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Amazon.com’s (AMZN - Analyst Report) third quarter loss of 60 cents came in 52 cents higher than the Zacks Consensus Estimate. Around 37 cents related to its share of losses in LivingSocial.

Similar to the technology companies Intel (INTC - Analyst Report), Microsoft (MSFT - Analyst Report), Advanced Micro Devices (AMD - Analyst Report), Yahoo (YHOO - Analyst Report), Texas Instruments (TXN - Analyst Report) and Corning (GLW - Analyst Report), Amazon shares started sliding prior to the earnings release, as investors remain bearish on the sector.

While Amazon’s miss was huge, weak results were expected because of its investment focus. Therefore, shares were down just 1.0% in after-hours trading.

Revenue

Amazon reported revenue of $13.81 billion, up 7.6% sequentially and 26.9% from the year-ago quarter. This was better than the guidance for the quarter of $12.9-14.3 billion billion (up 6.0% sequentially, or up 25.0% year over year at the mid-point) and more or less in-line with consensus expectations. Year-over-year revenue growth was 30% excluding unfavorable currency impact.

Around 57% of sales were generated in North America, representing a sequential increase of 7.6% and a year-over-year increase of 32.9%. The balance came from the International segment, which grew 7.5% sequentially and 19.8% year over year (27% excluding unfavorable currency impact).

Active customer accounts increased by 8 million to more than 188 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 41% of total units in the third quarter, compared to 40% in the second 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 18.2% sequentially and 14.9% from last year. The consumption of digital content across categories is helping the business. While selling and lending books on the Kindle platform continues, Amazon has is also developing its direct publishing business.

In addition to Kindle ebooks, Amazon is going great guns with its video content. Prime Instant Video has the broadest reach, across Kindles, Microsoft’s Xbox 360, Sony’s (SNE - Snapshot Report) Playstation 3, Apple’s (AAPL) Mac or other PCs, as well as on TV. At the same time, titles were expanded to 30,000 movies and TV episodes in the last quarter. 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). The category saw strong double-digit growth in four of the last five quarters.

The Electronics and General Merchandise (EGM) business in North America was up 2.5% sequentially and 39.2% 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. 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 the expansion in the market and Amazon’s growing position within it.

Amazon’s International media business (17% of total revenue) was up 6.2% sequentially and 7.1% year over year. EGM, which was around 25% of total revenue, grew 8.5% sequentially and 30.4% 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. In the last quarter, the company launched the Japanese Kindle Store amazon.co.jp, through which it will sell a collection of over a million books, including 50,000 books in the Japanese language.

At the same time, Cloud Player was launched in the U.K., Germany, France, Italy and Spain. Therefore, 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.

Gross Margin

The gross margin shrunk 81 bps sequentially and expanded 180 bps year over year to 25.3%. 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 has a positive impact.

Gross profit dollars were up 4.2% sequentially and 36.7% 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.

Operating Metrics

Amazon’s operating expenses of $3.52 billion were up 8.5% sequentially and 42.2% 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 and content, and general and administrative expenses as a percentage of sales were up 63 bps, 51 bps, 156 bps and 6 bps, respectively from a year ago. Fulfillment and technology & content costs remain focus areas, so were also up on a sequential basis.

As a result, the operating margin of -0.2% was down 104 bps and 93 bps, respectively from the previous and year-ago quarters. The operating loss of $28 million was down significantly from profits of $107 million and $79 million in the previous and year-ago quarters, respectively.

The North America segment operating margin was down 100 bps sequentially and up 126 bps from the year-ago quarter. The International segment operating margin was down 129 bps sequentially and 334 bps from the year-ago quarter (a lot of the investment over the past year was in this segment).

EBITDA was $743 million, down 8.6% sequentially and up 48.3% from last year. The cash margin of 5.4% was down from 6.3% in the previous quarter and up from 4.6% in the year-ago quarter.

Net Income

Amazon generated third quarter net loss of $105 million, or a -0.8% net income margin, compared to profit of $7 million, or 0.1% in the previous quarter and of $63 million, or 0.6% 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 -$0.23 compared to 2 cents and 14 cents in the previous and year-ago quarters, respectively.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $5.25 billion, up $278 million during the quarter. The company generated $943 million of cash from operations, spending $716 million on fixed assets (including internal-use software and website development costs), $37 million on acquisitions net of cash acquired and $144 million to pay down debt and long term obligations. There were no share repurchases in the last quarter.

Amazon saw inventories increase 15.6% sequentially, with turns declining from 8.7X to 8.1X. Receivables increased in the quarter, with DSOs increasing to nearly 16 days.

Guidance

Management provided guidance for the fourth quarter of 2012. Accordingly, revenue is expected to come in at around $20.25-22.75 billion (up 55.7% sequentially, or up 23.3% year over year at the mid-point), below consensus expectations of $22.79 billion. Operating income/loss (including $290 million for stock based compensation and amortization of intangible assets) is expected to come in at approximately -$490 to $310 million.

Our Take

There was nothing new in Amazon’s third 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. Despite the Mini from Apple, we think Amazon devices come with their own value proposition, so there will be many takers.

Amazon has the huge task of maintaining its U.S. market share and expanding globally. We expect share losses, but think that the market will expand fast enough for Amazon to maintain a solid growth rate. However, this 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 & content 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. 

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, the uncertainty regarding the timeline remains, which is the reason we remain Neutral on the shares.

Amazon shares currently carry a Zacks Rank of #3, which translates to a Hold recommendation in the short term (1-3 months).

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