Amazon.com Discusses Low Q2 Profits and Future Strategy

Jul.26.06 | About: Amazon.com, Inc. (AMZN)

Amazon.com Inc. (NASDAQ:AMZN) reported Q2 earnings last night, and the stock fell 12% in subsequent late trading. Revenue rose 22%, but Amazon's operating expenses rose 34% and technology and content costs rose 58%, leading to lower profitability and cash flow generation. Here are Amazon CEO Jeff Bezos and CFO Tom Szkutak fielding questions on the company's conference call (excerpt from the full Amazon conference call transcript, emphasis added):

Anthony Noto - Goldman Sachs:

Jeff, I was wondering if you could comment a little bit on Amazon's long-term vision and how you would qualify the way you think you can differentiate the brand going forward? I mean, there's a lot we read about in the papers, and obviously there's a lot of initiatives that have happened in the last quarter. I just wonder if we could revisit that as we have seen you announce, obviously, groceries. There's a lot of talk around a lot of other things as it relates to the media categories and digital strategy. On your site, there's a lot of new videos and other entertainment types of contents as opposed to pure product sales.

Tom, my question is you guys have talked about maximizing free cash flow dollars. I definitely understand the impact from Toys 'R' Us on your lower operating income for the fourth quarter. I don't necessarily see the benefit from lowering prices further, because it results in a pretty significant pickup in revenue. 25% revenue growth is an acceleration, that's really a positive. But it looks like it is coming at the cost of operating income, and therefore free cash flow relative to what you would have thought excluding Toys 'R' Us. I was wondering if you could comment on that. Thanks.

Jeff Bezos:

Sure. Our strategy for our business is a three-fold with respect to finding the elements that matter to customers that are durable in time where we can build flywheels that we can continue to put energy into.

The three big flywheels are selection, price and availability. So if you look at each of those, we know that 10 years from now, customers will still care about selection. We know they will still care about availability and price. They'll want to get their products quickly. So the energy that we put into building those flywheels today will continue to pay dividends, even ten years from now.

So the price one is very straightforward. The more scale we have, the better our cost structure, both on the variable side with COGS and because we get to leverage our fixed expense as well. So there, we will have the ability to offer lower prices and that makes the Company scale increase, which again allows us to keep spinning that flywheel and further drive down costs and prices and so on.

With availability, you will see a similar flywheel. As you have a distributed node fulfillment center network, you get to put products closer to customers. That makes it possible to economically do outbound transportation for things like Amazon Prime. So the fact that we have a big multi-node network and that we have the volume to economically support a multi-node network puts us in a very unique and differentiated position to offer a membership program like Amazon Prime to economically afford to do things like Free Super Saver Shipping. So availability is another one.

Then selection has a similar thing. You see that the number of in-stock ASINs that we have under our own roof is up very dramatically year-over-year, more than 40%. Again, in order to be able to do that, you need a certain amount of volume because when you look at those low-turn ASINs in the tail, you need to have enough volume that you can afford to carry even those slow-moving ASINs and make them available to customers on a very rapid basis.

The third-party strategy also plays into that selection point, where the more customer volume we have, the more flow we have, the more active customers, the more third-party sellers want to interact with that customer flow.

Tom Szkutak:

I think Jeff answered a good portion of the second part of your question, Anthony, with his answer as well, in terms of the pricing strategy. But you're absolutely right, pricing in the short term is expensive, but it has the benefits that Jeff described as he talked about the flywheel as it relates to pricing. It gives us the ability over the long term to have a bigger scale, to get better COGS reductions. It has the ability to leverage our fixed cost structure better as well.

So as you think about our guidance and the pricing piece specifically, that is exactly how we're thinking about it. In addition to that, the way you should think about it is it's existing categories plus new categories. As we launch these new categories, we want to make sure that we get the scale quickly to get some of the benefits that Jeff described. So that is what we intend on doing and that is the rationale.

Anthony Noto - Goldman Sachs:

Tom, do you think the forecasted acceleration in revenue growth to 25% year-over-year, which is faster than this quarter and the third quarter, and a seasonally stronger growth rate of 65% compared to last year at 60%, is completely due to the lower prices or is it also due to groceries and other categories you may not have announced yet?

Tom Szkutak:

It is due to a number of things that we talked about. We are investing heavily in the toy category for the second half, some of the new categories we have launched. We are expanding selection in the existing categories. We're putting more selection under our own roof, which we also think is helpful, as well as the pricing.

But in terms of what I was describing with the impact on the bottom line, and those are the elements, but certainly on the top-line perspective, it is pricing, additional selection and new categories.

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