Amazon (AMZN) Miss Due to Higher Costs (AMZN) first quarter earnings missed the Zacks Consensus Estimate by 10 cents, or 17.9%. We attribute the miss to higher expenses, since revenue was in line with the Zacks Consensus, beating by 0.1%.

Management mentioned a number of initiatives that increased expenses in the last quarter. These included additional fulfillment centers, increased technology spending and a headcount increase of 2,200 to support the very fast-growing business.


Revenue of $6.6 billion was down 7.9% sequentially (due to seasonality), but up 41.2% year over year (at the upper end of management guidance). The FX impact on revenue was $48 million.

Approximately 55% of sales were generated in North America, which declined 5.0% sequentially and grew 54.7% year over year. The balance came from the International segment, which declined 11.2% sequentially and increased 35.3% year over year.

The revenue growth was attributable to a 39% increase in units and an increase in active customer accounts to 118 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 were up 19%, with seller units at 32% of total units sold on its properties.

Segment Details

The North America Media business declined 17.1% sequentially but grew 15.3% from the year-ago quarter. Management attributed the sequential decline to seasonality in textbook sales, softer demand for video games and game consoles (due to a lack of new game releases).

The significant increase from the year-ago quarter was attributable to much higher volumes. The business has weathered the recession extremely well, consistently posting year-over-year gains despite sequential fluctuations. The last four quarters in particular have seen double-digit growth.

The Electronics and General Merchandise (EGM) business in North America increased 3.3% sequentially and grew 76.1% from the year-ago quarter. This was again the strongest year-over-year growth in the last two years.

The company records ebook sales through Kindle devices under this segment, and it looks as if this business did very well during the quarter. Management stated that physical book sales also grew double-digits from the year-ago quarter. We believe that additional details on the pricing rather than just the number of books sold would enable a better estimation of book sales.

Amazon’s e-book reader Kindle remains a fast-selling product, especially after the price cut. In the last quarter, the company added many more titles, with the total selection now standing at 630,000. Management stated that Prime continued to do well in the last quarter.

The International segment was down 11.2% sequentially, but up 35.3% year over year. The media business (24% of total revenue) declined 15.4% sequentially and grew 19.8% year over year. EGM, which was around 21% of total revenue, was down 6.0% sequentially and up 58.6% year over year. The addition of new product categories, better selection within categories, competitive prices and stronger sales from Prime contributed to the increase.

Operating Results

The gross margin expanded 165 bps sequentially to 24.5%, although it was down 40 bps from the year-ago quarter. Sequential variations in gross margins are largely mix-related. In the last quarter, management decided to move fulfillment costs related to third party inventory from the COGS line to the fulfillment line, which benefited the sequential comparison by 40 bps.

Competitive Pricing in international markets continued to impact year-over-year comparisons. The North America gross margin increased 145 bps sequentially and 99 bps year over year, while International grew 156 bps sequentially and declined 116 bps year over year.

The operating expenses of $1.3 billion were up 8.3% sequentially and 45.1% from the year-ago quarter. Fulfillment expenses increased the most sequentially (up 81 bps excluding the 40 bp impact from cost of sales). Management stated that there would be 13 more fulfillment centers by 13 by year-end, so the expense will continue to increase.

Technology costs (up 108 bps sequentially) will also continue to increase as Amazon extends support to its many new product lines and web services. Marketing expenses (up 39 bps sequentially and 44 bps year over year) is again a strategic decision on the part of management, as the company increases efforts to promote the brand online and also resorts to offline media such as TV. G&A expenses (up 36 bps sequentially and 7 bps year over year) were the result of recent headcount additions, which management stated were for general operations, both factory and office work.

All this resulted in an operating margin of 4.1%, which was down 141 bps sequentially and 40 bps year over year. Operating profit dollars were down 31.5% sequentially, but up 28.6% year over year. The number includes $10 million of higher operating costs related to FX. We believe that the increased expenditure at this time will provide the necessary leverage to drive continued growth in revenue and profits going forward.

The North America operating margin shrunk 165 bps sequentially, particularly impacted by the higher technology costs, which are mostly included in the segment. However, it was up 47 bps from the year-ago quarter. The International segment operating margin shrunk 6 bps sequentially and 121 bps from the year-ago quarter.

The International segment decline was largely related to pricing and further impacted by higher costs of operation, as Amazon continues to increase selection and product lines (new grocery stores in the U.K. and Germany in the last quarter) and also expands geographically.

Amazon generated first quarter net income of $209 million, or a 3.2% net income margin, compared to $301 million, or 4.2% in the previous quarter and $162 million, or 3.5% net income margin in the same quarter last year. There were no one-time items in the last quarter. Accordingly, the GAAP EPS came in at $0.45 compared to $0.66 in the Mar 2010 quarter and $0.32 in the Jun quarter of 2009.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $5.11 billion, an increase of $45 million from the end of the previous quarter. The company generated $250 million of cash from operations and spent $196 million in fixed assets (including internal-use software and website development costs). Including long-term liabilities, the debt-cap ratio was a mere 18.0%. The net cash at quarter-end was $3.82 billion.


Management provided guidance for the third quarter of 2010. Accordingly, revenue is expected to come in at around $6.9-7.6 billion (up 10.6% sequentially, or up 33.3% year over year at the mid-point). Operating income (including stock based compensation of around $130 million) is expected to come in at approximately $210-310 million.

Our Recommendation

We reiterate our Neutral recommendation and short-term Hold (Zacks Rank #3) recommendations on Amazon shares, given the fact that the company remains the largest and most successful player in the ecommerce market and continues to display strong top and bottom line growth. While increased expenses could be pressuring the shares at the moment, we expect continued momentum and therefore advise investors to wait for a more attractive exit point.

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