Investments, Aggressive Pricing Hurt Amazon's Q2 Earnings - Analyst Blog

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Amazon.com ( AMZN ) reported a 27 cents loss in the second quarter, missing the Zacks Consensus Estimate of a loss of 13 cents. Amazon hasn't had a very good track record of late, missing estimates as often as it beats them. This could be because management doesn't care for earnings guidance and focuses on opportunistic purchases of content and capacity that are announced at opportune moments.

Amazon.com, Inc - Earnings Surprise | FindTheBest

There is no doubt that Amazon is good at driving penetration rates and picking up market share. But the company seems bent on spending huge amounts of money for staggeringly low returns, which makes results and share prices extremely volatile. For instance, the 14 cent miss in the last quarter sent shares down 10.6% in extended trading.

The numbers in detail- 

Revenue

Amazon reported revenue of $19.34 billion, down 2.0% sequentially and up 23.2% from the year-ago quarter. This was within the guidance range of $18.1-19.8 billion (down 4.0% sequentially, or up 20.7% year over year at the mid-point) and in line with our expectations.

Both product and service sales grew double-digits from the year-ago quarter, with the percentage contribution of the two categories at 79% and 21%, respectively.

Around 62% of sales was generated in North America, representing sequential and year-over-year growth of 1.2% and 26.4%, respectively. The balance came from the International segment, which grew -6.9% sequentially and 18.2% year over year (14% excluding favorable currency impact).

Active customer accounts increased 6 million to more than 250 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 41% of total units in the quarter, up 1 percentage point from the previous 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 down 12.8% sequentially and up 13.4% from last year to 13% of total revenue. Growth continues to be driven by the consumption of digital content across categories (books, music, video).

The Electronics and General Merchandise ( EGM ) business in North America (43% revenue share) was up 6.9% sequentially and 29.1% 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 (12% of total revenue) was down 9.9% sequentially and up 7.0% year over year. EGM , which was around 25% of total revenue, was down 5.3% sequentially and up 24.8% from the year-ago quarter. There remains a preference for electronics instead of content in international locations, which is why Amazon has been increasing its fulfillment centers. Amazon has also launched Kindle stores in many international markets including Brazil, Canada, China, Japan and Mexico, where thousands of local language books are being sold. New product categories, better selection within categories, competitive prices and free shipping remain drivers.

The Other segment is still small (around 6% of total revenue, mostly in North America) and includes Amazon Web Services (AWS). The North America business was down 3.0% sequentially and up 38.4% from the year-ago quarter. The International contribution was down 5.7% from the previous quarter and up 4.2% from the year-ago quarter. AWS continues to launch new services and enhance the security of its services. In the last quarter, Amazon again reduced prices significantly, which was the reason for the revenue decline in the last quarter. Management stated that usage increased 90%.

Gross Margin

The gross margin expanded 192 bps sequentially and 210 bps year over year to 30.7%. 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. Amazon's strategy of heavily discounting products and services when it is building a position in any market also has an effect. Third party sites are doing well, which has a positive impact.

Gross profit dollars were up 4.5% sequentially and 32.2% from last year. The consistently rising gross profit dollars from year-ago periods indicates steadily rising business volumes. It also indicates that Amazon brings a value proposition for customers that encourage them to stick with it.

Operating Metrics

Amazon's operating expenses of $5.96 billion were up 7.5% sequentially and 34.9% 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 & content and G&A costs increased year over year as a percentage of sales by 62 bps, 58 bps, 141 bps and 13 bps, respectively.

As a result, the operating margin of -0.1% shrank 82 bps sequentially and 58 bps from the year-ago margin. Amazon reported an operating loss of $15 million compared to a profit of $146 million in the previous quarter and $79 million in the year-ago quarter.

The North America segment operating margin was down 109 bps sequentially and 66 bps from the year-ago quarter. The International segment operating margin was up 30 bps sequentially and down 46 bps from the year-ago quarter.

EBITDA was $1.49 billion, up 0.5% sequentially and 31.1% from last year. The cash margin of 7.7% increased from 7.5% in the previous quarter and 7.2% in the year-ago quarter.

Net Income

Amazon generated third quarter net loss of $126 million, or 0.7% of sales, compared to income of $108 million, or 0.5% in the previous quarter and loss of $6 million, or 0.0% in the same quarter last year. There were no one-time items in the last quarter. Therefore, the GAAP EPS was the same as the pro forma EPS of -$0.25 compared to $0.23  in the previous quarter and -$0.01 in the year-ago quarter.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $7.99 billion, down $680 million during the quarter. The company generated $862 million of cash from operations and spent $1.29 billion on fixed assets (including internal-use software and website development costs).

Amazon saw inventories fall 1.1% sequentially, with turns down from 8.4X to 8.1X. Receivables grew in the quarter, with DSOs up from 18 to 19.

Guidance

Management provided guidance for the third quarter of 2014. Accordingly, revenue is expected to come in at around $19.7-21.5 billion (up 6.5% sequentially and 20.5% year over year at the mid-point), below seasonality and roughly in line with street estimates. Operating loss (including $410 million for stock based compensation and amortization of intangible assets) is expected to come in at approximately $810 to $410 million.

Our Take

Amazon has taken a very aggressive stand to maintain supremacy in its chosen markets.

The company's strategy to boost media consumption is two-fold. On the one hand, it is aggressively acquiring and creating new content, whether it is books, music or other video. On the other hand, it is trying to get consumption onto a common platform such as Prime Music, Prime Instant Video and now, Kindle Unlimited. The platform model will be a natural boost to consumption, since the more a person consumes, the cheaper it gets for him/her on a per-unit basis. This would attract more users, which in turn would give Amazon leverage against content providers and help it drive down costs. The ultimate winner is the consumer with Amazon's benefits largely coming from scale.

The challenge to this business model comes from competing ecosystems from Google ( GOOGL ) and Apple ( AAPL ). Apple is leveraging its high-quality devices and Google its operating systems to drive media sales. Apple is more of a competitor for Amazon because it already accounts for a chunk of ecommerce sales. But Google should also not be discounted because its Play sales are growing rapidly. So Amazon needs to have competing devices to provide suitable options to its loyal customers and also, hopefully, draw more customers to its own ecosystem. This is the reason it was quick to get into the tablet market and has also introduced a new Fire phone. We should expect more devices from Amazon (think Glass, smartwatch, etc) and increased execution risk.

One of the major positives driving the gross margin is Amazon's shipping costs, which the company has been lowering by building closer-to-consumer fulfillment centers and a "local" strategy that gives consumers the option to pick up the product at a nearby store. If it is able to further automate the process, there could be further cost reduction here and resultant improvements in gross margins.

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). But uncertainty regarding its investment plans and the probability of continuing losses in the near term leads us to recommend investors to avoid the shares.

Amazon shares carry a Zacks Rank #5 (Strong Sell). A better-ranked stock from the same sector is Chinese ecommerce company Ecommerce China Dangdang ( DANG ), which has a Zacks Rank #2 (Buy).


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Earnings , Stocks

Referenced Stocks: AMZN , AAPL , DANG , GOOGL

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