Re: Q3 Results

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By howardroark
October 27, 2004

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From what I saw in the release and heard on the call, this looked like a pretty disappointing earnings report from Amazon. I've seen Amazon over the past few years as showing signs that it can maybe finally make good on some of the Dell / WMT analogies of creating a virtuous cycle of lowering prices, driving volumes, generating cash and deepening efficiency advantages over competition. The key to this has been the ability to reinvest profits into the business via free shipping and lower prices to drive enough gross dollar volume such that the resultant scale advantages provide attractive overall returns on the investment in pricing and service. And when you have a business like Amazon's with these fabled near-zero or even negative incremental capital costs to grow, the ability to drive volume over your fixed operating costs via price investments is that much more valuable. But everything seemed to point in the wrong direction on those key fronts in the release.

The entire North American segment grew 15% in the quarter while its EBIT actually dropped 8%. Tangential costs relating to A9 notwithstanding, that's a marked difference from the incredibly leverage they were getting from incremental revenue in 2002 & 2003. Fulfillment was back up to 9.3% and gross profits continue to decline despite increased third party units. In many ways it's starting to look as though the incremental trade off (decreased gross profit margins but attempted increased gross profits dollars to leverage over fixed costs) from the free shipping deals has been substantially weakening since the first successful offering drove so much volume growth a couple of years ago. And now guidance for 05 at the midpoints imply 14% revenue growth on only 11% EBIT growth. This complete lack of leverage is pretty surprising. While investment projects like search and China perhaps explain some of it, Amazon also has some natural margin tailwinds such as continued increased third party units, a few maturing international markets and complete leverage over depreciation. The way I look at it is not so much that EBIT margin guidance is disappointing, but rather that the ability to drive incremental revenue is disappointing given the significant investment in price and services implied by margin guidance.

And maybe this isn't news, but Capex guidance back up at $150m (2X depreciation) also surprised me, implying FCF that would probably be flat to down year over year at the $560m EBIT midpoint depending on where working capital played out. Even inventory turns dropped into the 16s for the first time in as long as I can remember, though the negative operating cycle was in tact because suppliers pretty much financed the increase. I actually thought Anthony Noto asked exactly the right questions on the call -- essentially: it looks like the trade off between effectively lowering prices and driving gross profit dollars is worsening, why? But I don't think he really got a legitimate answer aside from the partial impact of technology initiatives on margins.

Not one of Amazon's more impressive quarters given the progress they've made over the last couple of years, and guidance that I would say is seriously worrisome for the intelligent valuation case which necessarily at these prices rests on the ability to drive significant continued volume efficiently and exploit the near zero or negative incremental capital costs of the business. I was actually surprised the stock wasn't down even more than it in the after-hours, but I haven't been following the story as carefully so maybe much of this was expected.

On the other hand, if there's anyone left out there who still thinks that Amazon will still be bankrupt in five (now three, actually) years..

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