Amazon Toying with Vertical Integration

Amazon.com (AMZN) has been pursuing growth at all costs. Its recently announced Q1 2008 results are a testament to that drive. It reported the quarter’s revenue at $4.13 billion, meeting analyst expectations and reporting a 37% increase over the previous year. Its earnings for the quarter at $0.34 were marginally higher than the market’s expectation of $0.32, and are 30% higher than previous year earnings.

Media revenue increased by 28% over the previous year to $2.54 billion while Electronics and other General Merchandise [EGM] revenue increased by 56% over the period to $1.48 billion.

Region-wise, North America contributed $2.13 billion recording a 31% growth. The rest of the world revenues grew by 44% to $2.01 billion.

Going forward, for Q2, it expects net sales of between $3.875-$4.075 billion, which is a growth of 34%-41% with GAAP operating income of $0.12-$0.16 billion. For the year 2008, it expects net sales between $19.1-$20 billion, a growth of 29%-35% with GAAP operating income of $0.74-$0.94 billion.

I have repeatedly mentioned that Amazon needs to expand its margins. The management however, continues to follow the low-price strategy to drive up sales. It attributes its sales growth for the quarter to “low prices and millions of in-stock items available for immediate shipment”. Its operating margin continues at 5.8% for the quarter, despite addition of new categories even in the international segment.

Amazon’s competitor, eBay (EBAY) recently announced its results, and unlike Amazon, eBay continues to give higher margins.

The management does not give a more detailed breakdown of revenue contributors. So, Kindle revenues are still not available to analysts. It has increased the content to 115,000 titles from the 90,000 titles at launch, which is indicative of at least some commitment.

The most interesting move I saw this quarter from Amazon, however, is the news that it will only sell print-on-demand books printed by its own POD provider, Booksurge. In fact, the book publishing business is ready for a complete overhaul, and who is better positioned than Amazon to pull this off? With Booksurge, Amazon is offering 35% royalties to authors, promotion opportunities on Amazon (e.g. cobranding with best-sellers for $1000 a month), etc.

When you contrast this with the 10-15% royalty that major publishers offer their authors, and virtually no marketing (except in the case of a few titles), Amazon is starting to address the two most important issues in the book industry. I can’t wait to see what Amazon would do to turn this around. The vertical integration basically takes out all intermediaries except the Author (35%) and Amazon (65%), and can become a compelling option for 90% of the authors.

Amazon’s stock reported an increase of 1.8% during the day on Wednesday, but in the after hours session, it fell by 4.8% to close of $77.10. Yesterday, it was trading in the $77-79 range.

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You can read more on my comparison of Amazon with eBay in the following articles:

eBay vs Amazon: Which is a Better Company?

eBay vs Amazon: My Take

Here is the most recent comparison chart of the two:

click to enlarge

Comments

[DeaverB]

Good article except for the low cost criticism. That's why Amazon has such a loyal following. Then they can move into audible.com and print on demand books. When brands lose their low price focus, a la McDonalds and Walmart, they wind up being medicore and inspire competitors (McDonalds recovered with the dollar menu, where they started, and are booming again; Walmart has inspired Dollar store competition and growth; resurge in profits at traditional grocers). Amazon has blown every competitor away. I used to shop more widely; now I got to amazon and buy. Period.

As long as Bezos stays focused on value, amazon charges forward. When he talks about "raising margins," as David Glass did at Wal-Mart--got whacked and backed off, but Lee Scott did--sell.

[Marty]

Very well done article, thank you! Whatever Bezos is up to it is always interesting. I have always enjoyed shopping on Amazon and keep an eye on what they are doing since I am a seller on Ebay. The info on Booksurge is intersting and makes a lot of sense.

One risk I see though is that much of Amazon's recent success came from a few mistakes Ebay made by allowing millions of items to transition off the site when it raised fees and made some comments about its own stores product that left some bewildered.

However, Ebay has lowered fees, attracted many of the larger sellers back and also is working on numerous trials which seem to imply lower fees are coming (from blog posts I have read). It is not so much the people that had moved but the line of people that follow when people have success (as they have on Amazon). When this process reverses ,Amazon will lose that surge to the growth profile.

Marty

[User 172133]

RE: AMZN's Free Cash Flow -they have Very Little
(posted on a message bd)
people have used the wrong formula to compute FCF for AMZN. There are various methods to compute the number depending on the type of enterprise you are dealing with.

If you use the formula from Investopedia Advisor, the link YOU posted earlier in this thread, you would see that there is no increase in FCF
www.investopedia.com/terms/f/freecashflow.asp
Formula from your link-

Net income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow
In some cases FCF can be calculated by taking operating cash flow and subtracting capital expenditures, (not meaningful in AMZN’s case, as it ignores cash on hand @12/31/07 that would be used to pay bills- it is not Free Cash, if accounts payables did not increase by $1.2 bn there would have been only a small increase in Cash Flow.
See Balance sheet- finance.yahoo.com/q/bs?s=AMZN&annual
HOW CAN YOU ADD THIS INCREASE OF A/P TO FREE CASH FLOW?? IT’S NOT FREE CASH, IT HAS TO PAID OUT IN THE NEXT QUARTER?????
“Free cash flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution owners of the capital employed in the company (stockholders)”.

FCF computation for AMZN using 12/31/07 from-
finance.yahoo.com/q/cf?s=AMZN&annual
(ignoring other smaller input items)
Net Income................................476ml
+Amortization/Depreciation.........246
-Change in Workng Capital........-832 (a/p, a/r etc)
–Capital Expenditure.................-224
________________
= Free Cash Flow....................-332ml
There may be other ways to compute FCF, but the above is more accurate (other minor inputs can be added) as the definition of FCF


Article-
Free Cash Flow: Free, But Not Always Easy
by Ben McClure, Contributor - Investopedia Advisor

The best things in life are free, and the same holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery....


...To do it another way, grab the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets...


www.investopedia.com/terms/f/freecashflow.asp