Shares of Amazon.com (AMZN) were losing up to 8% of their value in Friday's (April 26, 2013) trading session. The "Earth's most customer-centric company" which brings consumers, sellers, companies and content creators together, reported its first quarter results for 2013.
First Quarter Results
Amazon.com generated first quarter revenues of $16.07 billion, up 21.9% on the year before. The company experienced some currency headwinds, as the US dollar gained ground against many other currencies. In constant currencies, revenue growth would have come in around 24%. Partially due to the strong dollar, revenues missed consensus estimates of $16.16 billion.
Growth was driven by service sales, which rose 44.5% to $2.8 billion. "Normal" net product sales increased by 18.0% to $13.3 billion.
Despite the strong revenue growth, operating income fell by some 6% to $181 million to just 1.1% of total revenues. As a result, net income fell by 37% to merely $82 million, or $0.18 per share. Despite the drop in earnings, profits came in ahead of consensus estimates of $0.09 per share. CEO and founder Jeff Bezos commented on the past quarter and some exciting developments in the TV business.
Amazon Studios is working on a new way to greenlight TV shows. The pilots are out in the open where everyone cans have a say. Our customers will determine what goes into full-season production. We hope Amazon Originals can become yet another way for us to create value for Prime members.
Continued Margin Compression As Customer Experience Investments Increase
Operating margins for the first quarter came in at just 1.13%, which is down 33 basis points compared to a year ago. Strong revenue growth resulted in strong margin expansion as gross margins rose by almost 240 basis points to 26.6%. Increased investments in technology, fulfillment and customer service put pressure on margins.
Fulfillment costs rose by 136 basis points to 11.18% as the company is investing heavily to increase the distribution capabilities in its attempt to prepare for same-day delivery. Investments in technology and content increased rapidly as well, up 144 basis points on the year to 8.61% of total revenues.
Note that most of the increased investments, and consequently margin pressure, is attributable to Amazon.com's international division. North American sales were up 26.4% on the year before, coming in at $9.39 billion. Operating income came in at $457 million, and was up 17 basis points to 4.87% of total sales.
International sales rose by 16.0% to $7.43 billion. As a result of increased investments, the international activities reported an operating loss of $16 million, which compares to a profit of $49 million in the year before. Amazon is investing heavily in China but also in plagued countries in Southern Europe.
About The Second Quarter
Amazon.com gave a relatively wide and slightly disappointing range for second quarter revenues. Net revenues are expected to come in between $14.5 and $16.2 billion, up between 13 and 26% on the year before. At the midpoint of the guidance, revenues are expected to fall by 4.5% compared to the first quarter. In 2012, second quarter revenues fell by merely 2.7% compared to a seasonal strong first quarter. The company expects to report anywhere between an operating loss of $340 million and a profit of $10 million, which is down significantly from a operating profit of $107 million over the past year.
Amazon.com ended its first quarter with $7.9 billion in cash, equivalents and marketable securities. The company operates with $3.0 billion in long term debt, for a net cash position of approximately $5 billion.
For the full year of 2012, Amazon.com generated annual revenues of $61.1 billion on which the company lost $39 million. At this rate, the company could be on track to generate annual revenues surpassing $70 billion on which the company is expected to roughly break-even.
Factoring in a 7% decline in Friday's session, the market values Amazon.com at around $115 billion. Excluding the net cash position, operating assets are valued around $110 billion. This values the company at around 1.5 times annual revenues.
Some Historical Perspective
Long term shareholders in Amazon.com have seen a lot of value being created under command of founder Jeff Bezos. Trading as low as $7 in 2002, shares have seen incredible returns as they steadily rose to highs of $285 earlier this year. Shares have seen a modest 10% correction, mostly on the back of the first quarter results, currently exchanging hands around $255 per share.
Between 2009 and 2012, Amazon.com increased its annual revenues by roughly 150% to $61.1 billion, or by some 35.5% per annum on average. Despite the impressive growth in revenues, operating income and net profits have been on the decline. After reporting a $902 million net profit in 2009, the company reported a modest loss over the past year.
At the moment, Amazon.com is suffering from two major threats: the success of Prime, which pushes up shipping costs and the impact of online states sales taxes.
As internet e-commerce business is maturing and state and federal budgets come even under a greater strain, the call for internet sales taxes is increasing. Amazon.com, which traditionally did not collect sales taxes, has started to collect sales taxes in nine states, including California. The company will collect sales taxes in another seven states in the coming period, which partially explains the slowdown in revenues.
Another drag, not on revenues, but on profitability, is the success of Amazon Prime, the subscription service which costs consumers $79 a year. First quarter net shipping costs rose 14% to $763 million, thereby trailing overall revenue growth. Amazon.com made slight progress in cutting down these costs. As shipping costs rose 24% to $1.40 billion, shipping revenues actually grew by 37% to $633 million. Consequently, total shipping costs as a percentage of sales fell by 40 basis points to 4.7%.
The best way to see the future for Amazon.com is to look at North America, the most advanced market which the company serves. Operating margins for the business increased to 4.87%, implying that if the international business would perform on par, the company could have an operating earning capacity of $3.5 billion in 2013, based on estimated sales of $70 billion. The fact that Amazon.com is deliberately trying to steer operating income towards break-even, or slightly positive in recent years, tells me the company is still in its "investment" phase and geared towards the future.
The weakness following the first quarter earnings report is mostly to blame to the conservative revenue outlook for the second quarter. While Amazon is admitting that general macro-weakness is impacting the guidance, a 275 basis point headwinds in currencies is not helping either.
As mentioned above, to look at the future for Amazon.com, one has to look at the performance in the US. Amazon.com has the most loyal customers here, has the best distribution capabilities following the release of Prime, and it is benefiting from the ecosystem around its Kindle. While Facebook (FB) is based on a network of friends and LinkedIn (LNKD) is based on your professional network, Amazon is based on a network of online purchases, giving the company tremendous value in its data. Unlike some of its competitors, it can gather data of not just what consumers find interesting, but what they are actually buying.
Networks have the tendency to grow exponentially in value as their usage increases, while they have very low marginal costs, thereby killing competition and becoming an effective monopoly. While a website-based network such as Facebook could be replicated, one has to commit billions of dollars of investment to replicate Amazon.com, as you need the distribution capabilities as well.
Overall the quarter was nothing special, but it was good to see that gross margins increased another 260 basis points to 26.6%. Yet all margin gains and more were invested in fulfillment and technology, two cost factors which normally should be relatively stable or decline with positive sales leverage. To illustrate the size of these investments, if gross margins expansion would have hit the bottom line, operating income would have increase by $400 million over the past quarter alone.
Don't buy the arguments of the shorts that the company's valuation is way too high based on today's operations. Investors who believe in Bezos have always been in it for the long term, and shorts have been wrong the entire decade. If Amazon.com manages to expand its business at 15% for the coming 5 years, it is on track to generate annual revenues of $150 billion by 2018. If the company finally moves out of investment phase towards "cash cow" phase, it should be able to report healthy net margins of around 5% like other dominant retailers, putting it on track to earn $7-$8 billion.
Not too say that Amazon.com is a screaming buy at these levels, but for the long term, I would rather be long than short.