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By howardroark
October 24, 2001

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Revenue Growth

The first-ever non-seasonal sequential decline wasn't a surprise in light of the fallout from September 11. According to Amazon, sequential revenue would have been about flat but for the 11th. The number that sticks out the most here is the 12% YoY decline in BMV sales, after Amazon had grown that category 33% from '99 to '00. That's a two-year CAGR of just 8% for that category. Try going back to December 31, 1999 and selling that one.

The growth deceleration (apologies to Gordon) in the ETK segment is even more striking, dropping from a ramping-up 681% growth from Q3 '99 to '00 to only 6% this year. To be fair, though, you have to exclude the toy and video sales generated for part of Q3 '00 which are now under the TOYSRUS umbrella, which still leaves only 23% YoY growth in ETK. Even so, the ETK category appears to be further from profitability than BMV was when it left its explosive growth days in the past.

For the most part, the revenue numbers were not all that surprising (as is evident from the not-a-contest guesses). The biggest news may be the lowered guidance for Q4, since the midpoint of Amazon's forecast has apparently dropped from 15% YoY growth to only 5%. That's a fairly significant ($100 million) difference; it's interesting that it didn't alter earnings guidance.

Operating Expenses

Compared to last quarter, operating expenses were basically in line, with the exception of R&D, which decreased substantially to 8.4% of revenue versus 9.7%. It's hard to tell how low AMZN can push R&D as a % of revenue long-term, but it's safe to say that this is one of the key costs that Bezos & Company believe will scale enough so the Q4's pro forma profitability goal can be met despite disappointing revenue. Judging from previous Q4s, it's very possible that R&D in Q4 is only around 5.5% of total revenue, which could account for a hefty 300 or so of sequential pro forma basis point savings.

Fulfillment don't seem to be improving with the alacrity you might expect in light of the restructuring implemented this year. At 12.7% of revenue, they were essentially flat from Q2 (12.8%), and in fact were slightly worse if you deduct service revenue from the denominator (13.7% versus 13.6%). It's an understatement to say it will be difficult for Amazon to hit its long-term goal of single digit fulfillment costs in Q4, even with the expansion of its "monetization" deals. On the other hand, marketing and G&A should both scale in the fourth quarter, and Q3's confirmation of Q2's numbers make it seem like Amazon can very possibly bring those two line items to under 7% of revenue in aggregate.

If you figure on fulfillment costs of 11.5% of revenue, R&D of 5.5% and Marketing plus G&A of 6.5%, you're left with 23.5% operating costs in Q4. That's the exact midpoint of the gross profit guidance for the quarter, which was 22% - 25% according to the Q3 release. Of course, pro forma operating profitability is before net interest expense, which will be around 3% and will likely give Amazon a pro forma net loss even in the face of operating profitability. Based on those cost numbers, which I would say are attainable but optimistic, I would give Amazon a 40% chance of hitting its goal. Considering, however, the crescendo of Street and media noise that management has created - and thus has riding - on this single, fictional bogey, and considering management's discretion in affecting accounting results in any give period, I'll give 'em a 65% chance of hitting pro forma profitability in Q4.

Cash Position

Including the AOL investment, the cash position is at $668 million, with only $9 million consisting of equity securities. Excluding the AOL proceeds and currency gains, it was a cash outflow quarter, with operating cash outflow + PP&E coming in at ~$77 million, which isn't a big surprise. Inventories were basically flat from Q2, which, though not stellar in light of a sequential revenue decline, could probably be explained by holiday ramping, and still reflect an overall improvement in inventory management as compared to the heady days of 2000. Payables continue to be an item to watch for Amazon, as they suffered a slight sequential decline, and now account for only 37.1% of revenue. That's compared to '00 Q3, where creditors allowed Amazon to build payables to a whopping 47.8% of revenue. The reigns are clearly pulled in a bit, but the sequential tightening is slight. Thank you AOL?

Amazon's predicting $900 million in Q4 and $550 million after Q1. There's not much reason to disbelieve that, unless you foresee trade creditors pulling the plug. What will it take for Amazon to generate $232 million in cash next quarter, and then to limit its burn to $350 million in Q1? Well, Amazon will basically have to burn $59 million a quarter for the next two rather than the $77 million it burned last quarter. Even moderate improvements in cost efficiency could get that done. Of course, last quarter's burn rate is my number, and excludes items, including inflows from option exercise, which in particular should increase a bit now that Amazon as issued 26 million option in the Q which are currently in the money (average K=$7.93), and on average will likely positively affect cash balance even ignoring any substantive improvements.

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