Amazon.com (AMZN) reported a 95 cent loss in the third quarter, missing the Zacks Consensus Estimate of a loss of 73 cents. Shares slumped in extended trading yesterday and continued to decline in the pre-market today.
Amazon hasn’t had a very good track record of late, missing estimates more often than it beats them. Everyone has been waiting for the big day when its “opportunistic” buying would generate profits. But Amazon continues to disappoint, as it struggles to build position in hardware, cloud and ecommerce and even CFO Thomas Szkutak agreed that the company needed to choose new projects carefully.
Amazon has never made much money on hardware, but its smartphone has been particularly disappointing. The company took a $170 million charge in the last quarter related to the Fire phone. Spending may be expected to continue as Amazon tries to stay relevant in digital commerce.
Its Prime membership makes a lot of sense and increases the stickiness of the customer base, but here too the company is trying to acquire or create content, which is another expensive business.
But the biggest blow came from the guidance for the fourth quarter, when typical holiday seasonality allows retailers to make most of their annual profits. Amazon said that not only would the company generate losses this quarter, but revenue would also be impacted by the stronger dollar.
The numbers in detail-
Revenue
Amazon reported revenue of $20.58 billion, up 6.4% sequentially and 20.4% from the year-ago quarter. This was within the guidance range of $19.7-21.5 billion (up 6.5% sequentially and 20.5% year over year at the mid-point) but short of our expectations of $20.82 billion.
Both product and service sales grew double-digits from the year-ago quarter, with the percentage contribution of the two categories at 78% and 22%, respectively.
Around 63% of sales was generated in North America, representing sequential and year-over-year growth of 7.2% and 24.9%, respectively. The balance came from the International segment, which grew 5.0% sequentially and 13.6% year over year (13% excluding favorable currency impact).
Active customer accounts increased 10 million to more than 260 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 42% of total units in the quarter, up 1 percentage point from the previous quarter).
Key strategies for driving revenue growth remain a vast selection, competitive pricing, free shipping, user experience on Amazon properties and the Amazon Prime program. Fulfillment centers are also important, since they are essential for providing the level of customer service that Amazon customers have come to expect of the company. Over the past year, Amazon has been investing heavily in fulfillment and technology & content.
Segment Details
Amazon’s North America media business was up 11.0% sequentially and 4.8% from last year to 13% of total revenue. Growth continues to be driven by the consumption of digital content across categories (books, music, video).
The Electronics and General Merchandise (EGM) business in North America (43% revenue share) was up 5.1% sequentially and 30.6% from last year. EGM is a more seasonal business with holiday-driven spending having a significant impact. This seasonality has increased manifold since Amazon launched the Kindle platform. Therefore, year-over-year comparisons are more meaningful. We see very strong double-digit growth (although decelerating) in each quarter since December 2009, which is indicative of the expansion in the market and Amazon’s growing position within it.
Amazon’s International media business (12% of total revenue) was up 5.5% sequentially and 3.5% year over year. EGM, which was around 25% of total revenue, was down up 5.0% sequentially and 19.6% from the year-ago quarter. Amazon has also launched Kindle stores in many international markets including Brazil, Canada, China, Japan and Mexico, where thousands of local language books are being sold. New product categories, better selection within categories, competitive prices and free shipping remain drivers.
The Other segment is still small (around 7% of total revenue, mostly in North America) and includes Amazon Web Services (AWS). The North America business was up 14.7% sequentially and 39.6% from the year-ago quarter. The International contribution was down 16.0% from the previous quarter and consistent with the year-ago quarter.
AWS continues to launch new services and enhance the security of its services. In the last quarter, Amazon again reduced prices significantly (28-51% depending on the service), which was the reason for the revenue decline in the last quarter. Management stated that usage increased by nearly 90% from the year-ago quarter.
Gross Margin
The gross margin shrank 180 bps sequentially and expanded 120 bps year over year to 28.9%. Sequential variations in gross margins are usually largely mix-related, although pricing is growing into an important factor given the increase in product categories all over the world. Amazon’s strategy of heavily discounting products and services when it is building a position in any market also has an effect. Third party sites are doing well, which has a positive impact.
Gross profit dollars were flattish sequentially and 25.9% from last year. The consistently rising gross profit dollars from year-ago periods indicates steadily rising business volumes. It also indicates that Amazon brings a value proposition for customers that encourage them to stick with it. The sequential softness is disappointing however.
Operating Metrics
Amazon’s operating expenses of $6.50 billion were up 9.1% sequentially and 36.7% from the year-ago quarter. Amazon’s heavy investing activities (headcount, fulfillment centers, content, etc) over the past few quarters have been driving up its costs. Specifically, fulfillment, marketing, technology & content and G&A costs increased year over year as a percentage of sales by 94 bps, 76 bps, 163 bps and 35 bps, respectively.
As a result, the operating margin of -2.6% shrank 257 bps sequentially and 250 bps from the year-ago quarter. Amazon reported an operating loss of $544 million compared to losses of $15 million in the previous quarter and $25 million in the year-ago quarter.
The North America segment operating margin was down 297 bps sequentially and 218 bps from the year-ago quarter. The International segment operating margin was down 244 bps sequentially and 249 bps from the year-ago quarter.
EBITDA was $1.08 billion, up 27.3% sequentially and 49.5% from last year. The cash margin of 5.2% fell from 7.7% in the previous quarter and 6.4% in the year-ago quarter.
Net Income
Amazon generated third quarter net loss of $437 million, or 2.1% of sales, compared to loss of $126 million, or 0.7% in the previous quarter and loss of $41 million, or 0.2% in the same quarter last year. There were no one-time items in any of the quarters under consideration. Therefore, the GAAP EPS was the same as the pro forma EPS of -$0.95 compared to $0.27 in the previous quarter and -$0.09 in the year-ago quarter.
Balance Sheet and Cash Flow
Amazon ended with a cash and investments balance of $6.88 billion, down $1.10 billion during the quarter. The company generated $1.77 billion of cash from operations and spent $1.38 billion on fixed assets (including internal-use software and website development costs).
Amazon saw inventories rise 10.1% sequentially, with turns down from 8.1X to 8.0X. Receivables grew in the quarter, with DSOs flat at around 19.
Guidance
Management provided guidance for the fourth quarter of 2014. Accordingly, revenue is expected to come in at around $27.3-30.3 billion (up 39.9% sequentially and 12.6% year over year at the mid-point), well below seasonality and somewhat lower than the street. Operating income (including $470 million for stock based compensation and amortization of intangible assets) is expected to come in at approximately -$530 to $430 million.
Recommendation
Amazon has taken a very aggressive stand to maintain supremacy in its chosen markets, but whether it will succeed in these plans looks like an open question now.
The company’s strategy to boost media consumption is two-fold. On the one hand, it is aggressively acquiring and creating new content, whether it is books, music or other video. On the other hand, it is trying to get consumption onto a common platform such as Prime Music, Prime Instant Video and now, Kindle Unlimited.
The platform model will be a natural boost to consumption, since the more a person consumes, the cheaper it gets for him/her on a per-unit basis. This would attract more users, which in turn would give Amazon leverage against content providers and help it drive down costs. The ultimate winner is the consumer with Amazon’s benefits largely coming from scale.
The challenge to this business model comes from competing ecosystems from Google (GOOGL) and Apple (AAPL). Apple is leveraging its high-quality devices and Google its operating systems to drive media sales. Apple is more of a competitor for Amazon at the moment because it already accounts for a chunk of ecommerce sales.
But Google should also not be discounted because its Play sales are growing rapidly. So Amazon needs to have competing devices to provide suitable options to its loyal customers and also, hopefully, draw more customers to its own ecosystem. This is the reason it was quick to get into the tablet market and also tried its luck with a phone. We should expect more devices from Amazon (think Glass, smartwatch, etc) and increased execution risk.
We think that Amazon is performing true to form, continuing to grow revenue and generate very strong cash flow quarter upon quarter (discounting seasonal variations). But uncertainty regarding its investment plans and the probability of continuing losses in the near term leads us to recommend investors to avoid the shares.
Amazon shares carry a Zacks Rank #3 (Hold). A better-ranked stock from the same sector is Chinese ecommerce company Ecommerce China Dangdang (DANG), which has a Zacks Rank #2 (Buy).
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