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Shares of Amazon.com (AMZN) are setting fresh all-time highs while its recent earnings report reveals weakness in its international operations. As revenue growth, which supports the current sky-high valuation, is slowing down, investors should be cautious.

Second Quarter Results

Amazon.com generated second quarter revenues of $15.70 billion, up 22% on the year. Sales growth was limited due to unfavorable exchange rate movements which shaved off $392 million in revenues. In constant currencies, revenues were up by 25%. Revenues came more in line with consensus estimates of $15.73 billion.

Operating income fell by 26% to $79 million. Net losses came in at $7 million, or $0.02 per share. This compares to a profit of $7 million last year. Analysts were looking for earnings per share of $0.05 per share.

Founder and CEO Jeff Bezos commented on the second quarter developments:

We're so grateful to our customers for their response to Kindle devices and our digital ecosystem. This past quarter, our top 10 selling items worldwide were all digital products - Kindles, Kindle Fire HDs, accessories and digital content.

Looking Into The Results

Amazon.com's activities in North America continue to boost the overall performance. Revenues rose by 29.6% to $9.5 billion, while operating income rose by 18.9% to $409 million, resulting in operating margins of 4.3%.

International revenues were up by merely 12.7% to $6.2 billion. The company broke even on an operating level, compared to a modest $16 million profit last year.

Gross margins rose by a solid 250 basis points to 28.6% of total revenues, driven by stronger growth at high margin businesses including the Amazon's cloud business. Technology and content spending, rose by 46.6% to $1.59 billion . These expenses, or actually they most represent investments, are impacting short term earnings.

Shipping revenues rose by 38% to $646 million, outpacing revenue growth. Shipping costs rose by 29% to $1.36 billion, resulting in net shipping costs of $718 million, which is up 23% on the year before.

Amazon.com aggressively grew its staff by 40% to 97,000 workers.

Third Quarter Guidance

For the current third quarter, Amazon.com expects to generate sales between $15.45 and $17.15 billion. This implies that sales are expected to grow between 12 and 24% compared to last year, a marked slowdown compared to the growth rate in the second quarter. On average, analysts were looking for third quarter revenues of $17 billion.

Amazon.com expects to report operating losses which could come in anywhere between $65 and $440 million. Last year, the company reported a $28 million operating loss. Consensus estimates for operating income stood at $390 million.

Valuation

Amazon.com ended its second quarter with $7.5 billion in cash, equivalents and marketable securities. The company operates with $3.0 billion in long term debt, for a solid net cash position of $4.5 billion.

For the first six months of its fiscal 2013, Amazon.com generated revenues of $31.77 billion, up 22.1% on the year before. Net profits fell by almost a half to $75 million. At this rate, the company could generate annual revenues of around $75 billion, while reporting modest profits.

Trading around $310 per share, the market values Amazon.com at some $140 billion, or its operating assets around $135 billion. This would value the company's operating assets at about 1.8 times annual revenues.

Some Historical Perspective

While Amazon.com has been widely criticized for not earning meaningful profits, or any profits at all, shares have continued their upwards move higher. Over the past decade, shares have seven-folded on the back of very impressive revenue growth rates.

Between 2003 and 2009, shares moved in a wide $30-$100 trading range. Shares topped $100 per share in 2009 and have steadily moved upwards, currently exchanging hands at all time highs around $310 per share.

Between 2009 and 2012, Amazon.com has increased its annual revenues by some 150% to little over $61 billion. A $902 million profit in 2009 has largely evaporated over the past year.

Investment Thesis

The combination of a continued lack of profitability, coupled with fresh all time highs for Amazon's stock, has been an issue of fierce debate in the investment community.

I would consider myself in the camp of those arguing that Amazon is deliberately depressing current earnings in order to invest in future ventures which should boost long term profitability, and consequently the value of the entire firm.

Amazon.com is growing its ecosystem, not just by selling books and movies, but also by selling more Kindles, which should drive future content revenues. The company furthermore recently closed some movie deals with established production houses. The continued investments in fulfillment and distribution are not just resulting in great customer service, it prepares the company for same-day delivery as well, which allows the firm to even sell groceries, which is a massive potential market.

As such, traditional valuation multiples, especially price-earnings ratios, are not applicable in the case of Amazon.com. Still, investors have great confidence in Jeff Bezos who clearly states that long term profitability and value creation is the primary goal. In this case, investors don't even mind that Amazon.com missed earnings estimates again for the second quarter, in fact, they are not even upset with the disappointing outlook for the third quarter.

Even on traditional valuation metrics, Amazon.com is valued at 1.8 times this year's expected revenues. This is a significant premium compared to the likes of Wal-Mart (WMT), which trades at 0.5 times annual revenues, but does operate with a sizable debt position.

This valuation leaves the company vulnerable as it could disappoint the investment community, notably if its revenues are missing compared to consensus estimates. The growth slowdown in its international operations is worrying, although the North American operations continue to grow at an impressive pace.

The US operations are much more profitable as well, reporting operating margins of 4.6%, while European operations struggle to break even. Applying US margins to the global company, and Amazon is on track to generate operating profits of around $3.5 billion for the year. The continued leverage in the business model, current over investments, and future possibilities to monetize the massive database of online customer behavior could further boost profitability, especially as the pace of investments will slow down.

Amazon.com is rapidly diverging from just selling books and movies. Instead it has focused on the Kindle to boost the ecosystem while it is also actively engaged in boosting its cloud presence with its Amazon Web Services. Amazon also boost video content offerings through agreements with Viacom (VIAB) and NBCUniversal. These initiatives, coupled with continued investments in its "traditional" business in Europe and Asia and the solid performance of domestic operations, should drive the revenue growth potential of the overall business.

For now investors continue to trust Bezos in his vision to sacrifice short term gains in order to create the most long term shareholder value. Trust continues to be high, while it has been successfully put to the test in the past quarter. Shares have set fresh all time highs despite disappointing results and a soft outlook.

Back in June of this year when there were rumors about Amazon.com rolling out in the online grocery business, I took a look at the company's prospects. Amazon.com was to contemplate serving 20 to 40 markets with groceries, an industry still largely unaffected by the e-commerce revolution. Yet a successful move would be massive for Amazon.com allowing the company to grow its revenues going forwards while leveraging its current distribution network.

An expansion into this terrain will not immediately result in profits to shareholders. Still Amazon.com has demonstrated commitment to loss-making projects, which fortify the strategic direction of the company, in the past. Its cloud-business, Kindle and video streaming content are current examples. The over investments into warehousing and distribution capacity in recent years could result in massive operating leverage if the company could sell groceries under its current business model as well.

Since the start of June, shares have risen another 15%. While I have been a long time fan of Amazon.com and its stock, I am a bit cautious at these levels given the slowdown in revenue growth, the main support behind the current valuation.

Source: Amazon Keeps Amazing - Revenue Slowdown Is Worrying As Valuation Is Based On Growth