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Amazon.com Inc. (AMZN)

Q3 2006 Earnings Call

October 24, 2006 5:00 pm ET

Executives

Jeff Bezos - founder and CEO

Tom Szkutak – CFO

Kim Nelson - IR

Analysts

Jeetil Patel - Deutsche Bank

Anthony Noto – Goldman Sachs

Robert Peck - Bear Stearns

Paul Keung - CIBC World Markets

Imran Khan – JP Morgan

Mark Mahaney – Citigroup

Safa Rashtchy - Piper Jaffray

Doug Anmuth - Lehman Brothers

Mark Rowen - Prudential

Scott Devitt - Stifel Nicolaus

Heath Terry - Credit Suisse

Presentation

Operator

Good day, everyone and welcome to the Amazon.com third quarter 2006 financial results conference call. Today's call is being recorded. For opening remarks and introductions I would like to turn the call over to Ms. Kim Nelson. Please go ahead, ma'am.

Kim Nelson

Hello and welcome to our Q3 2006 financial results conference call. Joining us today is Tom Szkutak, our CFO. Jeff Bezos, our founder and CEO, and Tom will both be available for Q&A. The following discussion and responses to your questions reflect management views as of today, October 24, 2006 only and will include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results is included in today's press release and our filings with the SEC including our 2005 annual report on Form 10-K.

As you listen to today's call, we encourage you to have our press release in front of you which includes our financial results as far well as metrics and commentary on the quarter. During this call we will discuss certain non-GAAP financial measures. In our press release, slides accompanying this webcast and our filings with the SEC, each of which is posted on our IR website, you'll find additional disclosures regarding these non-GAAP measures including reconciliations of these measures with comparable GAAP measures. Finally, unless otherwise stated, all comparisons in this call will be against our results for the comparable period of 2005.

Now, I will turn the call over to Tom.

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Tom Szkutak

Thanks, Kim. I will begin with comments on our financial results. The trailing 12-month free cash flow declined 23% to $366 million, driven primarily by our increased expenditure in technology and content. The combination of common stock and stock-based awards outstanding was 435 million shares compared with 438 million, down 1%. During the quarter we repurchased 8 million shares or $252 million under our previously announced authorization to repurchase up to $500 million of the Company's common stock.

Return on invested capital is 23%. ROIC is free cash flow divided by average total assets minus average current liabilities. Revenue grew 24% to $2.3 billion or 23%, excluding the $20 million favorable impact from year-over-year changes in foreign exchange rates. In Q3 2005, worldwide revenue benefited by 260 basis points of year-over-year growth from Harry Potter 6, plus preorder attachments. Excluding Harry Potter 6 plus preorder attachments and changes in FX, revenue growth was 26%. Worldwide unit growth was 22% or 24%, excluding HP 6 plus attachments.

Active customer accounts surpassed 61 million, up 17%. Electronics and other general merchandise, or EGM, increased to $699 million, up 43%, or 41% excluding foreign exchange rates. EGM represents 30% of worldwide sales up from 26%.

Gross profit grew 18% to $549 million in Q3. Gross margins decreased 113 basis points to 23.8%, which reflects lower product prices for customers, greater shipping loss driven by free shipping in Amazon Prime, and product mix.

Now I'll discuss operating expenses excluding stock-based compensation. Fulfillment, marketing, tech and content and G&A combined was $477 million or 20.7% of sales, up 227 basis points. Fulfillment was $209 million or 9.1% of sales, up 11 basis points. We opened a new fulfillment center in Leipzig, Germany which is now fully operational. Marketing was $63 million, or 2.7 percent of sales, up 45 basis points. Technology and content was $156 million, up 45% year-over-year or 6.8% of sales, up 98 basis points year-over-year and down 31 basis points as a percentage of sales from Q2.

We are investing in technology to innovate in areas such as seller platforms, web services and digital. Additionally, we continue to invest in increasing selection. In the last 12 months we have increased selection of unique products carried in our warehouses by over 50%. In addition to adding to our category leadership and buying teams for existing categories, we have added additional resources in new categories. You should expect we will continue to add selection over time. We expect the year-over-year percentage growth in technology and content to continue to decrease in Q4 2006.

G&A was $49 million or 2.1% of sales, up 72 basis points. As a reminder, in Q3 '05, we recorded a $12 million expense reduction related to actual and expected reimbursement by an insurer of certain legal costs that had been previously incurred by us.

Now we will talk about our segment results. Consistent with prior periods, we don't allocate stock-based compensation or other operating expense to our segments. In the North America segment, revenue grew 21% to $1.26 billion. Media revenue grew 15% to $785 million even though the comparison quarter last year included the release of Harry Potter 6.

EGM grew 35% to $409 million, representing 33% of North America revenues up from 29%. Gross profit grew 17% to $343 million and gross margin decreased 78 basis points to 27.3%, primarily from lowering prices including free shipping at Amazon Prime as well as product mix. The North America segment operating income decreased 67% to $22 million, a 1.7% operating margin.

In the International segment, revenue grew 29% to $1.05 billion. Revenue growth was 26%, adjusting for the $18 million year-over-year favorable FX impact during the quarter. Media revenue grew 20% to $757 million or 19% excluding FX. EGM revenue grew 55% to $290 million or 51%, excluding the impact of foreign exchange rates. EGM represents 28% of international revenues, up from 23%. Gross profit grew 21% to $206 million or grew 18% excluding FX, while gross margin decreased 130 basis points to 19.6%, which reflects price decreases and product mix. International segment operating income decreased $4 million or 8% to $50 million, a 4.8% operating margin. Excluding the favorable impacts of foreign exchange, international operating income decreased 9%.

The combination of operating income in our North American and International segments is our consolidated segment operating income or CSOI. Our segment information in our press release reconciled CSOI to GAAP operating income. CSOI declined 40% to $72 million. The decline in operating income was mainly due to technology and content investments. Unlike CSOI, our GAAP operating income includes stock-based compensation expense and other operating expense. GAAP operating income decreased 28% to $40 million. Third quarter 2005 operating income included a negative impact of $40 million, related to a patent litigation settlement.

Our provision for income taxes was $19 million in Q3 and our current estimate of our annual effective tax rate is 51%. Our effective tax rate remains higher than the 35% statutory rate, primarily due to taxable income associated with the transfer of certain operating assets in connection with establishing our EU Headquarters in Luxembourg.

We expect these assets transfers to beneficially impact our effective tax rate over time. Since we have deferred tax assets related to our NOLs, these asset transfers will not have a significant impact on our cash taxes paid in 2006, which we expect to be approximately $25 million compared with $12 million in 2005. We are endeavoring to optimize our global taxes on a cash paid basis, not for tax expense on a financial reporting basis.

GAAP net income was $19 million or $0.05 per diluted share compared with $30 million and $0.07 per diluted share.

Turning to the balance sheet, cash from marketable securities decreased $199 million to $1.2 billion. As a reminder, we repurchased $252 million of our common stock in the third quarter. Inventory increased 61% to $736 million and turns decreased 11% to 13.2 as we expanded selection and improved in-stock levels across product categories.

Our investment in net fixed assets, which includes net capitalized software development costs, increased to $449 million. Our capital expenditures were $62 million for Q3, of which $28 million were software development costs.

Our growth continues to be fueled by our relentless focus on the primary inputs of customer experience, convenience, selection and price. Some recent examples of our progress include Amazon Prime. In Q3 '06 we continued to see strong quarter-to-quarter sequential growth for new Prime memberships. We continue to see increased purchases by Amazon Prime customers across more categories, with especially heavy purchases in electronics, kitchen, and health and personal care.

We launched Amazon Unbox, a digital video download service offering customers thousands of television shows, movies, and other video content from more then 30 studio and network partners from Hollywood and around the world; and we're pleased to introduce even more selection with our recent addition of Showtime Premium programming.

Amazon Business Solutions launched, in beta, Web Store by Amazon and Fulfillment by Amazon, giving small and medium-sized businesses access to Amazon's order fulfillment, customer service, and customer shipping offers and underlying website technology.

Our Japanese website launched its health and beauty store, offering customers a selection of over 35,000 items in 12 categories including supplements, drinking water and soft drinks, condiments, processed foods and health foods as well as cosmetics and products for bath care, nursing care and relaxation.

Our Automotive Parts and Accessories store now has over 1million automotive products offered by Amazon in leading mass market and specialty retailers. In Q3 we saw a wide range of auto part purchases from air filters, shock absorbers, and handheld diagnostics scanners to a recon engine Ford 302 5 liter Xtreme OHV Remanufactured long block engine that we delivered to a customer in Spokane, Washington.

Amazon's innovative Part Finder allows owners of approximately 10,000 different cars and truck models to find the correct replacement parts, performance parts, or accessories for their vehicle.

Amazon Web services launched in Amazon Elastic Compute Cloud, Amazon EC2, in limited public beta. Amazon EC2 is a web service that provides resizable compute capacity, making web scale computing easier for developers. Just as Amazon Simple Storage Service, Amazon S3, enables Storage in the Cloud, Amazon EC2 enables Compute in the Cloud. Developers continue to adopt Amazon's web services. Over 200,000 have registered to date up greater than 60% year-over-year.

Third-party sales remains a key part of our selection expansion. Worldwide active seller accounts were approximately 1.1 million and third-party units representing marketplace and merchants units sold on Amazon sites were 30% of total units, flat with the prior year. Additionally, our international third-party business expanded with the launch of Merchants@ in the UK and Germany.

Some pricing highlights include the average customer discount for music purchased on www.amazon.com increased more than 350 basis points year-over-year. The average customer discount for DVDs purchased on www.amazon.com increased more than 200 basis points year-over-year. Over the past 12 months, customers have saved over $0.5 billion on shipping through our worldwide free shipping offers in Amazon Prime.

I will conclude my portion of today's call with guidance. Incorporated into our guidance of the order trends we have seen to date and what we believe today to be appropriately conservative assumptions. However, there's a high level of uncertainty surrounding fluctuation in the euro, pound, yen, Canadian dollar and yuan exchange rates, as well as the global economy and consumer spending and the impact on both of world events. While we are cautiously optimistic, it is not possible to accurately predict demand; and therefore our actual results could differ materially from our guidance.

Let me also remind everyone that we mark our euro-denominated debt to market at the end of each quarter which results in a gain or loss for any movement in the euro between reporting dates. We also have euro exposure related to our interest expense on this euro-denominated debt. We incur a foreign currency gain or loss corresponding with intra-company balances denominated in foreign currencies which are settled among subsidiaries. Depending on the amount and timing, an unfavorable resolution of outstanding legal matters could materially affect our business results of operations, financial position, or cash flows in a particular period.

Our effective tax rate is subject to a significant variation based on changes in our corporate structure and business operations, the amount of expenses incurred that are permanently non-deductible for U.S tax purposes such as stock-based compensation paid to foreign employees; the tax characterization of income earned; changes in current tax laws; and changes in estimates including accurately predicting our taxable income and the taxable jurisdictions to which it relates.

Our guidance assumes that we won't record any additional intangible assets or any further revisions to stock-based compensation or our restructuring-related estimates and that foreign exchange rates remain approximately where they've been recently.

For Q4, we expect net sales of between $3.625 billion and $3.95 billion, a growth of between 22% and 33%. This guidance anticipates approximately 225 basis points of positive impact from foreign exchange. GAAP operating income to be between $145 million and to $235 million or between a 12% decline and 43% growth. This includes stock-based compensation and amortization of intangible assets of approximately $35 million.

We anticipate consolidated segment operating income, which excludes stock-based compensation and other operating expense, to be between $180 million and $270 million or between a 3% decline and 46% growth.

For the calendar year 2006, we expect net sales of between $10.35 billion and $10.675 billion, a growth of between 22% and 26%. This guidance anticipates a small negative impact from foreign exchange. GAAP operating income to be between $339 million and $429 million or between a 22% decline and a 1% decline. This includes approximately $113 million of stock-based compensation and amortization of intangible assets.

We anticipate Consolidated Segment Operating Income, which excludes stock-based compensation and other operating expense, to be between $452 million and $542 million, or a 20% decline and 4% decline. As you can see from our guidance, we expect operating leverage will show significant sequential improvement in the fourth quarter.

We anticipate our 2006 free cash flow growth rate to trend similar to our operating profit growth rate year-over-year with some variability from changes in working capital. This excludes the impact of FAS 123R, which could be up to $100 million of excess tax benefits from stock-based compensation being classified as positive financing cash flows instead of operating cash flows, up from $7 million in 2005.

We expect capital expenditures, including capitalized software development costs, to be approximately $225 million We will continue to strive for year-over-year annual growth of free cash flow and free cash flow per share while investing in our long-term opportunities. We are confident that if we continue to improve customer experience and execute efficiently, our value proposition as well as our free cash flow will expand.

Thanks, and with that, Kim, let's move to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeetil Patel - Deutsche Bank.

Jeetil Patel - Deutsche Bank

Two questions. You historically have talked about overall profit margins and cash flow margin percentages not important or indicative of the business strategy. Can you just give us a sense of how we should think about the operating profile or your game plan in areas like web services, business solutions and social networking services? I have a quick follow-up.

Tom Szkutak

Certainly when you think of web services and some of the other areas that you mentioned, it's very early. So it's certainly something we are very optimistic about over the long term. In terms of projecting anything near term, I don't think it is appropriate to do so.

Jeetil Patel - Deutsche Bank

Do you look at those businesses that are in this nascent mode today as ways to fuel the growth of the core franchise? Or is it leveraging the existing infrastructure and assets that you have built out over the past nine years and putting them to use in the marketplace? How do you look at new business versus driving the existing operation?

Tom Szkutak

It is some of both. We certainly think that this can be a meaningful business over the long term and can have an impact on the overall economics of the company. The reason we're doing the web services that we are doing is because they are things that we've gotten good at over the last 11 years in terms of building out this web scale application called Amazon.com. So as we go about exposing the guts of Amazon, there are other developers out there who require those same sorts of web scale services. So these are assets and skills that we needed to build for ourselves anyway. What we're doing here is exposing those and, over time, build that into a meaningful business.

Jeetil Patel - Deutsche Bank

Thanks.

Operator

Your next question comes from Anthony Noto – Goldman Sachs.

Anthony Noto – Goldman Sachs

Thank you very much. Tom and Jeff, in the past, when we have talked about the fact that we thought your cost of gross was increasing, you have pointed to the fact that you have been spending on elements in the P&L that don't necessarily drive revenue in the near term; technology and content.

But as we look over the past three quarters, your marketing expense line has accelerated from 25% year-over-year growth in Q1 to 30% year-over-year growth in Q2 to 50% year-over-year growth in Q3. In your release you disclosed the fact that your marketing expense will be variable with revenue and increase or decrease depending on the competitive environment and other factors.

So as your tech and development expense year-over-year started to decline, this other line item, which is tied directly to revenue, is starting to accelerate. So I was wondering if you could give us a little perspective on what is actually driving that increase in your cost of revenue? What do you think about the prospects for that as you go into 2007 and your ability to get back to double-digit incremental operating margins? Thanks.

Tom Szkutak

Sure. If you take a look at our marketing expense, it has been in the range of approximately 2.2% to 2.7% over the last several quarters, 2.7% being the most recent quarter. If you look at what we've done over really the past year, we have added a lot of new selections. In fact, if you look at the unique selection that we have added under our own roof, that is up over 50% year-over-year.

So what we're really doing is we've spent a lot of time adding selections; we have spent a lot of effort also making sure that our prices are low. So we're trying to make sure that our customers realize that we have great selection and good prices in the form of advertising. So that is what we're doing. It is still, I think, at a very modest spend level, being less than 3% of revenue.

Anthony Noto – Goldman Sachs

I guess it just really begs the question, is it just sort of a transition from the first year investment in technology to be able to sell the products on your site and offer them, and now you have to invest in the marketing to be able to get awareness of those products so people will buy them? When does that transition stop and we can get back to that profitability and return on your investments since your cash flow is still declining?

Tom Szkutak

Anthony, that is not the way we are thinking about it. You should think that of it in, at least in the recent history, it's been in a lower relative range. And again, we've talked quite a bit in the past about trying to make sure that we educate customers. That is what we're doing in this case. I wouldn't think of it as a fundamental shift in any way.

Anthony Noto – Goldman Sachs

Okay, thank you.

Operator

Your next question comes from Robert Peck - Bear Stearns.

Robert Peck - Bear Stearns

Hi guys, just a couple of quick questions here. First of all, touching on Jeetil's question there in a different way, when we think about products such as Askville and EC2 and S3 and all that, can you maybe breakdown for us what is the incremental spend going to those type of more technological or even social products versus the core development of the platform? That is number one.

Number two is, could you talk to us about any integration issues or hurdles you have had building the toy store up? If there are any impacts for Q4?

Then could you give us more details around Unbox? Any sort of statistics you have as far as downloads, streams; anything else to give a gauge on how Unbox is doing versus the other competitors out there? Thanks.

Tom Szkutak

In terms of the question on specifics on spend, we haven't broken out technology and content in terms of the specific details. But what we've tried to do is give you some help by talking about some of the larger buckets. So if you look at the year-over-year increase, certainly you're seeing investments in web services, investments in digital, investments in the seller platform, investments in other customer experience. That is from a technology standpoint.

In addition to that, certainly new categories. The content piece of technology and content and some of the announcements that we have made recently in terms of Automotive and other category launches are certainly part of that spend as well.

In terms of your second part of the question on toys, we have certainly been spending a lot of time trying to improve selection in toys, certainly in a very short period of time both with retail selection as well as third-party selection. So we have been spending time certainly over the past several months doing that, making sure that we monitor prices carefully.

So those two things we have certainly have been doing over the last several months, getting ready for the most seasonal aspect of toys, which is Q4. We have over 125,000 unique items in toys currently that we are offering. So those are things that we think over the long term toys is something that is going to be very good for customers and for shareholders. We are pleased with what we're doing there.

In terms of the last part on Unbox, in terms of any statistics it is just very early. We are certainly pleased that we continue to add selection in Unbox but again, video is very early. We're going to continue to innovative on that over time and make the experience even better for customers.

Robert Peck - Bear Stearns

Thank you.

Operator

Your next question comes from Paul Keung - CIBC World Markets.

Paul Keung - CIBC World Markets

Hi, Tom. The first question is on life after Toys 'R' Us, I guess. Looking at the category, looking at where you are today versus where you would have been six months or a year ago, do you think the category will be better, the same or worse in terms of revenue growth and profitability this quarter in light of what you're going to do?

The second question has to do with your third-party business in Europe. I am just wanting to get an update in terms of how the Marks & Spencer launch went this month. Should we start to see an acceleration in the number of new customers on that platform now that you have the big one up and running?

Tom Szkutak

In terms of Toys 'R' Us, in terms of the revenue and the profitability, it is incorporated into our guidance in Q4. We are not breaking out the specific number within guidance. I apologize, I couldn't hear the second part of your question. Could you repeat the last part of your question?

Paul Keung - CIBC World Markets

Yes, the second part of the question had to do with the third-party business in Europe. I guess with the launch of the Marks & Spencer relationship in the UK this month, I was wondering if we should start to see an acceleration and adding new partners on that third-party platform in Europe now that the bigger one is up and running?

Tom Szkutak

In terms of the third-party platform in International we're actually pleased with it. In the comments I made earlier, we have launched merchants at International for the UK and Germany. So certainly over time you will be seeing more and more partners selling our platforms so we're actually pleased with that.

In terms of any specific announcements on timing, we generally don't announce specific times related to launches until they happen.

Paul Keung - CIBC World Markets

Thank you.

Operator

Your next question comes from Imran Khan – JP Morgan.

Imran Khan – JP Morgan

Hi, thank you very much. Tom and Jeff, two questions. You talked about the inventory and stock selection increase, but if I look at the balance sheet it seems like your inventory grew 61% year-over-year, up from 36 and 33 in Q1 and Q2. I was trying to get a better sense if there is anything you're seeing into the quarter that increases your confidence to increase that inventory at that level?

Secondly, actually probably a very similar question, your revenue growth guidance is guiding an acceleration. Just trying to get a better sense of what are you seeing into the quarter? Thank you.

Tom Szkutak

I apologize, you're breaking up in part of your question, but in terms of the inventory increase up 61%, the two key drivers of that is expanding selection, as I mentioned earlier in one of the other questions. Year-over-year, we have increased our selection in our warehouses up 50% year-over-year. So certainly that is part of what you are seeing in inventories. We are also improving our in-stock levels. We're having more quantities on hand to better service customers. So those are really two aspects that you are seeing.

Just as another note, certainly what you have seen in the past as you look at Q3 as a reminder, that we have started to bring in inventory to get ready for the holiday season. So you are seeing some of that reflected in the balance.

Then in terms of investment, just also note that as you see the inventory rising, you're also seeing the payable balance rise substantially as well. Our days at the end of Q2 were 53 days. At the end of Q3 they were 63 days. Then it was also up year-over-year from 58 days to 63 days.

Imran Khan – JP Morgan

With regards to the revenue growth acceleration guidance? I'm trying to get a sense to understand your confidence level for the Q4 guidance?

Tom Szkutak

Sure. Again, the range that we have given for Q4 is 22% to 33%. As I had mentioned, that also includes favorable exchange of approximately 225 basis points. So that is the range that we have given. We are cautiously optimistic as we enter Q4 because of the selection that we have added which relates back to the inventory question, the in-stock improvement that we are working on as well as throughout the year, the lower prices.

In addition, with the Amazon Prime certainly becoming more meaningful, having Amazon Prime customers certainly taking advantage of all the selection that we have, for the first time toy customers will be able to have the advantage of that during Q4 as well as Supersaver Shipping. So all of those things we think are reflected in the guidance that we have given today.

Imran Khan – JP Morgan

Thank you.

Operator

Your next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

Thank you very much. Could you talk about what kind of impact we could see on margins from the rollout of Merchants@ internationally? Or maybe a way to get at that would be, could you maybe break out what percentage of units sold internationally would be third-party versus your overall average?

Secondly, just a brief comment on the operating income guidance for the fourth quarter. While you increased your revenue guidance for the fourth quarter just slightly, but you did, lower your operating income guidance. Was there something you saw that made you more concerned about margins or less confident about margins in the December quarter? Thank you.

Tom Szkutak

In terms of the first part of your question, in terms of Merchants@, it is difficult to predict what the ultimate third-party mix will be in each of our geographies. What we have said in the past is that certainly, as you look at our overall third-party units as a percentage of total worldwide, that we are further ahead in North America than we are in International. Certainly the launch of Merchants@ International in the countries that I have mentioned will certainly help that over time from a third-party mix standpoint.

So again, difficult to predict exactly where that is going to end up. Ultimately the customer will decide. But we will continue to add retail selection as well as third-party selection. Again, the Merchants@ will help us do that.

In terms of the guidance on CSOI, we actually tightened the range a little bit from what we gave you 90 days ago. The CSOI guidance for the year was 430 to 560. We tightened that during this guidance period to be 452 to 542. So we increased the lower end of the range by 22. We decreased the top end of the range by 18. So the midpoint increased slightly on the year.

You are right. Given the fact that we exceeded the midpoint for Q3 by a little bit, you are seeing Q4 come down slightly. But again, the way that I am thinking about it is, it is a slight increase on the year with strong sequential leverage in Q4, which we feel good about.

Mark Mahaney – Citigroup

Thank you very much.

Operator

Your next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Thank you. First, on that last point on the leverage you mentioned in Q4, how much of it is due to the normal seasonality that you always see? How much of it is because of the lower spending that you're planning to do?

Secondly, beyond Q4, could you give us some outlook or guidance as to what factors will be impacting margins going forward? In the past you have indicated that you were continuing to spend and increase spending as a percentage of sales, especially on technology, as you had a number of initiatives. Have we reached a stability level for those? How should we look at the margins going forward? Thanks.

Tom Szkutak

In terms of Q4, when you look at our Q3 technology and content spend, you can see that the growth rate declines versus what we have seen recently. On a percentage of revenue it actually declined versus Q2. For Q4 you should expect the growth rate will decline further, but still growing. So that is certainly one of the key drivers from a leveraged standpoint.

The other one, certainly as you mentioned, I wouldn't view it as seasonal, but I view it as the growth rate. Certainly when you look at the range of growth that we are expecting, the growth rate is also helping us get leverage in Q4. So those are really the key drivers as it relates to Q4.

And then in terms of going forward, we are not giving guidance, consistent with what we did last year. We're not giving guidance beyond Q4.

You mentioned technology and content. What we have said over the last few quarters and consistent with that, we said that we will continue to grow technology and content. But with the deliberate buildup that we have had over the past years, we are going to be growing into that investment. But you should expect still that we will be growing on an absolute dollar basis.

Keep in mind that when you think about technology and content, it is certainly the technology aspect of that; there is also a content aspect to that which is adding new selections and category expansion, which certainly we will be continuing to do over time.

Safa Rashtchy - Piper Jaffray

Thank you.

Operator

Your next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

Thank you. For the last several quarters, Tom, you have been talking about investing in seller platforms, digital web services and search. It seems like this quarter you dropped Search from that mix given the recent scale back in A9. So can you talk about why the change in strategy around A9 and Search? What has changed in the marketplace? Are there any cost savings involved there or perhaps how you're able to deploy the engineers working on Search? Thank you.

Tom Szkutak

Sure. We still have a substantial investment in search. A9 was doing a few things for us; and one was product search, which we continue to invest in. We continue to learn a lot of things from our resources there. You shouldn't expect to see savings from that. We have certainly reallocated some resources to areas that we think are more beneficial to customers and shareholders over time, and that is what we're doing there.

Operator

Your next question comes from Mark Rowen - Prudential.

Mark Rowen – Prudential

Thanks. Two questions. It looks like your fulfillment cost deleveraged by about 20 basis points year-over-year and that is the first time that has happened in a while. Is that because of the new facility in Europe? Do you expect that deleveraging to continue for a few quarters until you build into the capacity?

Second in the toy business, Wal-Mart just talked about how that was one of the categories they were going to be very aggressive on and rolling back prices on certain items. Do you feel you need to beat them on price? Or is your offering more about selection and you don't have to worry too much about the limited items that they are going to have at very cheap prices? Thanks.

Tom Szkutak

In terms of the first part of your question related to ops , certainly one piece of that is capacity. You mentioned the facility. We are operational in Leipzig, Germany, which is certainly a piece of that. Other things that are going on there, I mentioned the selection that we have been adding as well as improving in-stocks and you can see the build up in inventory. Certainly those are all factors that are also impacting our operational costs as a percentage of revenue.

In terms of your specific questions, the second part of your question, we have a long-standing practice of not talking about any specific company. So I can't help you with that one.

Operator

Your next question comes from Scott Devitt - Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

I had two questions. First, on the fulfillment center utilization, particularly in domestic you have added groceries, toys, jewelry, and third-party fulfillment services just in the past year. I'm wondering if there's going to be a need for additional capacity in terms of actual fulfillment centers over the next year? Or if you can meet the increased selection with the infrastructure you have? Then I had one follow-up.

Tom Szkutak

Yes. In terms of any type of guidance for next year, we are not providing. We will certainly look, we learn a lot as we go through our seasonal time of the year so we'll be going through that, obviously, in the next few months. As we go through that and learn from what we see, we will certainly make our plans more specifically for next year and we can update you as we go there.

I'm sorry; you had a second part to your question?

Scott Devitt - Stifel Nicolaus

Related to the lower gas prices and on the consumer-facing side of your business, have you noted any short-term increase in consumer purchasing patterns that would have been reflected in your fourth-quarter guidance? That would be the first question.

Then on a longer term basis, even if energy prices were to stabilize at lower prices, what would it take to have the impact on your back-end logistics costs in terms of re-negotiations with the logistics providers? Thanks.

Tom Szkutak

In terms of the first part of your question, I don't think we are a great bellwether for the economy. But certainly any of the recent trends as well as the trends that we think will happen into Q4 are reflected in our guidance.

Operator

Your final question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

You have often talked about this ultimately being a 10% operating margin business. With all of the changes in the business over the years, as well as this focus on services, is that still the case or have those expectations changed?

On a shorter term basis, as you start building out the toy inventory and building your relationships with suppliers in that category, can you talk to us about what your experience has been and whether you have been able to get the kind of inventory commitments that you want, particularly on the hot toys for the season?

Tom Szkutak

In terms of the first part of your question related to operating margins, the way we think about it, as a reminder, is we are actually trying to maximize free cash flow and free cash flow per share. So that is forefront what we are trying to do over the long term. So as it relates to operating margins, it is difficult to see where they will end up.

Certainly, as we were talking about earlier as it relates to third-party mix, we are going to continue to add retail selection, we are going to continue to add third-party selection; and ultimately the customers are going to dictate what that mix will be, which will also certainly have an impact on our operating margins.

So that is how we think about it. Where we will end up is difficult to say. But whether it is a double-digit or a high-single digit is hard to say. But certainly our goal is to maximize free cash flow and free cash flow per share.

As it relates to toys, could you just repeat the second part of your question as it relates to toys?

Heath Terry - Credit Suisse

I was just saying that as you have started to build out the supplier relationships and buying inventory for this holiday season, can you talk to us about what your experience has been, particularly with regard to being able to get the type of inventory, hot toys and such that you would actually want and pricing that you would want for the business?

Tom Szkutak

Well, we have been in the toy business for some time as a provider. We've also had, in terms of relationships, we certainly have some relationships outside of the U.S. as we have toy categories launches outside of the U.S.

In terms of getting into specific details, I don't think it is appropriate on a vendor by vendor basis or anything like that. But we are certainly pleased with the selection we have. We have added a lot of selection in a very short period of time, over 125,000 unique items. Customers are going to benefit from that selection during Q4. Prime customers will have the benefit of getting product, toys shipped quickly to their home or office or families. We also offer Free Supersaver Shipping. Which again, those are things that will be very helpful to toy customers. We will continue to add selections over time in that category.

Kim Nelson

Thanks, Heath, and thank you for joining us on the call today and for your questions. A replay will be available on our Investor Relations web site at least through the end of the quarter. We appreciate your interest in Amazon.com and look forward to talking with you again next quarter.

Operator

That does conclude today’s conference call.

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Source: Amazon.com Q3 2006 Earnings Call Transcript
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