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Amazon.com, Inc. (AMZN)

Q3 2007 Earnings Call

October 23, 2007 5:00 pm ET

Executives

Kim Nelson - IR

Tom Szkutak - CFO

Jeff Bezos - President, CEO, Chairman of the Board

Analysts

Jeetil Patel - Deutsche Bank Securities

Anthony Noto - Goldman Sachs

David Joseph - Morgan Stanley

Victor Anthony - Bear Stearns

Mark Mahaney - Citi

Brian Pitz - Bank of America

Scott Devitt - Stifel Nicolaus

Justin Post - Merrill Lynch

Imran Khan – JP Morgan

Doug Anmuth - Lehman Brothers

Jeffrey Lindsay - Sanford Bernstein

Shawn Milne - Oppenheimer

Colin Sebastian - Lazard Capital Markets

Operator

Good day, everyone and welcome to the Amazon.com third quarter 2007 financial results teleconference. (Operator Instructions) For opening remarks, I will be turning the call over to the Director of Investor Relations, Ms. Kim Nelson. Please go ahead.

Kim Nelson

Hello and welcome to our Q3 2007 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 October 23, 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 2006 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 on this call will be against our results for the comparable period of 2006.

Now I will turn the call over to Tom.

Tom Szkutak

Thanks, Kim. I'll begin with comments on our financial results. Trailing 12-month free cash flow increased 118% to $800 million, while the combination of common stock and stock-based awards outstanding was unchanged from a year ago at $435 million. Worldwide revenue grew 41% to $3.26 billion, or 38% excluding the $75 million favorable impact from foreign exchange. Q3 2007 revenue benefited by approximately 290 basis points of year-over-year growth from Harry Potter VII sales, plus attachments.

Media revenue increased to $2.09 billion, up 36%, or 32% excluding FX. EGM revenue increased to $1.08 billion, up 54% or 51% excluding FX. EGM accounted for 33% of worldwide sales in Q3 2007, up from 30% for the same period last year. Our worldwide unit growth was 32%, and active customer accounts exceeded 72 million, up 17% year over year.

Worldwide gross profit was $762 million, up 39%. Gross margin decreased 45 basis points to 23.4%, primarily due to lowering prices and change in product mix partially offset by increases in our third-party business. Worldwide active seller accounts were over 1.2 million, and third party units were 32% of total units versus 30% in the prior year.

Amazon Prime memberships more than doubled year over year.

Now I will discuss operating expenses excluding stock-based compensation. Fulfillment, marketing, tech and content and G&A combined was $585 million, or 18% of sales, an improvement of 273 basis points year over year. Fulfillment was $285 million or 8.7% of net sales, down 31 basis points year over year. During the quarter, we opened new fulfillment centers in Phoenix, Arizona and Saran, France.

Technology and content was $181 million, or 5.6% of net sales, an improvement of 122 basis points year over year, as we continue to grow into our new level of spending. Marketing was $72 million or 2.2% of net sales, an improvement of 51 basis points year over year. In recent years, our marketing spend has been between 2.2% to 2.7% of net sales.

Now I'll 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 42% to $1.79 billion. This is the highest growth rate in seven years. Media revenue grew 38% to $1.08 billion. EGM revenue grew 54% to $631 million, representing 35% of North American revenues, up from 33%. We saw another quarter of strong sales in electronics, toys and baby, and soft goods which includes jewelry, apparel, shoes and sporting goods. North American gross profit grew 34% to $460 million, and gross margin decreased 159 basis points to 25.7%, primarily due to lower prices and changes in product mix. North American segment operating income increased 263% to $79 million, a 4.4% operating margin.

In the international segment, revenue was $1.47 billion, up 40% or 33% adjusted for the $72 million favorable foreign exchange impact. Media revenue grew 33% to $1.01 billion or 27% excluding FX. EGM revenue grew 54% to $448 million or 45% excluding foreign exchange. International gross profit grew 47% to $302 million, or 39% excluding FX, while gross margin increased 88 basis points to 20.5%, reflecting the increase in third party mix, partially offset by lower prices and changes in product mix. International segment operating income increased 94% to $98 million or 6.6% operating margin. Excluding the $5 million favorable impact from FX, international operating income increased 81%.

CSOI grew 145% to $177 million or 5.4% of net sales, up 228 basis points year over year. Unlike CSOI, our GAAP operating income includes stock-based compensation expense and other operating expense. GAAP operating income grew 207% to $123 million or 3.8% of net sales.

Our provision for income taxes was $44 million in Q3 or a 35% rate for the quarter, which includes an $8 million year-to-date adjustment to reflect our current estimate of our annual effective tax rate of 29%, which incorporates our strong North America growth.

As a reminder, there is potential for significant volatility of our effective tax rate due to several factors, including variability in accurately predicting the amount and mix of taxable income by jurisdiction. In 2007, we anticipate cash paid for income taxes will be approximately $25 million, compared to $15 million in 2006, as we continue to benefit from NOLs inside the United States. NOL utilization is impacted by many factors, including our excess stock-based compensation deductions.

GAAP net income was $80 million or $0.19 per diluted share, compared with $19 million and $0.05 per diluted share.

Turning to the balance sheet, cash and marketable securities were $1.91 billion, an increase of $690 million year over year. Inventory increased 32% to $970 million, and inventory turns decreased from 13.2 a year ago to 12.4 as we expanded selection, 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 $42 million from a year ago to $491 million. Our return on invested capital was 42%. 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 exchange rate fluctuations, as well as the global economy and consumer spending. It's not possible to accurately predict demand and therefore, our actual results could differ materially from our guidance.

As we described in more detail in our public filings, issues such as marking our euro-denominated debt to market quarterly, intra-company balances in foreign currencies that settle amongst our subsidiaries, unfavorable resolution of legal matters and changes to our effective tax rate can all have a material effect on guidance.

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 Q4 we expect net sales of between $5.1 billion and $5.45 billion, or growth of between 28% and 37%. This guidance anticipates greater than 300 basis points of positive impact from foreign exchange.

GAAP operating income to be between $221 million and $291 million, or grow between 12% and 48%. This includes $54 million primarily for stock-based compensation and amortization of intangible assets.

We anticipate consolidated segment operating income, which excludes stock-based compensation and other operating expenses, to be between $275 million and $345 million, or grow between 20% and 51%.

For calendar year 2007 we expect net sales of between $14.263 billion and $14.613 billion, or growth of between 33% and 36%. This guidance anticipates greater than 300 basis points of positive impact from foreign exchange rates.

GAAP operating income to be between $605 million and $675 million, or growth of between 56% and 74%. This includes $191 million primarily 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 $796 million and $866 million, or grow between 59% and 73%.

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 to 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 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. With that, let's move to questions.

Kim Nelson

Great. Thanks, Tom. Let's move on to the Q&A portion of the call with Jeff and Tom. Operator, will you please remind our listeners how to initiate a question?

Question-and-Answer Session

Operator

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

Jeetil Patel - Deutsche Bank

Looking at the -- call it almost 11 million -- new active customers you've had in the past year, can you discuss their purchase frequency or if they are buying from you just as voraciously as the previous set of active customers? What's driving the accelerated growth across the board?

Second, can you talk about the broader impact of lower consumer spending you're seeing in your business? Are you seeing any effect, or do you think that perhaps the online side is a little bit more immune to it, given that it seems to be more about pricing as a big driver of why folks buy online, in addition to convenience and other factors?

Tom Szkutak

Jeetil, I'll take the second half of the question first. In terms of the impact of consumer spending, I think what you're seeing for us, and we're certainly not a bellwether for the economy, but what you're seeing is customers reacting and responding to just a very good customer experience: continued focus on lower prices, increased selection and certainly, speed of delivery with Prime being a factor. We think that plays well, as reflected in our guidance for Q4 as we enter into the holiday season. The customer is really going to get a great customer experience again in Q4, as they did in Q3.

The first part of your question, we haven't broken out any particular details on active customers beyond what we mentioned earlier in the comments. So I really can't help you much with that one.

Jeetil Patel - Deutsche Bank

Do you think it's more driven by selection that you're seeing the accelerated growth, or do you think it's actually more just the customer/consumer reaction? Thanks.

Tom Szkutak

Again, as I mentioned, it's a combination of increased selection. We've increased selection in the categories we're in, going much deeper. We've added new categories over time, as you've seen. We continue to get even sharper on pricing, and those are things that we have a constant focus on. We also want to make sure that inventory is there, so that we can get it to customers very fast, which you can see reflected in our turns. So all of those things we spend a lot of time on, and that certainly impacts the customer experience. That is reflected in the growth rates that you've seen in Q3.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Tom, after an extended period of investment, you have now gone to a period of obviously being able to grow into your expenses and drive very high incremental margins. I was wondering as you look into 2008, would you characterize that as another year of growing into your expenses and driving continued margin expansion? Or is it a year in which you may have more balanced investment versus improved profitability?

I have a follow-up question for Jeff on the consumer as it relates to online behavior. Thanks.

Tom Szkutak

Unfortunately, we're not giving guidance on 2008 today. Consistent with what we've done over the last couple of years, we'll be giving guidance on our next call after our Q4 earnings. But as it relates to technology and content spending, roughly 15 or 18 months ago, we certainly talked about the fact that we had spent the previous two to two-and-a-half years increasing our investment in a number of key areas. We said in the second half of last year that would start to slow down. You saw that most prominently in Q4 of last year, and that continued in the first three quarters of this year, as we have grown into this level of investment. I think certainly that you've seen that to date.

I think one of the things you should keep in mind which is a little different than where we were back in 2004 when we started this increase in investment, is our base is bigger. We can afford to invest with this higher base that we have, more so than we did in 2004. So again, we will be sharing guidance for 2008 on our next call, but hopefully that helps.

Jeff Bezos

I'll just add to that by saying that the bigger base might allow us to make investments over time, with less of a step function change than you've seen in the past.

Anthony Noto - Goldman Sachs

I was also wondering if you could comment, if you think about Amazon's value proposition for the consumer today versus maybe three years ago, that value proposition has always offered increased selection, better prices and greater convenience.

What do you think has changed at Amazon vis-à-vis the “on land” experience that has resulted in a meaningful widening of that gap?

Jeff Bezos

I think it is really just the continuation of those things that you mentioned. Year in and year out, we have been adding categories and adding very significant selection and depth inside categories. It sometimes surprises people to learn that we continue to do that, even in the categories we have been involved in the longest, such as books. But we do continue to deepen our categories there.

We've gotten better at managing inventory, so we're more often in-stock, which allows us to deliver products to customers much faster. We've also just incrementally over time gotten more efficient, better at defect reduction so we can do things accurately for customers at low cost. That has allowed us to continuously lower prices.

I think it's the combination of those things: getting products to customers quickly, having the broad selection and the deep selection, and having very attractive price points in combination with free shipping. That package of things, we have been very, very consistent on for a long time. I don't think there any changes there. I just think that every year, we get a little bit better.

Operator

Your next question comes from David Joseph - Morgan Stanley.

David Joseph - Morgan Stanley

I have one question related to gross margin. It looks like it came down by about 44 basis points year over year, and we did notice that your shipping loss was up nearly about 40%, but it looks like your third party sellers were actually accelerated. I'm wondering if there was a one-time impact there from Harry Potter. Maybe you can also talk a little bit about the contribution from third party sales.

As an additional comment on that, our question would be fulfillment and G&A. G&A actually declined on an absolute basis; fulfillment declined on a percentage basis of revenue. Fulfillment might be scale, but can you tell us a little bit about if we're missing anything on fulfillment, but also what might have lead to decline in G&A? Thank you.

Tom Szkutak

In terms of gross margins, yes, Harry Potter is having an effect. It was slightly less than a contribution profit breakeven event for us. You should assume that's a lower gross margin than our average, so it is bringing it down.

In terms of our overall expense, as you look at our direct segment operating expenses, there are certainly a number of different impacts but keep in mind, as I was mentioning a few questions ago, in the first three quarters of last year our direct segment operating expenses in total which includes tech and content, fulfillment, G&A and marketing, were growing at a rate that was faster than revenue, and Q3 is no exception to that. So we're getting leverage on each of those line items.

David Joseph - Morgan Stanley

With the impact to gross margin on Harry Potter, should we expect that to normalize over the next couple of quarters?

Tom Szkutak

Again, we're not giving guidance on those individual line items, but certainly what we expect is reflected in our Q4 guidance, but it did have an impact on our Q3 results.

Operator

Your next question comes from Victor Anthony - Bear Stearns.

Victor Anthony - Bear Stearns

I wonder if you could give us an update on your international expansion plans beyond the six international locations that you have right now? I am curious as to what geographies look attractive. And, any sort of timeframe?

The second question is really on the international electronics and other general merchandise category. It looks like there was a significant acceleration in revenues on that line, and I was curious as to what is driving that particular acceleration.

The final question is really on your guidance for 4Q. It looks the pro forma operating margin at the midpoint is really calling for a modest improvement on a year-over-year basis, compared to the sizable jump in this particular third quarter that you just reported. I'm wondering if there's anything of note in that particular quarter in the guidance? Thanks.

Tom Szkutak

As it relates to the international expansion, we certainly will add new geographies over time, but we certainly think there's a lot of improvement in terms of additional selection that we can add in the geographies that we're in. We really like the geographies that we're in.

In terms of categories today, we're most penetrated in the U.S. right now, and each of the individual geographies outside of the U.S. don't have the same depth that we do in our Amazon.com website. So that's clearly a focus for us as we add new categories, selection within those existing categories as well as new categories.

You mentioned the EGM growth in international being accelerated this quarter. What's driving that is some of the things that we've been talking about which is really just fundamentals. We have been adding selection. We continue to try to improve the customer experience, making sure that our prices are sharp in all of the geographies and categories that we're in and continue to work on reducing those overall customer-facing defects. So those are the things that are really helping our international EGM growth.

In terms of guidance, the implied guidance for CSOI translates into a range of 5.4% on the low side to 6.3% on the high side for operating margins, with the midpoint being at 5.9%, which is up from 5.7% last year. Two things to keep in mind. One is, as you look at last year's results, through the first three quarters the growth rate for those individual quarters, excluding foreign exchange, were anywhere from 23% to 25%. In Q4, it jumped to 30% and we've had sizable growth since then. So again, we're overlapping that 30% growth rate.

The second piece is, as I was mentioning about our direct segment operating expenses growing at a faster rate for the first three quarters of last year, it was growing at a faster rate than revenue. In Q4, our direct segment operating expenses were actually growing at a slower rate than revenue and we are overlapping that as well. So those two factors, must certainly be taken into account as we look at our guidance for Q4.

Operator

Your next question comes from Mark Mahaney - Citi.

Mark Mahaney - Citi

I wanted to ask about the progress or status of some of the digital media offerings. It looks like Unbox is coming up through a couple of iterations, nice healthy improvement in the product and in the user interface. You've had the music service out. Can you quantify at all or give any qualitative comments about what kind of traction you're seeing for those segments?

Maybe just to stress out the negative, are you seeing any signs that is cannibalizing existing sales of CDs or of DVDs? Thanks a lot.

Jeff Bezos

I would just say that we're very happy with the early results that we're seeing. We're getting terrific feedback from customers. Everybody loves the DRM free format, so selling MP3s is very successful for us. We have a lot of initiatives that we continue to work on. One of the things with our MP3 store is the way we look at it, the onus is on us to continue to convince music labels that this is a good way to sell their music. So we continue to work on that, but we're very happy with the way that it's going.

Our approach on this is you get out there and you get started, and you try to figure out what customers want and try to figure out how to give it to them, and then just repeat that consistently over a number of years. So you can count on us to keep working on those things. We're thrilled with the early results from customers.

Mark Mahaney - Citi

No evidence that it's had any impact on the physical CD or DVDs sales?

Jeff Bezos

We haven't seen any evidence of that. I think it's way too early to know whether you would see any of that.

Operator

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

Brian Pitz - Bank of America

First, any commentary on the performance or traction of some of your newer, higher-margin categories such as handbags, shoes or even auto parts? Then maybe some thoughts on new areas for expansion?

A follow-on to the digital media question, you're offering this digital locker to store digital books and video downloads. Is it possible for you to add essentially similar features for music downloads as well, down the road? Thanks.

Jeff Bezos

Well, with respect to your last question first, that's exactly the kind of thing that we try to solicit feedback on from customers and see if it would be helpful and if it is, then work together with our industry partners to try and figure out how to make that happen.

As far as some of the new categories go, we like the results we see. When we launch a new category, we always go through a period where we have to have significant inventory upfront relative to the early sales, so that's one of the factors that contributes in our corporate-wide inventory turns. But those are very good investments and what we see is over time, we get very good at managing these new categories.

What we're initially trying to do when we launch a new category is make sure that the customer experience is good, even from the beginning. So we forward-invest in the customer experience in a new category to make sure that it's going to be acceptable to customers. We try to get better at it, and then we hone the economics in those new categories over time.

Operator

Your next question comes from Scott Devitt - Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

The question relates to Merchants@ internationally. I believe the marketplace has been open in the international market for a few years now, so I'm trying to get a better understanding of how significant Merchants@ can be internationally, over time.

I was wondering if you could just talk about the mix domestically between Amazon Marketplace for third party units and Merchants@, just to better understand the dynamics? Thank you.

Tom Szkutak

If you take a look at our international third party business, as I mentioned in the opening remarks, our total worldwide third party units as a percentage of total units is 32%. We haven't broken out the details between North America and international, but certainly the North America is more penetrated than international is. But we see nice progress in international in terms of improving as a percentage of third party units. So we are very pleased with how that part of the business is going, and that's certainly one of the drivers that you see reflected in our gross margins on international.

In terms of how big it can be, it's a difficult question to answer. What we do is two things. We're very focused on trying to improve our overall customer experience, which includes third parties. We're focused on improving the retail side of our business, meaning product that we sell directly, and so we are continuously trying to add selection, add new categories, improve in-stocks, as Jeff mentioned, to drive the retail business.

Then we're also focused on how do we improve the seller experience, so it makes it easier for sellers to sell?

So ultimately where that will end up in terms of balance will be up to the customer to decide on what that ultimate mix will be. But our goal is certainly to improve the experience, keep on improving the experience for both sellers and customers. We think with that, the customers can decide where that ends up.

Jeff Bezos

One category to highlight, perhaps -- especially as we go into the holiday season here -- is the toy category. This is going to be, by far, our best customer experience in the toy category in the company's history. And it is not only Amazon retail toys, but there is also now a very strong network of third party toy sellers in the toy category. The combination of those is providing an outstanding customer experience. That will be part of our record holiday, and we're really excited about it.

Scott Devitt - Stifel Nicolaus

Thank you very much. Are you able to give any information domestically related to Amazon Marketplace versus Merchants@ which maybe could give better color as to the international dynamics?

Tom Szkutak

I apologize. We really can't help you with that.

Operator

Your next question comes from Justin Post - Merrill Lynch.

Justin Post - Merrill Lynch

I have a couple of interrelated questions to gross margin. I've got your third party units up north of 40%. It really looks like you are taking share there. Can you quantify at all the impact on gross margins? Do you expect that to really help next year?

Then if you look at the U.S., if you back out the Harry Potter revenues, everybody is going to have their own assumptions, but it looks like gross margins were still down in the U.S., ex-that. Is that just because of the new categories, or was that more pricing-related? Could you really get into what drove that, and is that part of your 4Q guidance?

Tom Szkutak

In terms of the North America piece, certainly Harry Potter is having a negative impact on gross margins. Also, mix of business is impacting gross margins as well. In terms of the other part of your question, the first part, can you just repeat that again?

Justin Post - Merrill Lynch

We have your third party units outstripping your regular unit growth; we have it at over 40%. What kind of impact is that having on gross margins, and do you think that could be a positive driver as we look out to next year?

Tom Szkutak

Well in terms of impact, certainly our third party business in general helps our gross margins, and certainly other factors to think about when you look at our gross margins are we continue to lower prices for customers, we continue to try to make sure we get great prices from suppliers and also mix of business. Those are the key factors that are impacting gross margins. In terms of 2008 again, we will be giving our guidance for 2008 after the Q4 call.

Justin Post - Merrill Lynch

Last question. As you look out to the holidays, any specific products that you're excited about or want to mention that we should be looking for on Amazon?

Jeff Bezos

There are probably a bunch, but the one that I would highlight is Amazon Prime. I mean, especially during the holiday season, we have been very successful signing up Amazon Prime members, but there are still a lot of people out there that would benefit from being Amazon Prime members. The people who are members love it; that's certainly, for the holiday season, a very good product.

Operator

Your next question comes from Imran Khan – JP Morgan.

Imran Khan - JP Morgan

I understand that your gross profit margin in international is 20.5%. Obviously, third party is significantly lower in the international market. I am trying to get a better sense of how quickly you can narrow the gap between U.S. and international gross profit margins?

Jeff, you talked about putting customers first to drive the growth and increase shareholder value. As your third party business becomes a bigger and bigger part of your business and your third party sellers number grows, how do you ensure customer satisfaction? Thank you.

Jeff Bezos

I'll take that second one first. It's a very good question, and it's something we spend a tremendous amount of time thinking about and focusing on. We've done a lot over time to maintain that customer experience. It starts with making sure that we have a good method of evaluating third-party sellers and making sure that they are sincere and want to do a great job for customers. We have a big team of people that do that.

The other thing is we have started something called Fulfillment by Amazon, which is getting a lot of early traction, growing rapidly. It allows third-party sellers to effectively let us do the fulfillment for them so they can, using Fulfillment by Amazon, send products directly to our fulfillment centers and then we do the packing and shipping directly to customers.

That has a lot of systemwide efficiencies in it for the third party seller and for us, because for one thing, if a customer orders two items they may order an item from us and they might order an item from the third party seller. If the third party seller is using Fulfillment by Amazon, then we can marry those two items together in a single box, which saves a significant amount of money in transportation costs. We're able to pass some of that savings on to the third party sellers who use Fulfillment by Amazon.

At the same time, from a customer experience point of view, if we are the ones fulfilling that third party unit, the customers get all of the benefits that they are accustomed to when they buy an Amazon retail unit. So for example, they get gift wrap, they get Free Super Saver Shipping. If they are Amazon Prime members, they get two-day shipping for free on that third party unit. So it basically levels the playing field for third party sellers and allows them to give the consumer all of the same benefits that Amazon retail is providing. That's an example of the kind of program that we tried to put in place. We're seeing very good reception from our seller community in taking us up on that offer.

Tom Szkutak

In terms of the first part of your question, it's difficult to predict the answer to your question as it relates to gross margins. I can tell you how we think about it, though. Some of the inputs are as we enter new categories we're trying to make sure that we have a great customer experience.

We start with adding selection. We continue to work on the input to customer experience, making it convenient for customers, making sure that the pricing is right. Over time, what happens is you'll get scale in that particular category. When you do that, good things happen. You have more third parties that are attracted to those detail pages to sell their products on. We also get better savings from vendors as we buy more from vendors.

So as you think about those countries that we are in today, as we improve the scale of those by again, adding new selection, adding new categories, those are the things that will help us with our core part of our retail business as well as third parties and getting better savings from vendors.

So the combination are certainly the things that will help us improve over time in international.

Imran Khan - JP Morgan

Jeff, in terms of Amazon Prime, you have had that for a while. Could you talk a little bit about the learnings you have had from Amazon Prime? How does that help you to improve your fulfillment and inventory management efficiency? Do you think as we continue to have Amazon Prime and more customer takes, you can actually have better selections and better stock availability and can enhance your fulfillment? Thank you.

Jeff Bezos

Well, one of the opportunities over time is, what Amazon Prime does as it continues to grow is it increases our express shipping volume. We have more volume now being shipped two-day rather than standard because for $79 a year, Amazon Prime members get unlimited free two-day shipping with no hurdle. So you can right now our Free Super Saver Shipping offer is available to everyone, but it's a slower class of service and it has a $25 minimum order threshold in order to qualify for Super Saver Shipping. So Amazon Prime members have no threshold, and they get two-day shipping for free. It's a very big change in the customer experience for an Amazon Prime member, and one that we know they love.

Our opportunity over time on the cost structure side is a large one when we have sufficient scale to take advantage of it, because the opportunity is to modify the fulfillment center network so that it's optimized for faster delivery. You can imagine that a network optimized for two-day delivery would look a bit different from a network optimized for standard delivery. Those kinds of opportunities are available to us in the future as we continue to scale.

Operator

Your next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

I wanted to follow up on Prime. What have the early returns of Prime been in Japan? Second, can you give us some color on the large amount of hiring that you did during 3Q? I think you added 1,400 people to your headcount. Was that mostly based in fulfillment centers, or was there another part of the business?

Jeff Bezos

The answer to the second part of your question is yes, the majority of that was fulfillment center related as we get ready for the holiday season. Those are largely variable personnel as we grow our business in Q4.

In terms of the Prime question as it relates to Japan it's very, very early. From what we see so far we're very pleased. Customers love the offering that we have. They are very excited about it, so it's still very, very early but we're getting very good feedback from customers.

Operator

Your next question comes from Jeffrey Lindsay - Sanford Bernstein.

Jeffrey Lindsay - Sanford Bernstein

We had a couple of things we wanted to ask about. We understand from the press that there's some dispute about the patent exclusivity of 1-Click. Could you give us some guidance on how significant the loss of 1-Click patent exclusivity could be for Amazon?

Second, could you also give us some guidance on what the potential impact could be from loss of the Borders book business in 2008? Finally, could you just give us an indication of how well you're doing in fresh groceries? Thank you.

Jeff Bezos

In terms of 1-Click, we have a longstanding practice of not talking about such matters outside of our public filings. You should refer to our public filings.

In terms of the other parts of your question, the grocery piece, we have a category, dry goods/grocery that we're very pleased with the performance to-date. It's a great way for customers to buy a number of different dry goods, an assortment of dry goods items, generally in bulk. So we are very excited about what we see there so far. But again, it's still very early.

Jeffrey Lindsay - Sanford Bernstein

We were wondering about the Borders book business? Could you comment on that?

Jeff Bezos

I don't really have any comments on any specific contracts.

Operator

Your next question comes from Shawn Milne - Oppenheimer.

Shawn Milne - Oppenheimer

Tom, I just have a couple of housekeeping questions. In terms of your revenue growth guidance in the fourth quarter, are you assuming any material follow-on impact from Harry Potter?

I just wanted to follow up on the fulfillment question. It did dip below as a percent of sales a little bit from what we were looking for. Are you seeing any impact already from what Jeff was talking about in terms of scale with the fulfillment network? Or is it just the Harry Potter impact on fulfillment costs in the third quarter? Thanks.

Jeff Bezos

In terms of the impact of Q4 as it relates to Harry Potter VII, there certainly will be sales that will happen related to Harry Potter VII, but it won't be as sizable as what you're seeing in Q3, or at least we're not anticipating that. In quarters where we've had sales such as that, that has been the biggest impact. In terms of fulfillment, what you're seeing is just leveraging our overall fulfillment center infrastructure. I don't have any other comments beyond that.

Operator

Your final question comes from Colin Sebastian - Lazard Capital Markets.

Colin Sebastian - Lazard Capital Markets

Thanks for taking my questions, two quick ones, one is a follow-up on Prime. Obviously, you're seeing a positive impact there on unit sales and subscriptions doubled year over year. I'm wondering if you have begun marketing that more aggressively off of the website? If so, what traction you might be seeing there?

Jeff Bezos

Not in any significant way. Most of our marketing is to our existing customers on the website.

Colin Sebastian - Lazard Capital Markets

On FPS, the Flexible Payment Service, I'm curious what kind of traction you are seeing for that service early on? What kinds of retailers are you seeing adopt the service? Thank you.

Jeff Bezos

For anybody else on the call who may not know this, FPS stands for Flexible Payment Service. It is one of our infrastructure web services, with the Elastic Compute Cloud, the Simple Storage Service, and the Simple Queue Service. These services are all developer-facing services, so they are a set of APIs that software developers can use to build web scale applications.

Obviously if you're building web scale applications, in many cases you have to be able to charge people for things. The Flexible Payment Service is the first payment service specifically designed from the ground up for developers, and it has a lot of features that make it very flexible and easy to use for developers to incorporate payments into their own applications.

So that set of services that we're offering to developers is growing very, very rapidly and has gotten an unusual amount of traction. We are very, very gratified to see this early uptake in the development community. It's happening at the very small scale with small software developers; one-person and two-person shops. It's also happening at the middle scale with venture capital-funded startups; and then at the large scale, with enterprise customers all the way from the small up to the big. So it's a very exciting and new product offering.

These infrastructure services are things that we needed to build for ourselves in order to run the web scale application called Amazon. While we were in the process of building these things, we decided to build them in an external way so we could charge for them and turn them into a new profit center.

We're very excited about this.

Kim Nelson

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.com and look forward to talking with you again next quarter.

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Source: Amazon.com Q3 2007 Earnings Call Transcript
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