Analysis of Amazon's 10-K (AMZN)

Stifel Nicolaus analyst Scott Devitt analyzes Amazon.com Inc.'s (AMZN) 10-K filing:

Highlights of Amazon’s recently filed 10-K:

International Business Factors. Orders from several of Amazon's internationally focused Web sites are fulfilled primarily from a single fulfillment center, with only a limited ability to reroute orders to third parties for drop-shipping. Management does not expect to benefit in newer market segments, whether products, services or new geographic areas, from the first-to-market advantage that the company experienced in the U.S. online book channel.

Settled Lawsuits. In August 2003, plaintiffs alleged that Amazon made false or misleading statements during the period from October 29, 1998, through October 23, 2001, concerning the business, financial condition and results, inventories, future prospects, and strategic alliance transactions. Earlier this year, the company signed Stipulations of Settlements which were approved in the fourth quarter of 2005, and disposed of all claims asserted in these lawsuits in exchange for payments totaling $48 million, substantially all of which is expected to be funded by Amazon's insurers.

Recent Lawsuit. In December 2005, Registrar Systems LLC filed a complaint against Amazon and Target Corporation for patent infringement. The complaint alleges that certain elements of Amazon's Web site technology, infringes on two patents obtained by Registrar Systems and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, costs, and attorneys' fees. Amazon expects to dispute the allegations of wrongdoing in this complaint and defend vigorously in this matter.

Metrics Trends. Amazon is able to turn its inventory quickly and have a negative operating cycle.
Inventory turnover was 14, 16, and 18 for 2005, 2004, and 2003. Accounts payable days were 54, 53, and 50 for 2005, 2004 and 2003.

Stock Comp. Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $7 million, $8 million, and $4 million for December 31, 2005, 2004, and 2003. Management expects the corresponding amount for 2006 to increase substantially and possibly be in excess of $100 million. Accordingly, amounts presented for operating cash flows and free cash flows for 2006 will be negatively affected in comparison to prior results; however, the underlying economic substance is not affected by this change in reporting classification.

Foreign Exchange Effects. Changes in currency exchange rates negatively affected 2005 net sales by $73 million, and positively affected net sales by $276 million and $232 million for 2004 and 2003. As a result of fluctuations in foreign exchange rates during 2005, International segment revenues declined $78 million and operating results declined $7 million in comparison with the prior year.

Shipping. Free shipping and membership offers reduce shipping revenue and reduce gross margins on retail sales. Amazon Prime, introduced in 2005, is a shipping membership program in which members receive free two-day shipping and discounted overnight shipping. Amazon has begun offering free membership trials for Amazon Prime, and expects to continue to offer these trials in the future. The company views its shipping offers as an effective worldwide marketing tool and intends to continue offering them indefinitely. The net cost to Amazon for shipping activities was $239 million, $197 million, and $136 million for 2005, 2004 and 2003.

Third-Party Sales. Sales of products by third-party sellers on Amazon's Web sites continue to increase, representing 28%, 26%, and 22% of unit sales in 2005, 2004, and 2003. Since revenues from these sales are recorded as a net amount, they generally result in lower revenues but higher gross margin per unit.

Gross Margins. North America segment gross margins in 2005 improved by 30 basis points compared to 2004 resulting in part from increases in sales by third-party sellers, increases in amounts earned from service agreements, and offset partially by efforts to continue reducing prices for customers. International segment gross margins in 2005 improved by 162 basis points compared to 2004 resulting from several factors including increasing sales by third-party sellers and increases in discounts received from product suppliers, offset partially by changes in mix of product sales and year-round free shipping offers.

Fulfillment. Amazon expanded its fulfillment capacity in 2005 and 2004 through gains in efficiencies as well as increases in leased warehouse space. The company plans to continue expanding its worldwide fulfillment capacity in order to meet anticipated shipment volumes. Management expects absolute amounts spent in fulfillment and fulfillment-related cost of sales to increase over time.

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