Online mega-retailer Amazon (AMZN) reported strong first quarter results. Revenue was slightly worse than consensus estimates anticipated, growing 22% year-over-year to $16 billion. Conversely, earnings per share exceeded consensus expectations, but still fell 35% year-over-year to $0.18. Amazon reports a metric of trailing twelve months (TTM) free cash flow, which declined 85% sequentially to $177 million as the firm invests heavily in fulfillment centers and distribution.
Amazon's earnings guidance was relatively weak, with the firm anticipating it will post operating income of negative $340 million to positive $10 million in the second quarter-meaning the company isn't likely to come anywhere near the consensus expectation of $0.22 per share. Revenue is anticipated to fall between $14.9 billion to $16.2 billion, which was a rather large range implying a potentially weak quarter. With the vast majority of Amazon's share price attributable to long-term growth in revenue and earnings potential, any sign of weakness in the story tends to cause doubt about the firm's business model and long-term operating margins.
However, gross margins increased 260 basis points year-over-year to 26.6%, driven largely by a continued shift to third party sellers. We're big fans of the third party selling business, which allows Amazon to operate as a toll collector via Best Ideas Newsletter holdings eBay (EBAY) and Visa (V). This business model has the three-fold impact of creating higher-margin sales, reducing inventory risk, and decreasing the amount of working capital necessary to operate the business. Third party sales accounted for 40% of all transactions on Amazon, and we think this number could eclipse 50% in the coming years.
Here is where Amazon's competitive advantage comes into play. Although the company spent billions of dollars in capital expenditures to build nationwide fulfillment centers, it helps the firm come closer and closer to creating a highly efficient distribution and supply-chain giant. Since the company handles fulfillment for several of its third-party sellers, Amazon could gain a tremendous advantage in terms of shipping time. In fact, we think the possibility looms large just around the corner, if it weren't for the lack of shipping capacity and Amazon's unwillingness to develop a shipping business for itself, we think same day and next day shipping would be the Amazon standard. We believe fulfillment expense growth should ultimately fall more in-line with revenue growth.
Overall, we understand the market's tepid reaction to Amazon's first quarter results and sales guidance. Amazon is a growth company, and signs of slowing revenue growth could certainly be cause for concern. Nevertheless, we think growth will remain strong for the remainder of 2013, and while we do see eBay as a major threat to Amazon's growing network effect, Amazon's focus on distribution centers and supply-chain management could create a compelling competitive advantage to justify higher listing fees. At current levels, we think Amazon looks fairly valued, so we aren't looking to add the name to the portfolio of our Best Ideas Newsletter.
Additional disclosure: EBAY is included in the portfolio of our Best Ideas Newsletter.