units and an increase in active customer accounts to 121 million. Amazon also benefited from higher third-party sales, which are a percentage of revenue earned by its partners on goods sold in its online marketplaces. Active seller accounts stayed above 2 million, with seller units at 34% of total units sold on Amazon properties.
Key strategies for driving revenue growth remain a vast selection, competitive pricing, free shipping, user experience on Amazon properties and the Amazon Prime program.
Segment Details
Amazon’s North America Media business increased 20.2% sequentially and 12.7% year over year. Overall media sales were strong across the board, with particular strength in books. However, the year-over-year growth was impacted by tougher comps on the music side, particularly with respect to Michael Jackson and Beatles titles.
The Electronics and General Merchandise (EGM) business in North America increased 11.3% sequentially and 79.9% from a year ago. This was again the strongest year-over-year growth in the last two years. The company records ebook sales through Kindle devices under this segment and it looks as if this business continues to do well during the quarter. We believe that additional color on the pricing rather than just the number of books sold would enable a better estimation of book sales.
The International segment was up 15.4% sequentially and 31.8% year over year. The media business (23% of total revenue) grew 13.5% sequentially and 16.0% year over year. EGM, which was around 22% of total revenue grew 17.5% sequentially and 54.5% year over year. The addition of new product categories, better selection within categories, competitive prices and stronger sales from Prime contributed to the increase.
Operating Results
The gross margin declined 104 bps sequentially to 23.5%, although it was up 10 bps from the year-ago quarter. Sequential variations in gross margins are largely mix-related, although pricing is growing into an important driver as well. Competitive pricing in international markets continued to impact year-over-year comparisons, especially since the International segment is seeing much stronger growth rates. Third party sites are also doing well, which usually impacts the margin.
Additionally, Amazon has launched many new categories in this segment and initial costs on new products are usually high. As a result, International the gross margin declined 60 bps and 80 bps from the previous and year-ago quarters, respectively. The North America gross margin dropped 139 bps sequentially, but grew 57 bps from the year-ago quarter. Gross profit dollars increased 10.3% sequentially and 39.4% year over year.
The operating expenses of $1.5 billion were up 12.5% sequentially and 47.4% from the year-ago quarter. Fulfillment expenses increased 13 bps sequentially (as a percentage of sales), while all other expenses saw sequential declines. Out of the 13 fulfillment centers planned for the year, Amazon has already set up 10. The rest will be up by year-end. Therefore, there may be a slight increase in the current quarter as well.
Year-over-year comparisons show significant increases in both fulfillment and marketing expenses. Management stated that marketing costs, which primarily come from paid search and associates, were impacted by the inclusion of Zappos, which was absent in the year-ago quarter, as well as additional expenditure on TV ads for Kindle.
The operating margin of 3.5%, was down 57 bps sequentially and 106 bps year over year. However, operating profit dollars were flattish (down 0.7% sequentially), but up 6.8% year over year.
The North America operating margin shrunk 106 bps sequentially and 98 bps from the year-ago quarter. The International segment operating margin shrunk 66 bps sequentially and 118 bps from the year-ago quarter. The International segment decline was largely related to pricing and further impacted by higher costs of operation, as Amazon continues to increase selection and product lines and also expand geographically.
Amazon generated first quarter net income of $231 million, or a 3.1% net income margin, compared to $209 million, or 3.2% in the previous quarter and $180 million, or a 3.3% net income margin in the same quarter last year. There were no one-time items in the last quarter. The GAAP EPS came in at $0.51 compared to $0.45 in both the June 2010 and September 2009 quarters.
Balance Sheet and Cash Flow
Amazon ended with a cash and investments balance of $5.89 billion, an increase of $777 million from the end of the previous quarter. The company generated $855 million of cash from operations and spent $315 million on fixed assets (including internal-use software and website development costs). Including long-term liabilities, the debt-cap ratio was a mere 17.9%. The net cash position at quarter-end was $4.49 billion.
Guidance
Management provided guidance for the fourth quarter of 2010. Accordingly, revenue is expected to come in at around $12-13.3 billion (up 67.3% sequentially, or up 32.9% year over year at the mid-point), better than consensus expectations of around $12 billion. Operating income (including stock based compensation of around $140 million) is expected to come in at approximately $360-560 million.
Our Recommendation
We have a short-term Buy recommendation (Zacks Rank #2) on Amazon shares, given the fact that the company remains the largest and most successful player in the ecommerce market and continues to display strong top line growth. We also view positively management’s increased investments in infrastructure, which would support continued growth in 2011.
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