Amazon.com’s (AMZN - Analyst Report) second quarter earnings were just short of the Zacks Consensus Estimate 2 cents. Earnings came in at slightly over 1 cent, down from 28 cents and 42 cents in the previous and year-ago quarters, respectively. Earnings include acquisition and integration costs of $65 million related to Kiva Systems, which also raised the tax rate.
Investors did not react much since there were no surprises, with shares rising 1.36% during the day and another 0.85% in after-hours trading.
Amazon reported revenue of $12.83 billion, down 2.7% sequentially and up 29.5% from the year-ago quarter. This was better than the guidance for the quarter of $11.9-13.3 billion (down 4.4% sequentially, or up 27.1% year over year at the mid-point) and in-line with consensus expectations. Year-over-year revenue growth was 32%, excluding an unfavorable currency impact.
Around 57% of sales were generated in North America, representing a sequential decline of 1.4% and a year-over-year increase of 35.5%. The balance came from the International segment, which dropped 4.3% sequentially and grew 22.2% year over year (28% excluding unfavorable currency impact).
Active customer accounts increased by 7 million to more than 180 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 40% of total units in the second quarter, compared to 39% in the first quarter and 36% in the year-ago 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.
Amazon’s North America Media business declined 14.7% (normal seasonality), while increasing 18.2% from last year. The consumption of digital content across categories is helping the business.
While selling and lending books on the Kindle platform is on the rise, Amazon has increased focus on its direct publishing business. The company reported that 20 of the top 100 best-selling Kindle books were from Kindle Direct Publishing authors.
In addition to Kindle ebooks, Amazon is going great guns with its video content. It has now extended Prime Instant Video to Microsoft’s (MSFT - Analyst Report) Xbox 360. Customers can now consume Prime Video on Kindles, Sony’s (SNE - Analyst Report) Playstation 3, Apple’s (AAPL - Analyst Report) Mac or other PCs, as well as on TV. At the same time, titles were expanded to 18,000 movies and TV episodes.
Amazon’s reach and value proposition are making it a key player in the video distribution business, providing stiff competition to the likes of Netflix (NFLX - Analyst Report). Year-over-year growth rates have been trending down over the last three quarters.
The Electronics and General Merchandise (EGM) business in North America was up 3.5% sequentially and 41.2% 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.
Management stated that Kindle Fire remained the highest selling product on amazon.com since its launch. Therefore, year-over-year comparisons are more meaningful. We see very strong double-digit growth in each quarter since December 2009, which is indicative of Amazon’s growing market position.
Amazon’s International media business (18% of total revenue) was down 10.7% sequentially and up 8.2% year over year. EGM, which was around 25% of total revenue, was flat sequentially and up 34.4% from last year. This seems to indicate a greater preference for purchasing electronics rather than content in international locations.
Once the electronics business gains momentum and Amazon has enough fulfillment centers set up, we expect further investment in content. For the time being, however, new product categories, better selection within categories, competitive prices and free shipping remain drivers.
The Other segment, while still small (not a significant percentage of total revenue) includes Amazon Web Services (AWS). Revenues from the segment followed similar patterns as the other two, declining sequentially and increasing year over year.
The gross margin expanded 212 bps sequentially and 198 bps year over year to 26.1%. 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.
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 were down 6.0% sequentially and 40.1% from last year, due to volume changes. The increase from last year is very encouraging, indicating that despite its market position, Amazon continues to grow without sacrificing margin. It also indicates that Amazon brings a value proposition for customers that make them stick with it.
Amazon’s operating expenses of $3.24 billion were up 9.2% sequentially and 48.1% from the year-ago quarter. Amazon’s heavy investing activities (headcount, fulfillment centers, etc) over the past few quarters have been driving up its costs.
Specifically, fulfillment, marketing, technology and content, and general and administrative expenses as a percentage of sales were up 74 bps, 54 bps, 126 bps and 29 bps respectively from the previous quarter and 107 bps, 74 bps, 139 bps and 13 bps, respectively from a year ago. While both fulfillment and technology costs remain focus areas, technology costs appear to be taking precedence at the moment.
As a result, the operating margin of 0.8% was down 62 bps and 119 bps, respectively from the previous and year-ago quarters. Operating profit dollars were down 44.2% sequentially and 46.8% year over year.
The North America segment operating margin was flat sequentially and up 74 bps from the year-ago quarter. The International segment operating margin was down 56 bps sequentially and 353 bps from the year-ago quarter (a lot of the investment over the past year was in this segment).
EBITDA was $813 million, flat sequentially and up 38.0% from last year. The cash margin of 6.3% was up from 6.1% in the previous quarter and 5.9% in the year-ago quarter.
Amazon generated first quarter net income of $7 million, or a 0.1% net income margin, compared to $130 million, or 1.0% in the previous quarter and $191 million, or 1.9% 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 $0.01 compared to 28 cents and 42 cents in the previous and year-ago quarters, respectively.
Balance Sheet and Cash Flow
Amazon ended with a cash and investments balance of $4.97 billion, down $745 million during the quarter. The company generated $594 million of cash from operations, and also spent $657 million on fixed assets (including internal-use software and website development costs), $624 million on acquisitions net of cash acquired and $141 million to pay down debt and long term obligations. There were no share repurchases in the last quarter.
Amazon saw inventories increase 2.9% sequentially, with turns declining from 9.4X to 8.7X. Receivables increased in the quarter, with DSOs increasing to over 14 days.
Management provided guidance for the third quarter of 2012. Accordingly, revenue is expected to come in at around $12.9-14.3 billion (up 6.0% sequentially, or up 25.0% year over year at the mid-point), slightly below consensus expectations of around $14.10 billion. Operating loss (including $275 million for stock-based compensation and amortization of intangible assets) is expected to come in at approximately $350 to $50 million.
There were no real surprises in Amazon’s second quarter, so our thesis remains unchanged.
We continue to believe in Amazon’s prospects, especially its platform approach (Kindle, Prime and the still small but growing AWS). 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).
As such Amazon remains one of the leading players in the fast-growing ecommerce market. The increase in users, units and partners overall indicates that it is outgrowing the ecommerce market. We think that 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.
The Kindle platform will remain a major growth platform for Amazon this year. We think that this could be a good strategy to compete against the iPad, which has been encroaching on Amazon’s digital and ebook sales. However, Apple is under fire for price fixing by the Dept. of Justice, so it doesn’t look like Amazon will be significantly challenged in its key market.
Given that there is significant growth potential in domestic and more so in international ecommerce, 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.
As a result, both fulfillment and technology investments will likely continue to grow. We do not consider this negative, since differentiation among online retailers is very difficult and better experience and support are the things that can drive traffic. Therefore, we cannot fault management’s strategy of investing in the business at this time.
While the increase in operating expenses is hurting the bottom line, we believe this is necessary. We expect the operating leverage to translate into accelerated growth in future quarters. However, we feel that there is some uncertainty regarding the timeline, which is the reason we remain Neutral on the shares.
Amazon shares currently carry a Zacks Rank of #2, which translates to a Buy recommendation in the short term (1-3 months).