Sell-Side Reaction to Amazon's Q1 Results -- Scott Devitt (AMZN)

From Stifel Nicolaus analyst Scott Devitt's note to clients yesterday on Amazon.com Inc.'s (NASDAQ: AMZN) results:

1Q06 Results; Maintain Hold

• We maintain our Hold recommendation on Amazon shares. We do not believe the market appropriately credits Amazon for its competitive advantages, including customer experience (price, convenience, selection), technology, and fulfillment. That said, Amazon works from a much lower operating profit base than its competitors and investments are difficult to hide. We believe investors should be opportunistic in Amazon shares when visibility to operating leverage becomes more apparent.

• The company reported revenue of $2.28 billion and EPS of $0.12. We were expecting net sales of $2.2 billion and EPS of $0.14. We applied a lower tax rate to our GAAP EPS estimate so the results should be considered generally in line. On a cash operating income basis, Amazon reported $120 million compared to our estimate of $117 million.

• The company reported 5.3% operating margin and a gross margin of 24%. Amazon reported a trailing twelve-month free cash flow number of $501 million compared to $529 million in 4Q05. Normalized for a $40 million settlement and $13 million that moved to the financing line on the cash flow statement, free cash flow was $554 million, up 32%.

• Our full year revenue outlook is $9.98 billion with GAAP EPS of $0.51. Our 2007 GAAP EPS estimate is $0.71.
Our Thoughts

We found Amazon results to be mixed and we believe the shares could be weak through the spring / summer months. The positives included 25% constant currency revenue growth, international growth acceleration to 29% from 23%, normalized TTM free cash flow of $554 million up 32%, and return on invested capital of 32%. The negatives included North America segment income margin of 5% compared to 6.4% in 1Q05 and International segment income margin of 5.6% compared to 7.2% in 1Q05. We prefer to recommend Amazon shares at points of leverage in the business, which we believe could occur late 2H06 as the spending increases annualize and we gain visibility to the digital offering. Amazon's digital strategy maintains such relevance to the Amazon story both because 62% of revenue comes from the media category and because much of the incremental capital expenditures over the past two years can be attributed to the digitization of the platform.

The unknown with Amazon remains the ongoing litigation with Toys R Us. We have difficulty making an investment decision when litigation exists at which one cannot put a probability on either outcome. Amazon has not changed its guidance and noted that if it loses its appeal with Toys R US that operating income could be impacted by $50 million. At a minimum, we find it difficult to believe the shares can trade much higher until the appeal reaches a conclusion.

We believe Amazon has an outstanding franchise and brand and that the company is well-situated within the competitive landscape. Based on 2007 estimates, on an enterprise value-to-unlevered (tax-effected) free cash flow basis, Amazon trades for 27x compared to eBay (23x), Yahoo! (33x), and Google (34X).

Results

The company reported revenue of $2.28 billion and EPS of $0.12 compared to our revenue estimate of $2.21 billion and EPS of $0.14. The North American business generated $1.25 billion in sales, up 21% from first quarter 2005. Segment operating income growth declined from $66 million in the year ago quarter, to $62 million. Internationally, sales were $1.03 billion, up 18% from 1Q05 and comprised 45% of total sales. Excluding the unfavorable impact from year-over-year changes in foreign exchange rates, sales growth was 29%. International segment operating income decreased 6% year/year to $58 million. Management also noted that subscriptions to Amazon Prime saw strong sequential growth, though no indication was given as to the total number of Amazon Prime members.

Worldwide media revenue grew 15% year/year to $1.578 billion, or 69% of total sales. Worldwide electronics and other (EGM) revenue grew 33% to $639 million, and comprised 28% of worldwide sales. North America media revenue grew 17% to $815 million, and EGM revenue grew 33% to $374 million, representing 30% of North America revenues, up from 27%. North America segment operating income increase was $62 million, and operating margin declined sequentially from 5.5% to 5.0%. North American gross profit grew 22% to $341 million, and gross margin was 27.3%, down 9 basis points, largely due to Amazon Prime and free shipping, products and service mix and price reduction across product categories, though partially offset by third-party sales. International media revenue grew 13% to $763 million or 24%, excluding FX, while EGM revenue grew 33% to $265 million or 45% excluding FX, representing 26% of international revenues, up from 23%. Gross profit grew International gross margin declined from 20.5% in 1Q05 to 20.0% this quarter. Other revenue was up 31% primarily from Amazon Enterprise solutions. Apparel, jewelry and sporting goods revenue all more than doubled YOY.

Fulfillment was $193 million or 8.3% of sales, up 16% year/year. Amazon had an average payables period of 48 days during the quarter. Active customer accounts representing customer orders in the past year surpassed 57 million, and were up 19% year/year. Capital expenditures were $223 million on a TTM basis and $46 million for the quarter. Cash and marketable securities ended the quarter at $1.33 billion.

Free cash flow for the trailing 12 months was $501 million and grew 20% year/year. Trailing 12-month free cash flow includes a one time payment of $40 million in connection with the patent lawsuit settlement in 3Q05 and excludes $13 million of tax benefits from stock-based compensation that are classified as positive financing cash flows under FAS 123R. Adjusting for these two items, TTM free cash flow grew 32% to $554 million. Return on invested capital as calculated as trailing 12-month free cash flow divided by average total assets minus average current liabilities was 32%. The operating margin was 5.3% on a worldwide basis. Gross profit grew 19% to $547 million in 1Q, and gross margin of 24% was primarily due to increased third-party sales, changes in the geographic mix of business and an $11 million increase in other revenue primarily from Amazon Enterprise Solutions, formerly known as merchant.com, partially offset by a greater shipping loss driven by free shipping in Amazon Prime, as well as lower product prices and continued sales mix shift. We had expected operating margins of 5.5% and gross margin of 23.5% for the quarter. Shipping revenue was $129 million, up 20% from $108 million. Third-party units, representing Marketplace and Merchants@ units sold on Amazon sites, were 29% of total units, up from 27%. Inventory turnover on a TTM basis was 14.4 in the quarter.

Projections and Conclusion

For 2Q06, management expects net sales between $2.03 billion and $2.18 billion, and growth between 16% and 24% year/year, respectively. Operating income is expected to be between $32 million and $67 million and includes $38 million in stock-based compensation and amortization. For full year 2006, net sales are expected to be between $9.95 billion and $10.50 billion with operating income between $390 million and $520 million, which includes $125 million for stock-based compensation and amortization. Regarding the termination of the Toys R Us contract, if Amazon does not prevail, operating profit could be negatively impacted by as much as $50 million for the year, including by as much as $25 million for the second quarter. This is not reflected in the above guidance.

Our 2Q06 revenue estimate is $2.05 billion, and our EPS estimate is $0.08. Our full year revenue outlook is $9.98 billion with GAAP EPS of $0.51. We expect gross margin and net margin of 23.9% and 5.0% in 2006, respectively. Our 2007 EPS estimate is $0.71.

We maintain our Hold recommendation on Amazon shares. We do not believe the market appropriately credits Amazon for its competitive advantages, including customer experience (price, convenience, selection), technology, and fulfillment. That said, Amazon works from a much lower operating profit base than its competitors and investments are difficult to hide. We believe investors should be opportunistic in Amazon shares when visibility to operating leverage becomes more apparent.