Sell-side reaction to Amazon's earnings (AMZN 2Q05)

Mark Mahaney, Internet analyst for Citigoup, analyses Amazon's (ticker: AMZN) Q2 earnings results. Key extracts:

AMZN: A Strong Quarter, But Not An Inflection Point

SUMMARY

• AMZN reported a Beat & In-Line quarter -- $1,753MM revenue and $0.12 GAAP EPS beat our/Street estimates of $1,705/$1,732MM and $0.07/$0.09.  H2 oper. inc. guidance was below the Street, with revenue above.  The two biggest linked surprises were $50MM in high-margin Other revenue (third-party sales and advertising) and 25.7% gross margin - the highest since Q2:02.

• Fundies improved -- Rev growth accelerated from 22% in March to 24% in June (adjusting for FX and Harry Potter).  Organic rev growth has remained in a robust 22-27% range over the past 5 qtrs.  Oper. margin was up 10 bps Y/Y.

• We are incrementally more positive.  Our estimates rise -- 2006 proforma EPS goes from $1.01 to $1.04.  Our price target rises accordingly from $37 to $39.

• We reit the Hold. We question the long-term sustainability of Other revenue.  H2 guidance implies soft oper margins. And we don't see AMZN's current growth outlook supporting material valuation upside.

NEGATIVE FROM THE QUARTER

1. Whither proforma operating income upside? – We believe the bulk of this quarter’s upside was generated by the outperformance of high margin Other revenue in North America.  The risk here comes from the fact that this revenue is vulnerable to the loss of merchant partners and to the potentially one-time nature of Amazon’s co-branded credit-card promotion deals.  Raises the question of how sustainable is the margin trend.  We’re probably too skeptical here, but we’re not yet convinced.

2.  Soft H2 operating margin guidance – The midpoint of the company’s revenue and operating income guidance implies approximately 6.0% and 6.5% proforma operating margin guidance for the September and December quarters, both of which imply flattish or declining Y/Y margins.

3.  North American operating margins declined – Operating margins in North America were down 80 bps Y/Y to 7.5% despite the gross margin expansion.  This was due to the material ramp up in the technology and content spending.  The unanswered question is whether or not Amazon is getting a return on this investment.

4.  Lower inventory turns – Inventory turns were flat with the March quarter but down from 15 to 13 on a Y/Y basis. 5.  Higher full year capex guidance – The company raised full year capex guidance from $175MM to $200MM.  Seems to be a trend among Net companies...

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