Good day, everyone and welcome to the Amazon.com second quarter 2008 financial results teleconference. (Operator Instructions) For opening remarks I will be turning the call over to the Vice President of Investor Relations, Mr. Rob Eldridge; please go ahead.
Hello and welcome to our Q2 2008 financial results conference call. Joining us today is Thomas Szkutak, our CFO. Jeffrey 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, July 23, 2008 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 2007 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 Investor Relations 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 2007.
Now with that I’ll turn the call over to Thomas.
Thanks, Rob. I’ll begin with comments on our financial results. Trailing 12-month free cash flow increased 16% to $816 million. The combination of common stock and stock-based awards outstanding was 446 million shares compared with 435 million. Return on invested capital was 29%, down from 39%. Worldwide revenue grew 41% to $4.06 billion, or 35% excluding the $182 million favorable impact from year-over-year changes in FX.
Media revenue increased to $2.41 billion, up 31%, or 25% excluding foreign exchange. EGM revenue increased to $1.53 billion, up 58% or 52% excluding foreign exchange rates. Worldwide EGM increased to 38% of worldwide sales, up from 34%.
Worldwide unit growth was 32%. Active customer accounts exceeded $81 million, up 18%. Worldwide active seller accounts were more than $1.4 million, up 18%. Seller units were 29% of total units, unchanged from the prior year. Worldwide gross profit was $967 million, up 38%.
Now I’ll discuss operating expenses excluding stock-based compensation. Fulfillment, marketing, tech and content and G&A combined was $722 million, or 17.8% of sales, an improvement of 83 basis points year-over-year. Tech and content was $218 million, or 5.4% of revenue compared with 6.1%.
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 item.
In the North America segment revenue grew 35% to $2.17 billion. Media revenue grew 25% to $1.15 billion. EGM revenue grew 52% to $920 million representing 42% of North America revenues, up from 38%. We saw another quarter of strong sales in electronics, toys and baby, consumables, and soft goods, which includes jewelry, apparel, shoes, and sporting goods.
North America gross profit grew 29% to $559 million and gross margin decreased 129 basis points to 25.8% driven by changes in product mix and lower prices for our customers including free shipping offers at Amazon Prime. North America segment operating income increased 17% to $96 million, a 4.4% operating margin.
In the international segment revenue grew 47% to $1.89 billion. Revenue growth was 34% adjusted for the $179 million year-over-year favorable impact from foreign exchange rates during the quarter. Media revenue grew 38% to $1.26 billion, or 25% excluding FX, and EGM revenue grew 68% to $611 million, or 52% excluding FX. EGM now represents 32% of international revenues, up from 28%.
International gross profit grew 52% to $408 million, or grew 38% excluding foreign exchange rates, while gross margin increased 66 basis points to 21.5% driven by increases in [three p] product sales, improvements in vendor pricing and higher other revenue partially offset by lower prices to our customers and changes in product mix. International segment operating income increased 80% to $149 million, a 7.9% operating margin. Excluding the favorable impact from foreign exchange rates, international segment operating income increased 56%.
Consolidated segment operating income grew 49% to $245 million, or 6% of revenue, up 31 basis points. Excluding the $17 million favorable impact from FX, CSOI grew 38%. Unlike CSOI, our GAAP operating income includes stock-based compensation expense and other operating expense. GAAP operating income grew 86% to $217 million, or 5.3% of net sales.
Included in the second quarter 2008 GAAP operating income is a $53 million non-cash gain recognized on the sale of our European DVD rental assets.
Our income tax expense was $46 million in Q2 or a 22% rate for the quarter. We estimate that our effective tax rate in 2008 will be approximately 28% and that cash taxes paid will be less than $75 million. However there is potential for significant volatility due to several factors including variability in accurately predicting the amount and mix of taxable income by jurisdiction and the business acquisitions or investments. We are endeavoring to optimize our global taxes on a cash paid basis, not for tax expense on a financial reporting basis.
GAAP net income was $158 million, or $0.37 per diluted share compared with $78 million and $0.19 per diluted share.
Turning to the balance sheet, cash and marketable securities increased $789 million to $2.63 billion year-over-year. Inventory increased 51% to $1.11 billion and inventory turns improved to 13, up from 12.9 in the prior year even as we expanded selection, improved in-stock levels across product categories and geographies and introduced new product categories.
Accounts payable increased 52% to $1.96 billion and accounts payable days increased to 58 from 54 in the prior year.
Our investment in net fixed assets increased $208 million from a year ago to $651 million. On a trailing 12 month basis capital expenditures increased $78 million, up 40% year-over-year. Our Q2 2008 capital expenditures were $69 million.
During the quarter approximately $473 million in principal amount of our four-and-three-quarter convertible subordinated notes converted into 6.1 million shares of common stock and we redeemed $27 million from principal amount of the notes.
I’ll conclude my portion of today’s call with guidance. Incorporated into our guidance are the order trends that we’ve 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 and foreign currencies that settle amongst our subsidiaries, unfavorable resolution of legal matters and changes to our effective tax rate can all have a material affect on guidance. Our guidance assumes that we don’t conclude any additional business acquisitions or investments, record any further revisions to stock-based compensation estimates, and that foreign exchange rates remain approximately where they have been recently.
For Q3 we expect net sales of between $4.2 billion and $4.425 billion, a growth of between 29% and 36%. This guidance anticipates approximately 450 basis points of positive impact from foreign exchange. GAAP operating income to be between $115 million and $160 million, or between 6% decline and 31% growth. This includes approximately $80 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 $195 million and $240 million, or between 10% growth and 36% growth. For calendar year 2008, we expect net sales of between $19.35 billion and $20.1 billion, a growth between 30% and 35%. This guidance anticipates greater than 400 basis points of positive impact from foreign exchange.
Our GAAP operating income to be between $745 million and $920 million, or between 14% growth and 40% growth. This includes approximately $295 million for stock-based compensation and amortization of intangible assets.
We anticipate 2008 consolidated segment operating income which excludes stock-based compensation and other operating expense to be between $1.040 billion and $1.215 billion, or between 22% growth and 43% growth. Our goal continues to be operating leverage in 2008, with CSOI growing faster than revenue on a percentage basis.
We anticipate our free cash flow growth rate to trend similar to our operating profit growth rate over time, with some variability including from changes in working capital and excess tax benefits from stock-based compensation. We expect capital expenditures including capitalized software development costs to be approximately $325 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 and with that let’s move to questions.
(Operator Instructions) Your first question comes from the line of Mark Mahaney – Citigroup
Mark Mahaney – Citigroup
I wanted to ask about some of the digital media offerings, are there any data points, it’s a highly competitive space, music, video and now e-readers online, particularly the first two, what are the data points that you look at to judge how well you’re doing in that segment? Anything you can share with us and then any comment at all on the kindle and what kind of—how many units you’ve sold or any kind of demand metrics there?
We don’t really breakout those digital figures. What I can tell you on kindle is that we’re not releasing the number of units of kindle that we’ve sold, the number of devices, what we have said is that we are, if you look at the universe of titles where we saw the kindle version, so those 140,000 different titles, the percentage of all-in units that in kindle unit form versus their physical book equivalent for that same universe is low double-digits at this point, which we’re very excited about.
Your next question comes from the line of Justin Post – Merrill Lynch
Justin Post – Merrill Lynch
It looks like for several quarters now third party units were growing faster then your own units, it looks like it was kind of flat this quarter, are there any changes there? And as you look forward it looks like margins might be slightly lower operating income margins going forward, is that trajectory affecting your margin outlook as you look out to the back half?
To answer your first question third party units [or] the percentage of total units was 29% which is flat with last year. Keep in mind that our unit growth did accelerate in total so our unit growth was 32%. Also keep in mind or another data point is our third party units did grow faster then our retail units this quarter. So again, we’re still seeing very, very good growth there. A couple of things to think about the active seller accounts if you will, are up 18% year-over-year that compares to a year ago where they’re up 11%. We’ve had several quarters where we’ve seen accelerated growth of active seller accounts. So again we think that the business looks good. It’s really not impacting the guidance as we think about it. We’re very positive about both our retail business and our third party business. Ultimately the customer will decide what units they buy and we’re trying to make the experience better for customers and for sellers.
Your next question comes from the line of David Joseph - Morgan Stanley
David Joseph - Morgan Stanley
On that point of unit growth, so it seemed like it accelerated while gross margin actually declined year-over-year, so it seems that Amazon might be getting a little bit aggressive on pricing. I’m wondering if you might be able to provide a little bit more color on that and then just really a math question, excluding the sale of an asset for $45 million operating margin ex dot com according to our math would have come in line with our estimate of about 6.0%, is that correct?
In terms of pricing we’ve been pretty consistent. We’re trying to make sure we have very competitive pricing across many different categories and many different geographies and so we’ve spent a lot of time trying to make sure that that is the case and we’re always looking for ways to improve that to make sure we have the most, the best information as we do that. So that, in terms of a process standpoint, nothing has really changed there.
In terms of your question on the gain the gain was, the $53 million gain was not included in our guidance, it’s included in our GAAP operating income. It’s not included in our CSOI so if you look at our CSOI of $245 million, it’s not included in that number. So again, the range we gave for CSOI for Q2 was $200 million to $240 million; we came in at $245 million. The $245 million does not include the gain.
Your next question comes from the line of Jeetil Patel – Deutsche Bank
Jeetil Patel – Deutsche Bank
It seems like the flywheel is working internationally, if you look at third party and Prime, it looks like your kind of getting the similar lift that you got in the US as you had the Prime service ramp up. I guess if you could frame for us where international stands in terms of the ramp phase relative to going back in the North American market where timeframe revolution, where international looks today with third party and Prime versus domestically. And then second is there a way for you to leverage your customer buying relationships with consumers in your technology platform to basically go after other retailing opportunities. I guess I’m trying to allude to Universal Wish List and how that fits in and maybe even a Universal payment service from an affiliate standpoint how that fits into the grand scheme of things.
In terms of the first part of the question regarding third party and Prime its difficult to give a timeframe but I would say on both its certainly earlier for both, so both in terms of our third party as well as Prime in terms of penetration. And that’s really because we’ve been at it longer in North America. We like the progress that we’re making in both accounts in North America and international but its earlier as you’d expect.
Could you just repeat the second part of your question?
Jeetil Patel – Deutsche Bank
I’m just trying to understand how your customer buying relationships with over 80 million customers and your technology that you’ve been building out for years now, just how does an idea like Universal Wish List, which I think is available on the site or payments fit into that. How do you take your existing assets and how do those fit into that?
In the case of Universal Wish List we have a very large number of folks using the Amazon Wish List and we have for a number of years and so that’s a—basically a thriving feature and the idea behind Universal Wish List is that, its really just a customer service that as people go about their business on the web, if they would like to add something to their wish list from another vendor on another website we make it very easy for them to do that. So then they have still one place to point their friends and relatives to, to see their Universal Wish List.
Your next question comes from the line of James Mitchell - Goldman Sachs
James Mitchell - Goldman Sachs
Could you talk a little bit about your third quarter operating income guidance, I think in 2007 your operating income ticked up a little quarter-on-quarter from 2Q to 3Q and for this year you’re guiding for it to tick down a little, I wondered if that was due to just general corporate conservatism or whether there was any specific driver?
The only thing I’d call out is and we have announced a number of capacity increases and fulfillment and certainly with the large growth that we’ve seen, you’re seeing—you saw leverage in Q1 and Q2 on our fulfillment expense as a percentage of revenue. With the added capacity it’s a little bit lumpy in Q3 but we’re adding additional capacity to serve Q4. It is typical that we do it in Q3, we also do it in other quarters but it’s just a little bit lumpy in Q3 and certainly reflected in the guidance that we’ve given for Q3.
Your next question comes from the line of Brian Pitz – Banc of America Securities
Brian Pitz – Banc of America Securities
First a question on taxes, would you comment on any changes in demand from New York State customers given the recent collection of sales taxes there and then a separate question on gross margins, a gap remains between North America and international gross margins, can you talk about the key leverage points that will help to close the gap there?
In terms of New York, its really too early to comment there but I just want to remind everyone that we really collect either sales tax or value-added tax on approximately 50% of our business today and we collect at a number of states in the US, we collect in a number of the geographies outside of the US and so we have very good businesses in those geographies. In terms of your gross margin question, you’re absolutely right; we do have a delta between our North America and international business. A couple of the dynamics there, one of them which we talked about a little bit earlier, certainly our third party penetration is higher in North America then it is in international, and so that’s an opportunity for us. Certainly as we get the scale we’ve launched many, many new categories in international over the past 18 months and as those categories get more and more to scale, there’s opportunities on the margin side there. And so those are certainly the key ones in terms of differences.
Your next question comes from the line of Jeffrey Lindsay - Sanford C. Bernstein
Jeffrey Lindsay - Sanford C. Bernstein
What is the impact on your delivery and fulfillment charges particularly with regard to Prime, of increased transportation costs, is this really a 2009 phenomenon for you or is there a possible increase in delivery cost coming through the pipeline? And then could you just give us a comment on how you’re seeing any impact from consumer confidence on sales, product mix, sales frequency, smaller ticket items, are you seeing any difference now that consumer confidence is significantly lower?
On the fuel prices we suspect that higher fuel prices may be a relative advantage for us both in terms of relative to physical world stores because of the expense of driving to a store, even just driving 10 miles these days is a few dollars worth of gasoline and consumers we suspect are beginning to take that into account and think about that and try to do trip consolidation and so certainly our free shipping offers and Amazon Prime become very high, a clearly of even more value to customers under that set of circumstances.
And then relative to other online retailers because of our scale we have a distributed fulfillment center network that places products closer to customers that allows us to do fast transportation to customers, fast deliveries to customers but usually using ground transportation instead of air transportation and ground transportation is much more fuel efficient then air transportation. So probably this is a relative advantage for Amazon and its our job to insulate customers since we offer free shipping and Amazon Prime offers fast free shipping, the burden is upon us to make sure that we can do that in a way that is economical for us so that customers can continue to enjoy those free shipping offers and we have clearly no intention of changing those. We’ll keep them in place.
Jeffrey Lindsay - Sanford C. Bernstein
Do you think it will impact your margins negatively going forward?
This is something that we’ve been dealing with for quite some time, as part of our overall cost structure. We started in the US some of the free shipping offers back in 2002 I believe. Oil prices were around $22.00 a barrel back in 2002. They’ve continued to grow and certainly it is more costly but it’s not something that’s really new to us. Its part of our overall thinking as we look at our costs.
Jeffrey Lindsay - Sanford C. Bernstein
Are you seeing any change in consumer buying habits because of the lower consumer confidence?
We’re probably not the best bell weather for the economy and certainly one indication of that is just looking at our overall growth rates that you see for Q2. We have growth rates of 35% excluding the impact of the exchange that accelerated from last year where we saw a little bit under 33% excluding exchange and also an acceleration from Q1. So I don’t think I can really help.
Your next question comes from the line of Scott Devitt – Stifel Nicolaus
Scott Devitt – Stifel Nicolaus
As it relates to the guidance and the change for the guidance last quarter you gave full year GAAP Op In guidance $740 to $940 and the GAAP operating income this quarter was I believe $57 million above expectations including the $53 million gain so I’m trying to get my hands around the updated guidance which is mostly unchanged from the prior GAAP operating income guidance and whether this new guidance includes or excludes the $53 million gain.
Yes, the GAAP, the guidance excludes the $53 million gain.
Your next question comes from the line of Doug Anmuth - Lehman Brothers
Doug Anmuth - Lehman Brothers
On CapEx it looks like you raised your outlook by about $25 million so CapEx is now expected to be up about 46% year-over-year, can you talk about why the increase there and then can you detail the contribution from audible during the quarter?
In terms of the CapEx the increase, we spent CapEx in a number of different areas, certainly a big portion of it is fulfillment related also infrastructure related and then a few other smaller areas and so those are really the drivers for the CapEx growth, not only the increase from $300 to $325 but also the increase year-over-year. So really it relates back to the growth of the business which is causing that increase.
Doug Anmuth - Lehman Brothers
And the audible contribution?
We’re not breaking out the audible piece in our results for Q2.
Your next question comes from the line of Steve Weinstein – Pacific Crest Securities
Steve Weinstein – Pacific Crest Securities
If we want to back out the $53 million gain for the sale of the DVD business what would the offsetting tax impact be for that?
I can’t talk to the tax piece, I guess the best way to say it is the estimate for the year is 28% and you see a first half effective tax rate of 26% and that gain is reflected in the first half results in the 26% effective tax rate. Again our estimate for the year is 28%.
Your final question comes from the line of Imran Khan – JP Morgan
Imran Khan – JP Morgan
One of the biggest value propositions for your biggest consumer business in price discount and free shipping and things like that, as 30% of your business is now coming the sellers business how do you ensure the quality, the security and the safety that the consumer gets from your main business. The free cash flow growth rate was 16% versus 51% and I can understand that can fluctuate quarter-over-quarter and how should we think about the full year free cash flow growth rate?
For your first question the first way we do that is because we have an astonishingly good group of sellers who take their customer experience and the customer service that they provide on Amazon very, very seriously, and we give them lots of metrics and tools to help them manage that experience. So that’s sort of the first answer to your question is the sellers do a very good job. Some better then others and we try to make it very clear both to the sellers and to the consumers the quality of that particular seller.
The second thing is that we are more and more having sellers take advantage of fulfillment by Amazon which is a program that lets sellers put their inventory in our fulfillment centers. This is a very big advantage for sellers because it increases their sales. When sellers move into fulfillment by Amazon they end up selling more. The second reason it’s a big advantage is it’s a big advantage for the consumer because now those third party items are eligible for super saver shipping, they’re eligible for Amazon Prime, a third party item can be married together and put in a box with an Amazon retail item so that the outbound transportation is more efficient.
So there are a lot of advantages to fulfillment by Amazon and that’s another kind of a second part to the answer for how that third party business can have a very high level of customer experience for our consumers. Your question is a very good one, its one we think about a lot and we take very seriously.
In terms of the second part of your question we’re not giving guidance on annual free cash flow but just wanted to comment for a second on the Q2 growth, Q2 of last year if you go back to actually Q1 of last year we had free cash flow growth of 4%, Q2 on a trailing 12 months last year was a growth of 87% and the sequential growth was 34%. That was a difficult compare and a little bit of an anomaly compared to the last several years. If you look back over the last several year period you’ll see that our sequential growth that we had this quarter from Q1 to Q2 was very consistent with what we’ve seen other then that.
And if you look at the underlying pieces and metrics that support free cash flow you’ll see that our consolidated segment operating income over the past 12 months was up 56%, our AP days were up four days, our inventory turns were essentially flat 13 versus 12.9, and our CapEx was up 40% which was just slightly under our trailing 12 month revenue growth. So those are the underlying pieces that I think are most significant.
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. Thank you everybody.
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