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Amazon.com Inc. (NASDAQ:AMZN)

Q4 2006 Earnings Call

February 1, 2007 5:00 pm ET

Executives

Kim Nelson - IR

Tom Szkutak - CFO

Jeff Bezos -Founder and CEO

Analysts

Justin Post - Merrill Lynch

Anthony Noto - Goldman Sachs

Brian Pitz - Banc of America

Scott Devitt - Stifel Nicolaus

Mark Mahaney - Citigroup

Safa Rashtchy - Piper Jaffray

Robert Peck - Bear Stearns

Jeetil Patel - Deutsche Bank Securities

Douglas Anmuth - Lehman Brothers

Paul Keung - CIBC World Markets

Imran Khan – JP Morgan

Mark Rowen - Prudential

Presentation

Operator

Good day, everyone and welcome to the Amazon.com fourth 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 the Director of Investor Relations, Ms. Kim Nelson. Please go ahead, ma'am.

Kim Nelson

Hello and welcome to our Q4 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's views as of today, February 1, 2007, 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 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 will 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. We demonstrated significant sequential improvement in operating leverage, achieving 4% positive leverage in Q4 from negative 11% in Q3. Operating leverage is the change in consolidated segment operating income relative to the change in sales.

We increased Q4 CSOI by 24% year over year, as we grew gross profit by $183 million but operating costs by only $139 million. This marks a substantial improvement in leverage versus the other three quarters of 2006, as we lapped the higher spending in technology and content and gross profit dollars grew faster than operating expenses, driven by accelerated revenue growth.

In 2006, free cash flow decreased 8% to $486 million, largely reflective of our negative operating leverage during the first three quarters of the year. Sequentially, trailing 12 month free cash flow increased $119 million compared with Q3, an improvement of 33%. Worldwide revenue grew 34% to $3.99 billion or 30% excluding the $122 million favorable impact from year-over-year changes in exchange rates. Worldwide unit growth was 23%, and active customer accounts exceeded 64 million, up 16%.

Media revenue increased to $2.5 billion, up 25% or 21% excluding foreign exchange rates. EGM revenue increased to $1.4 billion, up 55% or 51% excluding FX. Worldwide EGM increased to 35% of worldwide sales, up from 30%. For the first time, non-media dollar growth exceeded media dollar growth, even though media grew 25% in the quarter.

Worldwide gross profit increased $183 million or grew 27% to $850 million in Q4. Gross margin decreased 108 basis points to 21.3% from product and third-party mix, lowering prices for customers in Amazon Prime. Worldwide active seller accounts were over 1.1 million, and third-party units representing marketplace and merchants@ units sold on Amazon sites, or 25% of total units versus 28% in the prior year.

Third-party mix decreased as we transitioned to our new toys, baby and video games stores in the US which are now, like most of our stores, a combination of Amazon retail and third-party sales. Worldwide revenue growth benefited by approximately 160 basis points year over year from sales in these categories and excluding these categories, third-party units as a percentage of total units increased year over year.

From an OpEx standpoint, we achieved the slowest growth rate in total segment operating expenses in over two years. G&A declined year over year, which reflects a benefit related to insurance recoveries of $8 million.

Now, I will talk about our segment results and consistent with prior periods, we do not allocate the segments or stock-based compensation or other operating expense line items. In the North America segment, revenue grew 31% to $2.21 billion, setting a six-year growth rate record. Media revenue grew 21% to $1.25 billion, fueled by double-digit growth across all categories: books, music, movies, video games and software. EGM revenue grew 51% to $876 million, representing 40% of North America revenues, up from 34%. North America gross profit grew 27% to $532 million, and gross margin decreased 76 basis points to 24.1% from product and third-party mix, lowering prices including free shipping and Amazon Prime. North America segment operating income increased 33% to $122 million, a 5.5% operating margin.

In the international segment, revenue grew 37% to $1.78 billion. Revenue growth was 28% adjusting for the $121 million year-over-year favorable FX impact during the quarter. Media revenue grew 29% to $1.25 billion or 21% excluding FX. EGM revenue grew 63% to $523 million or 50% excluding FX. This is the first time international EGM has surpassed $0.5 billion in sales in a quarter. EGM now represents 29% of international revenues, up from 25%.

International gross profit grew 28% to $318 million, or grew 19% excluding FX, while gross margin decreased 135 basis points to 17.9%, which reflects lowering prices, product mix and free shipping offers, offset partially by increased third-party mix. International segment operating income increased $14 million or 15% to $106 million, a 6% operating margin. Excluding the favorable impact from foreign exchange rates, international operating income increased 6%.

CSOI grew 24% to $229 million or 5.7% of net sales. Unlike CSOI, our GAAP operating income includes stock-based compensation expense and other operating expense. GAAP operating income grew 20% to $197 million or 4.9% of net sales. Our income tax expense was $91 million in Q4, compared to a benefit of $38 million in the prior year that resulted from the determination that certain of our deferred tax assets were realizable.

Our annual effective tax rate was 50%. Our effective tax rate was 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 our effective tax rate in 2007 to be approximately 35% or less.

However, there is potential for significant volatility of our effective tax rate due to several factors, including from variability in accurately predicting the amount and mix of taxable income by jurisdiction. We are endeavoring to optimize our global taxes on a cash paid basis, not for tax expense on a financial reporting basis. In 2006, we paid $15 million in cash taxes and in 2007, we expect cash taxes paid to be approximately $25 million as we continue to benefit from NOLs.

GAAP net income was $98 million or $0.23 per diluted share, compared with $199 million and $0.47 per diluted share.

Turning to the balance sheet, cash and marketable securities increased $19 million to $2.02 billion. In Q1 2006, we repurchased EUR250 million of convertible debt, and in Q3 2006 we repurchased 252 million of our common stock or 8 million shares. Inventory increased 55% to $877 million, and inventory turns decreased from 14 to 13, as we expanded selection and improved in-stock levels across product categories and geographies and introduced new product categories.

Our investment in net fixed assets, which includes net capitalized software development costs, increased $109 million from a year ago to $457 million. Our 2006 capital expenditures were $216 million, of which half were software development costs. Our return on invested capital was 29%. ROIC is TTM free cash flow divided by average total assets minus average current liabilities.

I will conclude my portion of today's call with guidance. Incorporated into our guidance are the order trends that we have seen to date and what we believe today to be appropriately conservative assumptions. However, there is a high-level of uncertainty surrounding fluctuations 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 intercompany balances denominated in foreign currencies, which are settled among subsidiaries. Depending on the amount and timing and unfavorable resolution of outstanding legal matters that could materially affect our business, results of operations, financial position or cash flows in a particular period.

Our effective tax rate is subject to significant variations, based on changes in our corporate structure and business operations; the amount of expenses incurred that are permanently nondeductible for US 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 in the taxable jurisdictions to which it relates.

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

For Q1, we expect net sales of between $2.85 billion and $3 billion, or growth of between 25% and 32%. This guidance anticipates greater than 300 basis points of positive impact from foreign exchange. GAAP operating income to be between $82 million and $122 million or between a 22% decline and 16% growth. This includes approximately $38 million for 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 $120 million and $160 million, or approximately flat to 33% growth.

For the calendar year 2007, we expect net sales of between $13 billion and $13.7 billion, or growth of between 21% and 28%. This guidance anticipates approximately 100 basis points of positive impact from foreign exchange. GAAP operating income to be between $355 million and $505 million, or between a 9% decline and 30% growth. This includes approximately $165 million for 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 $520 million and $670 million, or between 4% growth and 34% growth.

We anticipate our 2007 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. We expect capital expenditures, including capitalized software development costs, to be approximately $250 million. We will continue to strive for year-over-year annual growth in 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 the 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 Justin Post - Merrill Lynch.

Justin Post – Merrill Lynch

Could you talk a little bit about your gross margin trends embedded in your outlook for next year? Also, can you talk a little bit about this quarter? If we look at year-over-year incremental gross margins as around 18% on a year-over-year basis, why was it down versus your overall gross margin? Can you tell us what the Toys-R-Us impact was this quarter?

Tom Szkutak

Sure. As you look at our total year guidance for next year, we are not splitting out the individual pieces, giving guidance on the individual line items -- so we're not giving guidance on gross margin, for example. But the way you should think about it is we will certainly have lower prices next year, continued COGS reductions, as well as we think certainly we're going to be adding more third-party sellers. So again, I think those are some of the key dynamics as you look at our gross margins next year.

Could you repeat the second part of your question, Justin? I couldn't hear that.

Justin Post – Merrill Lynch

Sure. When we look at the year-over-year incremental gross margin, it seems to be around 18%, based on the numbers you report. But some of that was probably due to Toys-R-Us. So I'm wondering if you could help us understand what the impact was on this year's or last year's gross margin from Toys-R-Us.

Tom Szkutak

Yes. In terms of the Toys-R-Us impact, I can't help you, but I can say, from a revenue perspective, we certainly had both retail and third parties as it relates to toys, baby and video games; that impacted our total revenue by approximately 160 basis points. But in terms of the margin, we are not disclosing the specific margin related to that part of the business.

Justin Post – Merrill Lynch

Thanks. Good media sales.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

A comment on two things. One, your new active customers totaled 2 million in the quarter, which is a decline year over year of about 38%, and last quarter was also a decline of about 13%. So we see an acceleration there. I'm just wondering, do you think that the new active customer growth will continue to decline in 2007?

Second, I know that 2006 was an investment year. But if I look at 2005 versus your outlook for 2007, it appears at the midpoint that you'll add about $4.9 billion of incremental revenue and only about $31 million of incremental operating income. I just wonder, when do you think the model will show leverage, where an incremental dollar of revenue will really drive incremental operating income and free cash flow? Thank you.

Tom Szkutak

Sure. If you look at the active customers, it's actually up 16% year over year. What you're seeing is -- certainly we're seeing, with the revenue growth year over year excluding exchange rates, you're seeing a 30% growth. So we're getting more share of wallet from customers.

If you could just repeat, sorry, the second part of the questions, related to the leverage? That was from 2005 to 2007?

Anthony Noto - Goldman Sachs

Yes. I'm really just trying to understand, I know that 2006 was an investment year, and I think a lot of investors, including us, were hoping for some leverage in 2007. But now it appears that your operating income margins will be down in 2007 at the midpoint versus 2006 after an investment year. So I went back to 2005 and said, what has happened over that time period? It looks like you revenue will grow almost $5 billion, but your operating income would not have increased at all over that time period.

Tom Szkutak

Right. What you're seeing is we had an increase in our cost base both in 2005 and 2006. Certainly, we spent a lot of time talking about technology and content over the past few calls. You've seen that that growth rate has slowed, and so when you look at 2007, you should expect that our growth from an annual basis will be significantly less than it was in 2006.

But what certainly has happened from 2006 to 2005 is on top of that, you had gross margins coming down. The primary reason for that, there's certainly a lot of different factors, but certainly lower prices, the mix of categories that we're in; we entered a lot of new categories with new selection, and so that is driving it, as well as we were certainly helped throughout the course of the year by third-party sales.

So as you think about it going forward, even though you have seen the gross margins come down, a lot of these newer categories are becoming much more meaningful for us and over time, we will be able to get those margins to be very solid within our business.

Today, as you can imagine, with some of the new categories that we have, what we're trying to do is get to scale. When we get to scale on those particular categories, good things happen. Think about particularly in international, where we are very, very small within EGM just a few years ago, and now it's become a much more meaningful part of our business.

When that happens, we're able to get a lot more traffic to those particular categories. When that happens, you get a lot more third-party sellers coming to sell on our detail pages. We also get better prices with suppliers as their volume grows. So again, our strategy is to grow those businesses. Even though you see the gross margin going down, and that being one contributor of it, it's something that we are very happy with, because we need to get the scale in those businesses. Over time, that will be very beneficial to shareholders.

Operator

Your next question comes from Brian Pitz - Banc of America.

Brian Pitz - Banc of America

Thank you. A couple of questions. On operating margins, the split between US and international, can you talk about how we should think about that going forward? Are they pretty close to parity? It looks like in the current quarter they are, but just any thoughts on 2007 and beyond?

And then, web services, can you comment on the revenue opportunity there and potential timing? Are you factoring in any revenue from web services for 2007 in your guidance? Any kind of update on that would be great. Thanks.

Tom Szkutak

Sure. First, on the segments, the operating margins and how you should think about them, in addition to the comments I made about many of the categories that make up EGM in terms of that scale, we're certainly further ahead in scale in our North America segment in some of those categories, particularly, say, in consumer electronics. We have been selling in that category for a longer period of time.

But certainly, as you think about the two different segments, one thing that you should be aware of: our third-party penetration overall, we said, is 25%. Over the past several quarters, certainly we have had a much bigger penetration in terms of third-party units as a percentage of total in our North America segment versus our international segment. That is because we have been selling third-party units, particularly Merchants@ units in North America for a longer period of time. With the launch of Merchants@ international, more recently, that's certainly an opportunity for us to grow over time.

Then if you look at again, our EGM penetration is just a much smaller rate within international. So again, there's an opportunity to improve a lot more from the third party business vis-a-vis North America. But again, I think we have opportunities, really, in both segments to improve our operating margins over time.

Then the second part of your question, web services.

Jeff Bezos

The Amazon Web Services team has a number of different web services. They have the simple storage service, which allows you to store data in the Internet cloud, and then it's securely stored and you can retrieve it. It's self-service, it's very inexpensive; developers really like it. There's also EC2, which is the Elastic Compute Cloud. It does the same thing, but with compute instead of data. There's also e-commerce services, there's Mechanical Turk. So there are a number of things. There's Alexa Web Services. These services are getting a lot of adoption, and developers really love them, getting a lot of buzz in the blogsphere, being heavily used by startup companies.

As far as their impact on the financials, it will take some time before they have enough scale to have a meaningful impact that becomes visible, given the scale of our other businesses. So with a $10 billion business, even though these businesses are doing very well, it's going to take some number of years before they become meaningful. But we're thrilled with the progress, and that team is just doing a bang-up job.

Operator

Your next question comes from Scott Devitt - Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thank you. The domestic business, revenue growth accelerated from 21% last quarter to 31% this quarter. I understand a component that is the toys. So I was wondering if you could give us a normalized domestic growth rate. But beyond that, there was still acceleration, so if you could categorize where the growth was coming from -- new categories, the loyalty related to Prime, new customers or otherwise?

Tom Szkutak

The impact worldwide of toys, baby and videogames was approximately 160 basis points, and that translates into approximately 300 basis points for North America. So if you adjust that from the 31% you get about 28%.You are right, we did see very nice sequential growth versus third quarter, and really all of the quarters was the best growth rate overall in six years.

There was a number of different reasons for that, but certainly Prime adoption was certainly one. The fact that we, as you noticed, we worked very hard during the year, in terms of making sure that we had great low prices. We expanded unique selection considerably year over year. In addition to the unique selection, we improved a lot, particularly in the second half, on our in-stock levels. So the combination of all these factors is really what helped the North America growth in Q4.

Scott Devitt - Stifel Nicolaus

Thank you.

Operator

Your next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

Thank you very much. It looks like there has been a fair number of small merchants coming over and trying third-party sales on Amazon. What are you going to get those? Is that purely inbounds, or are you also trying to go out to other marketplaces and attract third-party sellers? Any quick comments on the product results so far for Amazon Unbox, and maybe implications that could have for broader digital downloading strategies? Thank you very much.

Tom Szkutak

I think from a third-party perspective, one of the things you're seeing is when we add the amount of unique selection that we continue to add, and just some of the category expansion and the traffic to those category expansions, that's naturally attracting more third-party sellers. So that's something I talked about a little bit earlier and something that we want to continue to do.

Jeff Bezos

We do have an outreach program, and it's very effective. But most of that activity is inbound. It's people just knowing, they see other sellers on the website, and they want to get their selection into that competitive mix so the website sort of serves as its own advertisement for sellers. That's a very effective and obviously very low-cost way of attracting new sellers. But the outbound reach is also very effective.

Tom Szkutak

Then on digital, the second part of your question, there's still a bunch of things in our pipeline that we will be rolling out over time. So I encourage you to stay tuned.

Mark Mahaney - Citigroup

Thank you very much.

Operator

Your next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Thank you and good afternoon. Could you give us a little bit more color on the dynamics of the gross margins, in particular? As I see it, this is the lowest gross margins you have recorded in the past five years. I understand the rationale you're giving, that you're growing the top line. But the dynamics that you mentioned like the partnerships, the third-party sales, the lower prices on Prime, have been with you, certainly throughout the past year and yet the margins have not been this low.

So to what degree are you getting the growth from the lower prices? Also, what can we expect, how low can we expect the margins going forward? Tied to that, do you still have any goals of double-digit operating margins?

Tom Szkutak

In terms of gross margin, I briefly mentioned this earlier in the call. There's a number of different dynamics, and you mentioned some of them. Lower prices were certainly one of them. But I think the one that you should certainly take a look at is the mix of products. Again, I think that's something that we actually like. Our non-media dollar growth worldwide for the first time was actually higher than our media growth, from a dollar standpoint.

Again, what that is telling us, as we look at it, is it's helping us get to scale in a lot of these individual categories. We still have a lot of work to do, to do that, but again, we're starting to see some meaningful changes with such high growth rates, with growth rates over 50% in EGM worldwide. So very, very strong across the board growth rates in a lot of categories. So those growth rates are going to help us.

Then compounded on top of that, as we continue to grow in those categories, is really going to help us get to scale, help us to continue to get better traffic, which will help us get third parties. Certainly, the third parties will help us expand margins, as well as get better prices as our volume gets bigger with many of these suppliers.

So again, that's what's going on there. That's something that we're trying to do to try to get that improving over time.

Safa Rashtchy - Piper Jaffray

Any target on the operating margin going forward?

Tom Szkutak

The operating margin certainly, as we said before, we focus on operating profit dollars. We start first with free cash flow dollars, then operating profit dollars. But certainly, we still think there's a lot of room, from an operating margin standpoint.

Jeff Bezos

We haven't changed our long-term view about what the model can be.

Tom Szkutak

Correct.

Safa Rashtchy - Piper Jaffray

Thank you.

Operator

Your next question comes from Robert Peck - Bear Stearns.

Robert Peck - Bear Stearns

My question sort of ties into Brian's a little bit there. He was talking about the revenue opportunity from Amapedia, EC2, Askville, et cetera. Could you tell us a little bit about what is being invested into that, and when we may see a pare back of some of that?

As part of that question, Endless.com, you are doing the negative shipping offers. Some believe that could be a testing ground for Amazon.com someday. Is negative shipping one of the options of where Amazon could go?

Jeff Bezos

Well, you are referring to our new shoe site, Endless.com. Endless.com, as a standard practice, offers free overnight shipping as well as a 110% price guarantee, 365-day returns and pre-return shipping, too. So that's the standard practice. But through February, Endless is offering negative $5 overnight shipping. It's an unusual promotion that we're doing to draw attention to Endless.com, so that we can introduce it to our customers and that's working very effectively.

Robert Peck - Bear Stearns

Is that's something that's on the table that, should it be successful, could be ported to Amazon.com?

Jeff Bezos

You know, that's not something that we have considered. This is a special promotion just through the month of February. We're getting such great traction with our standard practices of Free Super Saver Shipping on Amazon for orders over $25, as well as we have equivalent programs around the world. Also, of course, for Amazon Prime members, you pay $79 a year for unlimited free two-day shipping. That program, as you know, has also been met with a lot of adoption. So we are very excited about those, and we haven't considered the negative shipping beyond Endless.com.

Robert Peck - Bear Stearns

The first part of that question was the investment. Can you give us any sort of gauge of what's the investment into all of these endeavors, and when we may get to see some leverage on it?

Jeff Bezos

Well, the big investments are in digital and web services. Other things that you mentioned are very minor investments.

Robert Peck - Bear Stearns

Thank you.

Operator

Your next question comes from Jeetil Patel - Deutsche Bank Securities.

Jeetil Patel - Deutsche Bank Securities

Great, thank you. Two questions. As you look at your technology and content investment, about $600 million, that's what you spent in 2006, but what is intended for the growth of the existing business versus new businesses and ventures?

Second question, if you look on a contribution profit basis, do you think that just broadly, the ecommerce industry unit economics mirror what you're doing or do you think you're artificially surpassing overall the unit economics of the business by using a low price strategy? I'm trying to figure out whether your view is that the industry's profitability moves to your model, or you actually have been holding it back for the past couple of years.

Tom Szkutak

In terms of the first question, in terms of technology and content, we have not given a split in terms of what, if I understood the question, what is for the core part of the business and what is for future. But certainly, it's being spent on a number of different initiatives. Jeff mentioned a few of them. Certainly, we're making investments in terms of the incremental spend, which we're spending that largely on web services, digital, new categories as we launch them, seller platforms, making it easier for sellers to sell. So those are certainly key investment areas for the business.

Could you maybe repeat or restate the second part of the question?

Jeetil Patel - Deutsche Bank Securities

Yes. If you look at the overall variable profitability in your business, is your thesis on your aggressive pricing strategy to end customers that overall unit economics will migrate across the ecommerce market towards your model, in terms of, call it about a couple of dollars per transaction? Or do you think that you've been holding it back as a way to grow your volume in the near term in this growth environment?

Jeff Bezos

I suspect that what we will see over time is that there will be multiple winners of different scales pursuing different strategies in that regard. So you may see that it probably doesn't end up being one size fits all.

Operator

Your next question comes from Douglas Anmuth - Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. Your results suggest that Prime is really doing what you would like it to do, based on the top line growth, the lower gross margins and also the flattish shipping revenues, despite the 34% increase in sales. So this is a program that has been in place for almost two years now. Can you give us some sense of metrics around Prime, and also discuss the usage patterns during the holiday?

Then can you also talk about to what degree Prime customers are more or less price-sensitive than other shoppers? Thank you.

Jeff Bezos

Sure. In terms of Prime customers, what we're seeing right now is adoption is very strong, Prime customers are certainly buying more from us, so we're getting a bigger share of wallet from those particular customers. They're also doing more cross-shopping.

Beyond that, at this time, we're not disclosing other statistics or metrics around Prime. That said, though, it's something that from a business perspective, we do spend a lot of time on and continue to look at very closely. We like what we see, and so that's something that we think we certainly want to continue to grow that business and subscribers continue to grow nicely. We look forward to having more Prime customers because we think over the long term it's a great win for customers. Customers are seeing that today, and we think it will be great for shareholders over the long term as well.

Operator

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

Paul Keung - CIBC World Markets

I hate to ask the question again, but it's important, I guess, when you look at Amazon Prime, is the economics of a Prime customer very different than that of the average customer on the platform? I'm trying to understand whether this in itself long-term is going to be accretive to the overall platform.

Jeff Bezos

Yes. We certainly believe that it is, and we like the trends that we see. They are very positive, and we think certainly would be very helpful over the long term.

Paul Keung - CIBC World Markets

So it's equal or better for the economics then, is probably the right way to think about it on a transactional basis?

Jeff Bezos

Again, the way we're looking at it today, we were very pleased at the start of Prime, when we launched it. We continue to see favorable trends. We have found ways to become more productive with some of the volume we're getting with Prime customers. There's things that we think we can do over the long term to make it even better from an economic standpoint. So we're continuing to try to innovate on behalf of both customers and make it better for shareholders over time. But we like what we see so far, and we need to continue to make it even better.

Paul Keung - CIBC World Markets

The toys category, how fast did that category grow year over year this quarter?

Jeff Bezos

We're not breaking out any subcategory details. But again, the impact of toys, video games and baby was 160 basis points on our total revenue year over year.

Operator

Your next question comes from Imran Khan – JP Morgan.

Imran Khan – JP Morgan

Thank you for taking my question. I have a couple of questions. Your inventory was up 51% year over year, which is a slight deceleration from last quarter’s growth rate, but still pretty strong growth. So I am trying to understand where this growth is coming from. Is it toy category or some other categories?

Secondly, I was wondering if you could give us some color what kind of user impact you're seeing from the introduction of the Unbox product?

Jeff Bezos

In terms of the inventory question, we continued to add a lot of selection, a lot of unique selection during 2006. So that was certainly a driver. We also worked on improving in-stock selection over the course of 2006, which is why you are seeing the growth that you're seeing. Certainly, this is something that will have some volatility over time, but certainly you should expect that over time it will flatten off to potentially trickle upwards from a turn perspective. So that's how we're thinking about it.

In terms of Unbox, we continue to add selection at Unbox. We're getting very good repeat customer performance back to our site. So we are very pleased from that perspective. The team is seeing especially strong performance amongst television episodes, as well as hard to find video. As Tom said, of all of our category offerings, it has amongst the highest repeat rates so we're very encouraged by that.

Imran Khan – JP Morgan

Thank you.

Operator

Your final question comes from Mark Rowen - Prudential.

Mark Rowen - Prudential

Thanks. Tom, could you tell us how much video game consoles helped the North American media growth, given the strength in Xbox and your allocation in Wii's PS3's? Then on the gross margin, just a follow-up on that. It looks like the free shipping as a percent of revenue wasn't really any greater than it was a year ago. So my question is, was it primarily the promotional environment where you had to match competitive prices from other retailers, or was it primarily mix shift to lower margin categories that caused the gross margin erosion year over year?

Tom Szkutak

In terms of any specific product details on the consoles, we just don't break out that level of detail from a disclosure standpoint. In terms of the net shipping margin, you are right, it was flat at 3.1%. Certainly, the shift to our new toys, baby and video category impacted that. We talked about Prime impacting that as well. Offsetting that, we had some very good productivity as well, so those were the key drivers.

Mark Rowen - Prudential

I'm sorry? Productivity in --?

Tom Szkutak

Within transportation.

Mark Rowen - Prudential

I see. I'm not asking for the number on video games, but just directionally, did that help the growth rate to a material degree?

Tom Szkutak

I would say it this way. We are certainly not breaking that out, and within our media categories as well as our EGM categories, as you can see from the release, both from North America and from international, we had very strong growth across the board. Beyond that, there's not a lot I can share with you.

Mark Rowen - Prudential

Okay, thanks.

Kim Nelson

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

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Source: Amazon.com Q4 2006 Earnings Call Transcript
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