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Here’s the entire text of the Q&A from Amazon’s (ticker: AMZN) Q3 2005 conference call. The prepared remarks are here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Question-and-Answer Session

Operator

Operator Instructions The first question comes from Doug Anmuth with Lehman Brothers.

Q - Doug Anmuth

Great, thank you. I have two questions for you. First, regarding Amazon Prime, earlier in the year, you changed your guidance pretty significantly for the program. I think you also said that it may be the most expensive initiative you’ve done since free shipping. Can you give us a better sense of really how it’s doing so far? Is it actually as expensive as you originally thought? And then, also, regarding the $12 million credit reimbursement during the quarter, can you tell us during which quarter that actually came into the P&L originally?

A - Tom Szkutak

Great. In terms of Amazon Prime, it certainly is expensive in the short term, but we think it’s certainly the right thing to do. What we are finding is certainly customers like it. They are buying more. They are also doing more cross-shopping, and as I had mentioned, it’s especially heavy in certain categories, as I mentioned in the opening remarks.

A - Jeff Bezos

It’s expensive, as Tom is saying, but it has a lot of benefits for customers and, long term, for Amazon and Amazon shareholders. So customers, when they start using Amazon Prime, it not only saves them money on shipping but because, for free, as members they get expedited fast shipping, it actually changes the way they think about and use Amazon. And we have seen significant lift in Amazon Prime members. So we did say short-term investment; it is expensive in the short term. We think it’s one of the most important things that we are doing over the long-term.

A - Tom Szkutak

In terms of the $12 million credit, we had previously expensed that over several quarters. We haven’t disclosed the exact amounts per quarter, but it was over several quarters.

Q - Doug Anmuth

Thank you.

Operator

Our next question comes from Jeetil Patel with Deutsche Bank.

Q - Jeetil Patel

A couple of questions. It looks like International you were affected a bit by the currency effects. But can you talk about markets like Germany, where I think a VAT was implemented and I think growth had to kind of slowed down broadly in the e-commerce world out there, how that is performing as you have kind of compared against that? Second, Amazon Prime looks to be, I guess, generally successful, based on kind of your commentary. I guess one of the themes that you have kind of consistently executed on is rolling out these types of services globally across the broader franchise internationally, in UK and Germany. Can you talk to the concept of have you gotten enough data and analytics behind Prime to kind of look at this on a global scale, or are we still too early, in terms of kind of having the understanding of what the impact is on frequency and usage?

Q - Jeetil Patel

It is still early. However, you are right that we do like to operate consistently globally. And so, we will be trying to do that over time, but you just have to sort of stay tuned for that.

A - Tom Szkutak

In terms of the first part of your question, we are not breaking out any of the individual countries within international. But you are right; we did get hurt a little bit by currency. International revenue was 26% on a dollar basis, 28% on a local currency basis. And then unit growth was actually faster than that. So that’s just a little bit more information on that.

Q - Jeetil Patel

A quick follow-up, is there any way to leverage the 1 million sellers that you have that have grown 30% a year or two create pretty much an outbound advertising or distribution model for those products, and kind of leverage that and maybe create a distribution model around those seller or merchant accounts that you have today?

A - Jeff Bezos

Those are the kinds of things that we think a lot about. And it’s our practice not to talk specifically about what we might do in the future, but we do think about those kinds of things.

Q - Jeetil Patel

Okay, thanks.

Operator

We will go next to Mary Meeker with Morgan Stanley.

Q - Brian Pitz

Thank you. It’s actually Brian Pitz for Mary. A couple of things here can you talk about your add-on sales for Harry Potter more than your expectations and maybe provide a little more detail on the geographic breakout of sales for the book? And also, on a separate note, we noticed advertisements in your Gold Box items recently. Can you talk about the impact of these ads on your margins, and any thoughts regarding advertisements in other areas of your site? Thank you.

A - Tom Szkutak

The first part of your question, you said add-ons. I’m assuming you mean attachments to the HP 6 orders. We haven’t broken that out; the only thing that we said was that the total including those -- the total impact on revenue, including attachments were 260 basis points. In terms of the -- can you repeat the second part of the question again? Sorry.

Q - Brian Pitz

Just in terms of geographic breakout for sales.

A - Tom Szkutak

We haven’t split out, you know, Harry Potter by geography, but directionally, and you can assume that it’s approximately the same as the magnitude of the segments themselves. Again, that’s directional.

Q - Brian Pitz

Okay, and on the Gold Box advertisements, any thoughts for impact in areas where you could use advertisements such as that in other places on your site?

A - Tom Szkutak

Yeah, it's, you know, I think what you’re seeing, you know, I would think of it as small, but certainly something that we like, but it’s something that’s small.

Q - Brian Pitz

Thanks.

Operator

And we will go next to Anthony Noto with Goldman Sachs.

Q - Anthony Noto

Thank you, very much. Tom, if I’m doing the math correctly, it looks like your trailing 12-month free cash flow is growing slower than your trailing 12-month revenue growth. I just wanted to comment on that. And it looks like it’s before the CapEx line, so I wanted to get a perspective on that. And the second question is, if I back out the one-time benefit that you just mentioned, the $12 million, from the $120 million pro forma operating income line, it means you did about $109 million of pro forma operating income ex that onetime item, which implies your operating margin of about 4.9%, which is the lowest we’ve seen it in quite some time. And if I compare that to your guidance, you have upside relative to your expectations in revenue in guidance, but you didn’t really have upside in operating income. And I’m trying to understand, is that margin and that lack of leverage due to an opportunity that you saw in the quarter that caused you to spend more money, so we could see a benefit later on in 2006, or is that because something was more expensive than you had anticipated? Thanks.

A - Tom Szkutak

In terms of the first part of your question, on our free cash flow, it’s actually not before CapEx, in terms of the numbers that you gave. Our operating cash flows is actually up 35% year-over-year on a trailing 12-month basis, and that includes the $40 million settlement. So if you back that out, it’s actually operating cash flows are growing on a trailing 12-month basis up 43%. Free cash flow, excluding the $40 million payment, is growing 22%. And what you’re seeing is we’re spending certainly more this year than last year on capital expenditures, and it’s in a few different places. Certainly, as we add more computer science and software engineers and we are capitalizing parts of that development, you’re seeing that included in our CapEx. Also, as I mentioned in my opening remarks, we’ll continue to support our growth; we’re adding capacity. We added three fulfillment centers in Q3. That’s reflected in the CapEx that you saw over the past 12 months and in Q3. We also are adding two new ones in Q4, one in Japan and one in the US. Some of the CapEx certainly has been spent so far in Q3 and prior as well on those. So again, what you’re seeing is an increase in CapEx. On CSOI, as you mentioned, yes, you did the math right. If you back out the 12, it’s actually 109. So it’s 121 less the 12, you get to 109. So instead of our revenue growth of 27%, our CSOI growth was 28%. If you back out the 12, it’s 15. And again, what you’re seeing is, if you look at the operating expense, the most significant increase is technology and content, and that’s an opportunity. We have been very successful in hiring, over the last several quarters, software engineers and computer scientists. We’re going to continue to add more computer scientists and software engineers. Those computer scientists and software development engineers are continuing to innovate on behalf of customers. They continue to work on the seller platform, making it easier for sellers to sell. We are continuing to work on Search, on Digital and A9, and these are opportunities that we’re spending those dollars on for the future growth of our business.

Q - Anthony Noto

Great, thank you.

Operator

We will go next to Justin Post with Merrill Lynch.

Q - Justin Post

Hi, a couple of questions. A pretty wide range for operating income guidance in the fourth quarter. I’m wondering if you can comment at all on whether other income is difficult to forecast, and that could be part of that. Also, what your expectations are for pricing in the retail environment. We’ve come out with a pretty negative call at the firm on discounting in the fourth quarter. Can that change your numbers? Do you have to kind of match your competitors as the quarter progresses?

A - Tom Szkutak: We're -- just as it relates to Q4 in total, we’re optimistic. We are cautiously optimistic about Q4. Over the past 12 months, we have added a lot of great selections. We have continued to lower prices. So we are cautiously optimistic. It is, however, a seasonal quarter; it’s difficult to predict. From a cost standpoint, this is the first time we will have Amazon Prime in Q4. We think that’s going to be great for customers, but we also think it’s going to be expensive. And, since we haven’t gone through a Q4 yet with Amazon Prime, it’s difficult to estimate that impact. So that’s really, certainly, the key drivers; but again, we are cautiously optimistic. We think the experience of our customers is going to be the best experience they’ve had, and we are excited about it. But again, the wide range reflects the uncertainty that it’s difficult to predict.

A - Jeff Bezos

And the Amazon Prime point that Tom made is a good one because, in the holiday season, we know that people especially appreciate being able to get two-day shipments. And also, as Amazon Prime members, they can get anything shipped next day for just $3.99. So that is a very big event coming up for us.

Q - Justin Post

A follow-up, if I may. On the other income, it showed nice year-over-year growth. Can you provide any detail on whether that was related to the credit card referrals or whether it was merchant.com? What grew faster in the quarter?

A - Tom Szkutak

It was both. Those are the two principal pieces, the majority of other revenue.

Q - Justin Post

Thank you.

Operator

We will go next to Imran Khan with JPMorgan.

Q - Imran Khan

Yes, hi guys, two questions. First, I was wondering if you could comment on how much increased oil prices impact your gross margin. And secondly, if I look at international revenue, even if we look at it on the constant currency, the growth rate is 28%. It sounds like growth is decelerating pretty quickly from last year. I was wondering, what are you doing to maybe stabilize the growth rate in the international markets? Thanks.

A - Tom Szkutak

Sure. I’ll take international growth one first. International growth on a dollar basis was 26%, as you mentioned. Excluding FX, it was 28%. Unit growth is higher than that. Unit growth did not decelerate from the past few quarters. In terms of oil prices, our fulfillment and operations team continually work on trying to figure out ways to offset those costs . And we haven’t quantified that externally, but certainly we’re continually looking at ways to offset that cost in each of the quarters. And you can see the expansion that we had of 62 basis points in gross margins, and that’s reflected in those gross margins during the quarter.

Q - Imran Khan

Okay, thanks.

Operator

And we will go next to Safa Rashtchy with Piper Jaffray.

Q - Safa Rashtchy

Good afternoon and thank you. Can you talk about the level of spending you have in content and technology? I understand you’re focus and your success, as you have said, in hiring computer scientists and software engineers, but both the absolute as well as the percentage of content and development as a percentage of revenue has increased. And if I’m not mistaken, it’s the highest you have had since Q3 of 2002, at about 5.8%. Can you tell us some concept of how many engineers you have? How many more do you think you need? Should we expect this kind of trajectory of increase as a percentage of sales to continue next year and beyond? Thanks.

A - Tom Szkutak: Yeah, we're not -- just to take the latter part of the question first, we’re not giving guidance on 2006. You should expect, on a dollar basis, the technology and content is going to continue to grow. And, as I mentioned, you are right; it is at a high level from where we have been previously. It is 5.8% of revenue. And again, some of the things I talked about earlier, we’re going to continue to further innovate on behalf of customers. We’re going to continue to work on the platform, sell the platform, continue to work on Search, Web Services, Digital. Certainly, productivity within our operations is driven by technology, as well. So, again, those are things we think are important in the short and long term for our customers.

A - Jeff Bezos

And just to add to that, there’s a tremendous amount of opportunity and innovation yet to come, and we and our software engineering community are the ones who, in large part, help us unlock that innovation and opportunity. So things like Search Inside the Book, the fact that one of every two books that we sell here in the US now is -- the complete interior text of those books is searchable. Those kinds of initiatives are expensive. They require investments for many of those kinds of initiatives do not pay back in the initial period where you make the investment, but they are the right thing to do for the medium term in the business.

Q - Safa Rashtchy

I understand, but if I may follow up, you have always been focused on those new initiatives for customers, as well as for third-party merchants. But the rate of spending as a percentage has been accelerating significantly. Are you seeing new opportunities, or are there other areas that you need to spend this additional money on?

A - Jeff Bezos

The answer is we are seeing new opportunities. And we see it in some of the classic parts of our business, where we are able to do things like Amazon Prime, fast-track shipping, so that we can increase selection, have the stuff in stock and, at low cost, get it to you in two days if you are an Amazon Prime member. And also, in completely new areas of our business like Amazon Web Services, which we are opening up the insides of Amazon.com and making those available to developers all over the world. And that’s a business that’s growing very rapidly for us and something we’re going to continue to focus on. And then our Digital efforts, which we think are a very large opportunity for a company like Amazon that has a big media business. So some of those things you are not able to see and inspect yet, but we are working very hard on them.

Q - Safa Rashtchy

Right, thank you.

Operator: Our next question comes from Bob Peck with Bear Stearns.

Q - Bob Peck

Hey guys, congratulations on a good quarter. I just want to ask a couple quick questions here. The first is, could you touch quickly on your EFT effort there and what that could end up doing to fulfillment as a percent of revenues going forward? Number two, could you touch quickly on IPXL and what is going on there with the one-click patent? And lastly, Jeff, touching on what you just said, could you talk a little bit more about the digital media downloads, when we think we could see something like that, and how that could play as far as a DVD rental business for the Company?

A - Tim Stone

Bob, this is Tim. Could you just clarify your first question, on EFT?

Q - Bob Peck

The electronic funds transfer stuff, we have sort of been hearing you have been playing around with that to a degree; you have customers pay directly from bank accounts. And we know that the credit card portion is one of the large impacts of the fulfillment cost, as far as a percent of revs. And we are sort of wondering what traction you have gotten there, what progress you have gotten and where you sort of see that going, where it could take fulfillment as a percent of revs going forward?

A - Tom Szkutak

It’s very early. We have just launched EFT, as you’re describing it, on Amazon.com. You’ll probably recall that we launched something similar in Germany several years ago, so we do have some experience in this area. In terms of, could you repeat the other parts of your question? I apologize.

Q - Bob Peck

Sure. The second question was on the IPXL lawsuit with the one-click patent and where that stands, and the last part was on the digital media downloads and sort of a timeframe on that, maybe margins associated with it, and the sort of time of any sort of DVD rental program.

A - Tom Szkutak

In terms of the legal question, I don’t think it’s, we have a long-standing practice of not commenting on litigation. So I’m not going to comment here, as well. On Digital --

A - Jeff Bezos

On Digital, it’s too early to give you any details, any specific details. But it is something that we’re putting a lot of energy into with a talented team of folks, and we think we have some good offerings that we can bring to our customers over time. And I think there was one other piece of the question, but I forgot it.

Q - Bob Peck

It was the margins and any sort of tie-in with the DVD rental business.

A - Jeff Bezos

DVD rental is going very well in Germany and the UK. With respect to launching that in other countries, it’s not something that we’re prepared to talk about.

Q - Bob Peck

Thanks guys.

Operator

We will go next to Scott Devitt with Legg Mason.

Q - Scott Devitt

Thanks a lot. I had a question around A9, just interested if you could update us on how you are progressing with the strategy there, and maybe some specific data points or metrics around the pi discount and the loyalty that you have wrapped around that in that marketplace. And also, longer-term, if A9 is something that is going to continue to grow organically, or you think there will be either technology or other acquisitions in that area?

A - Jeff Bezos

The A9, for those of you who don’t know, has two things. The team works on Amazon product search and also the product search that we give to our merchant.com partners. And also, they have a consumer-facing website at A9.com that licenses Google Web search results and then adds some of the customer-centric things that Amazon has done over time. So it says things like people who visit this website also visit these websites. It stores your history on the server side. To use the A9 toolbar, you can keep track of the history of the sites you’ve visited. Based on that history, it will make recommendations to you of other sites to visit, things like that. And that team continues to innovate. Their goal is to build an enhanced Web search service, and we think there are going to be many winners of different magnitudes and different niches in that space.

Q - Bob Peck

Anything around the pi divided by 2 discount that you offer, and if that has added any loyalty or traffic to A9? I think there has to be a --

A - Jeff Bezos: Yes, we’re not providing any statistics or metrics on any of those A9 characteristics at this time.

Q - Bob Peck

Thanks a lot.

Operator

Our next question comes from Mark Rowen with Prudential.

Q - Mark Rowen

Thanks. A couple of questions. First, when I look at your operating margin internationally, it’s higher than the US, despite the fact that gross margins are 700 basis points lower. And I know you said that you put a lot of your technology development expense on the US business, but I was wondering if you could just help me understand why there is such a huge disparity in operating profit, despite, you know, or in gross profit, but that’s not showing up in operating profit, in those two businesses. And then, secondly, I know you don’t give out a lot of information on your third-party business. But the 30% of units that is third-party, I was wondering if you could give us a sense, at least directionally, of how much of that is outside of your media products?

A - Tom Szkutak

Sure, in terms of -- if I understand your question correctly, in terms of the gross margin difference between International and North America, there are a few principal pieces. One is both North America and International third-party growth continues to grow nicely, and we’re pleased with what we see there. But certainly, our third-party business is larger in North America than it is in International. So that’s certainly one of the key differences. One of the other differences is it’s still very early globally on our purchasing or vendor management initiatives. But we are further ahead, certainly, in North America than we are in International. So it’s an opportunity for us, and we certainly expect to capitalize going forward on that. In terms of what’s falling through in operating profit, I think you have it characterized right. Certainly, the bulk of the technology and content costs are certainly expended in the US and are allocated to the North America segment. You’re certainly seeing the significant portion of the G&A and/or legal-related costs hitting the North America segment as well. So those are some of the few differences.

Q - Mark Rowen

And the percentage of your third-party business that is done in media versus other, is that similar to your revenue mix, or it’s about 70/30?

A - Tom Szkutak

We haven’t broken that out. We do have, certainly have third parties in both EGM and media, in both segments.

A - Jeff Bezos

It’s a meaningful part of both businesses.

A - Tom Szkutak

Correct. And again, they are continuing to grow in both segments.

Q - Mark Rowen

Okay, thank you.

Operator

We will go next to Mark Mahaney with Citigroup.

Q - Mark Mahaney

Great, thanks. You talked about the impact of Harry Potter on the top line. Could you at all comment on how much of an impact it would have had on the margins? And then a quick follow-up to Mark’s question on the third-party sales, particularly internationally. Can you just talk directionally about how much lower the third-party penetration in total unit sales would likely be internationally than in the US? And any particularly interesting trends or any inflection point trends in terms of when that could gap up or reach up to US levels?

A - Tom Szkutak

In terms of the margin impact of Harry Potter 6, it was essentially a contribution profit breakeven event for us globally. In terms of third party, we haven’t given any splits for the individual segments as to where we are there. But what we have said, again, is both segments continue to grow nicely. We are pleased with the performance overall, and we will continue to invest to make it easier for sellers to sell. And certainly North America is further along than International, and that’s an opportunity for us.

Q - Mark Mahaney

Thank you.

Operator

Our next question comes from Heath Terry with Credit Suisse First Boston.

Q - Heath Terry

Great, thank you. I was just wondering if you could just talk a little bit more about your plans for, or what you’re seeing in terms of marketing. As sponsored search and, obviously, comparative shopping becomes more meaningful, how is that playing a role? Obviously, marketing expense has been incredibly consistent over the course of this year. Do you see that changing much as we go into Q4?

A - Jeff Bezos

I would just say that most of our marketing expense is very measurable. And, as a result, we are able to -- it’s susceptible to analysis. We are able to spend the right amount of money marketing these categories. So if you could meaningfully spend more and have it be contribution profit positive to do so, then you can sort of do that when it’s measurable. And otherwise, you can back away from it. We also have other programs like the associates program and other kinds of marketing methods besides the sort of sponsored links. And the other thing, of course, that we do, even though it doesn’t show up in the marketing line is we consider some of the investments we make in things like Amazon Prime, some of the investments we make in things like Super Saver Shipping, to be a marketing expense. Our best first avenue is to figure out meaningful ways to give the money to customers rather than to advertising venues and then, by providing that good experience, have customers have a deeper percentage of their wallet share with us.

Q - Heath Terry

Great, thank you.

Operator

And that does conclude our question-and-answer session today. I would like to turn the conference back over to our speakers for any additional or closing remarks.

Tim Stone, Vice President of Investor Relations

Thanks for joining us on the call today and for the questions. A replay will be available, as is typically the case, on our investor relations website at least until the end of the quarter. And we appreciate your interest in Amazon.com and look forward to talking with you again next quarter.

Jeff Bezos, Founder and CEO

Thank you.

Tom Szkutak, Senior Vice President and CFO

Thank you.

Operator

This does conclude today’s teleconference. Thank you for your participation. You may now disconnect.

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