(AMZN) Amazon Shares Plunge After Weak Third Quarter Earnings

Amazon.com’s (AMZN) third quarter earnings missed the Zacks Consensus Estimate by 10 cents, or 41.7%. While revenue growth remains strong, Amazon’s bottom line was again impacted by higher expenses.

We continue to believe in the company’s strategy, since we think the growth in the e-commerce segment is sustainable. However, investors were clearly disappointed, pulling share prices down 12.44% in after-hours trade.

Revenue

Amazon reported revenue of $10.88 billion, up 9.7% sequentially and 43.9% year over year (exceeding the mid-point of management’s guided range but missing consensus expectations of around $10.93 billion). Revenue growth was 39% excluding favorable currency impact.

Nearly 55% of sales were generated in North America, representing a sequential increase of 9.7% and a year-over-year increase of 43.8%. The balance came from the International segment, which grew 9.7% sequentially and 44.0% year over year (33% excluding favorable currency impact).

Active customer accounts increased by 8 million to more than 152 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 38% of total units in the third quarter, compared to 35% in the second.

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.

Segment Details

Amazon’s North America Media business jumped 21.6% and 21.1% from the previous and year-ago quarters, respectively.

The Electronics and General Merchandise (EGM) business in North America was up 4.0% sequentially and 56.3% from last year. The company records ebook sales through Kindle devices under this segment.

The International segment was up 9.7% sequentially and 44.0% year over year. The media business (21% of total revenue) was up 7.3% sequentially, while increasing 26.5% year over year. EGM, which was around 25% of total revenue was up 11.8% sequentially and 63.1% from last year. New product categories, better selection within categories, competitive prices and free shipping remain drivers.

Gross Margin

The gross margin shrunk 63 bps sequentially to 23.5%, but was more or less flat with the year-ago quarter. Sequential variations in gross margins are 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.

However, gross profit dollars continued to increase, up 6.8% sequentially and 43.8% from last year. The increases were volume related, implying that despite its market position, Amazon continues to grow very strongly.

Operating Metrics

Amazon’s operating expenses of $2.5 billion were up 13.0% sequentially and 64.1% from the year-ago quarter. The headcount increased substantially both on sequential and year-over-year bases, as employee additions, particularly in operations and customer services continues to accelerate.

In the last quarter, the increase in fulfillment expenses was the most significant (up 81 bps sequentially, 131 bps year over year), followed by technology and content (up 3 bps sequentially, 122 bps year over year). Marketing and G&A, although down sequentially as a percentage of sales, were up 21 and 6 bps from the year-ago quarter.

The operating margin of 0.7% was down 130 bps sequentially and 282 bps year over year. Operating profit dollars were down 60.7% sequentially and 70.5% year over year.

The North America segment operating margin shrunk 153 bps sequentially and 208 bps from the year-ago quarter. The International segment operating margin shrunk 147 bps sequentially and 391 bps from the year-ago quarter.

EBITDA was $223 million, down 62.1% sequentially and up 57.5% from last year. The cash margin of 2.1% was down from both the previous and year-ago quarters.

Net Income

Amazon generated fourth quarter net income of $63 million, or a 0.6% net income margin, compared to $191 million, or 1.9% in the previous quarter and $231 million, or 3.1% 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 14 cents compared to 42 cents and 51 cents in the previous and year-ago quarters, respectively.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $6.33 billion, down $29 million during the quarter. The company generated $797 million of cash from operations, spending $529 million on fixed assets (including internal-use software and website development costs), $48 million on acquisitions net of cash acquired and $91 million to pay off all its long-term debt.

Amazon saw inventories grow 16.8% sequentially, with turns dropping from 9.3X to 8.8X. Receivables grew in the quarter, due to the higher sales, with DSOs declining slightly from 13 to 12 days.

Guidance

Management provided guidance for the fourth quarter of 2011. Accordingly, revenue is expected to come in at around $16.45-18.65 billion (up 61.4% sequentially, or up 35.5% year over year at the mid-point), more or less in line with consensus expectations of around $18.1 billion. Operating income (including $200 million for stock based compensation) is expected to come in at approximately ($200) to 250 million (down nearly 37% sequentially).

Our Take

We remain positive about Amazon shares, despite the earnings miss in the last quarter.

Amazon is one of the leading players in an extremely fast-growing market. The increase in users, units and partners overall indicates that it is outgrowing the ecommerce market. We think 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. Additionally, Prime has helped retain customers.

Amazon is also building its Kindle platform, the latest addition being a tablet called Kindle Fire. We think this could be a good strategy to compete against Apple Inc’s (AAPL) iPad, which is increasingly encroaching on Amazon’s digital and ebook sales. However, it will not be so easy to take share from the market leader because of the extent of software development around Apple products.

Given that there is significant growth potential in the domestic and more so in international e-commerce, 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. We think that other online players, such as eBay Inc. (EBAY) and Google Inc (GOOG) are doing likewise.

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 main reason for our Neutral stand on the shares.

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

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