Amazon.com’s (AMZN) second quarter earnings beat the Zacks Consensus Estimate by 5 cents, or 13.5%. We expected the company to report stronger results this quarter as some of its investments started paying off. As may be expected, shares traded up (6.36%) in after-market trade.
Revenue
Amazon reported revenue of $9.91 billion, flat sequentially and up 51.0% year over year (exceeding the mid-point of management’s guided range). Revenue growth was 44% excluding favorable currency impact.
Nearly 55% of sales were generated in North America, representing a sequential decline of 1.1% and a year-over-year increase of 50.6% (50% excluding currency). The balance came from the International segment, which grew 2.6% sequentially and 51.4% year over year (36% excluding favorable currency impact).
Paid units were up 56% in the second quarter, compared to a 45% increase in the first. Active customer accounts also increased by 7 million to more than 144 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 36% of paid 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. 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. Amazon is delivering on all these fronts, which is the main reason for the revenue strength in the last quarter.
Segment Details
Amazon’s North America Media business declined 1.1% sequentially and grew 50.6% year over year.
The Electronics and General Merchandise (EGM) business in North America was up 5.8% sequentially and 67.3% from last year. The company records ebook sales through Kindle devices under this segment.
The International segment was up 2.6% sequentially and 51.4% year over year. The media business (21% of total revenue) was flat sequentially, while increasing 33.9% year over year. EGM, which was around 24% of total revenue was up 4.9% sequentially and 71.4% from last year. New product categories, better selection within categories, competitive prices and free shipping combined to generate these results.
Gross Margin
The gross margin expanded 127 bps sequentially to 24.1% but, shrunk 42 bps from the year-ago quarter. Sequential variations in gross margins are largely mix-related, although pricing is growing into an important driver given the increase in product categories all over the world.
The fact that new product launches come hand in hand with extra launch costs, is also a negative for the gross margin. Third party sites are also doing well, which usually impacts the margin.
Gross profit dollars increased 6.2% sequentially and 48.4% from last year. The increases were volume related, implying that despite its market position, Amazon continues to grow very strongly.
Operating Metrics
Amazon’s operating expenses of $2.2 billion were up 13.5% sequentially and 63.3% from the year-ago quarter. The headcount increased by 5,300, partly on account of an acquisition during the quarter and partly on account of Amazon’s continued investments in fulfillment (up 82 bps sequentially, 63 bps year over year) and technology (up 117 bps sequentially, 83 bps year over year). Other expenses were also on the rise.
Amazon announced another six fulfillment centers during the quarter, in addition to the nine announced in the first quarter. The company expects to add a few more this year. Amazon added 13 fulfillment centers in 2010, ending the year with 52 fulfillment centers.
The operating margin of 2.0% was down 124 bps sequentially and 208 bps year over year. Operating profit dollars were down 37.6% sequentially and 25.5% year over year.
The North America segment operating margin shrunk 135 bps sequentially and 161 bps from the year-ago quarter. The International segment operating margin shrunk 17 bps sequentially and 311 bps from the year-ago quarter.
EBITDA was $589 million, down 7.1% sequentially and up 15.5% from last year. The cash margin was 5.9%, down from both the previous and year-ago quarters.
Net Income
Amazon generated fourth quarter net income of $191 million, or a 1.9% net income margin, compared to $201 million, or 2.0% in the previous quarter and $209 million, or 3.2% net income margin in the same quarter last year. There were no one-time items in the last quarter. Therefore, the GAAP EPS was same as the pro forma EPS of 42 cents compared to 44 cents and 45 cents in the previous and year-ago quarters, respectively.
Balance Sheet and Cash Flow
Amazon ended with a cash and investments balance of $6.35 billion, down $526 million during the quarter. The company generated $423 million of cash from operations, spending $433 million on fixed assets (including internal-use software and website development costs), $469 million on acquisitions net of cash acquired and $140 million to pay off all its long term debt.
Amazon saw inventories decline 11.8% sequentially, with turns dropping from 10.5X to 9.3X. Receivables grew in the quarter, due to the higher sales, with DSOs increasing slightly from 12 to 13 days.
Guidance
Management provided guidance for the third quarter of 2011. Accordingly, revenue is expected to come in at around $10.3-11.1 billion (up 7.9% sequentially, or up 41.5% year over year at the mid-point), better than consensus expectations of around $9.37 billion.
Operating income (including stock based compensation and intangibles amortization of around $180 million) is expected to come in at approximately $20-170 million (down 93-37% from September 2010).
Our Take
We remain positive about Amazon shares, despite the earnings miss in the last quarter.
Amazon is one of the leading players in an extremely fast-growing market. The increase in users, units and partners overall indicates that it is outgrowing the ecommerce market. We think this has been possible in the past because of the broad selection, free shipping and user experience that Amazon has consistently provided. This has enabled the company to gain from the shift in offline to online consumption. Additionally, Prime has helped retain customers.
Given that there is significant growth potential in the domestic and more so in the international market, Amazon may be expected to benefit. However, the next phase of growth is dependent on its own capacity to serve customers, especially in international markets, where growth rates are likely to be higher and its own facilities fewer.
Additionally, we note that technology investments are also increasing, which is a good thing, since differentiation among online retailers is very difficult and better experience is the one thing that can drive traffic. Therefore, we cannot fault management’s strategy of investing in the business at this time. We think that other online players, such as eBay Inc. (EBAY) and Google Inc (GOOG) are doing likewise.
Judging from the last quarter’s performance, Amazon is heading the right way. While the increase in operating expenses is hurting the bottom line, we believe this is temporary. We expect the operating leverage to translate into accelerated growth towards the end of the year. However, we feel that there is some uncertainty regarding the timeline, which is the main reason for our Neutral stand on the shares.
Amazon shares currently carry a Zacks #3 Rank, which translates to a Hold recommendation in the short term (1-3 months).
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