Amazon Pre-Earnings: Electronics and General Merchandise Will Drive Growth, But Profitability Could Disappoint

Amazon (NASDAQ:AMZN) has been primarily focused on growing its revenues.  In a quest to gain scale, management has made growth the priority over improving margins, reinvesting profits through both lower pricing and higher expenditures.  Its low profitability has been a long standing concern, and will once again be the key highlight of the upcoming Q3 2014 results on October 23rd. While the revenue growth is expected to be strong, it will come at the expense of a decline in profits. During its last earnings call, Amazon guided a revenue between $19.7 billion and $21.5 billion, and operating loss between $810 million and $410 million for Q3.

We expect strong growth in the electronics and general merchandise category and North American region to be the pillars for Amazon’s top-line increase during the third quarter. Also, Amazon Web Services segment will likely continue to see robust demand due to rapid innovation and lower pricing. The number of Prime subscriptions should continue to see healthy growth rates.  This, in turn,  is expected to play out as a major competitive advantage for the company in the long-term.

Our price estimate for Amazon stands for $348, implying around 10% premium to the current market price.

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Recap Of Q2 2014 Results

During the second quarter, Amazon’s net sales increased by 23% to $19.3 billion, outpacing growth in the overall e-commerce market. This was primarily driven by over 26% growth in the North American geography and around 27% increase in the electronics and other general merchandise category. The consolidated top-line growth in the Media and ‘Others’ category stood at 10% and 37%, respectively, during the quarter.

The company’s loss had widened during the second quarter, with GAAP operating margin falling to -0.1% compared to 0.5% in the same period a year ago. The net loss was seen at $126 million, which was much higher than $7 million net loss in Q2 2013. The continued decline in profitability has contributed to 15% fall in Amazon’s stock price during the past three months. Amazon is expected to report heavy operating losses in the third quarter as well. The recent pricing changes seen at Amazon Web Services, along with heavy investments in diverse areas such as fulfillment and sortation centers, original content, hardware development and geographical expansion, are expected to weigh on the company’s margins in Q3.

Revenue Growth Will Be Fueled By High Demand In The Electronics And General Merchandise Category

The electronics and general merchandise category accounts for 66% of our valuation for Amazon’s stock, and around 69% of the total sales. Strong demand in this segment has fueled the company’s top-line growth in the past. In Q2 2014, the sales increases in the North American and international electronics and general merchandise categories were recorded at 29% and 25%, respectively. We expect this segment to post high growth in the third quarter as well, as the company continues to leverage its size, strong vendor network and technological advantage to expand its presence. According to ChannelAdvisor, Amazon’s same store sales during Q3 2014, exceeded more than twice the growth rate of the U.S. e-commerce market. ^[1]

The media segment has unperformed in the past few quarters – its consolidated sales grew by 10% in Q2 2014, with 13% and 7% growth in the North American and international regions respectively. Heavy investments are being undertaken on the media side, as over $100 million was spent on original content in third quarter. ^[2] It will be interesting to see how these investments impact revenue growth over the next few quarters. If this strategy fails to propel the media segment or Prime subscriptions in the future, it will have a negative impact on the overall profitability.

Amazon Web Services Will See High User Growth Driven By Product Innovation and Lower Pricing

Amazon Web Services business, which enables cloud storage and computing for corporate and small businesses, has shown promise over the recent past, and has contributed to the slight increase in Amazon’s EBITDA margin over the last two years. While revenue growth in the Amazon’s ‘Other’ segment (which includes Amazon Web Services) fell from 58% in Q1 2014 to 37% in Q2 2014, the volume of business has slowed to less an extent. This was largely the result of significant price reductions, which ranged from 28% to 51%.  However, usage of AWS (Amazon Web Services) increased 90% year-over-year. ^[2] We expect the usage growth of AWS to stay robust in the coming quarters, as there is a huge opportunity for Amazon to market its services to smaller, more nimble companies most inclined to outsource infrastructure. The company has ramped up its innovation in these services, and this will continue to bolster the adoption rate.

Amazon Prime Subscriptions Will Continue To Show Solid Growth

Amazon raised the price of its Prime service earlier this year, but this did not affect its adoption. Net additions of Prime subscribers were higher in Q2 2014 than in Q2 2013, despite the price increase. ^[2] We believe Prime subscriptions will continue to grow at a healthy rate in the future as well, as it offers a compelling service to customers. Free shipping on over 20 million items and access to more than 1 million songs (ad free) and to over half a million books that can be borrowed for free (by Kindle users) makes the service highly valuable for customers. We believe this service will act as a key competitive advantage for Amazon in the future and will also help raise the average revenue per active customer. Prime customers tend to purchase more as compared to non-Prime customers and hence, this factor could positively impact Amazon’s profitability in the long-term and could help stave off competition from newer players such as Alibaba and Wal-Mart.

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1. September 2014 ChannelAdvisor Same Store Sales (SSS) for eBay, Amazon, Search, CSE and other e-commerce channels, ChannelAdvisor, October 08, 2014 [↩]
2. Amazon.com’s (AMZN) Management On Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, July 24, 2014 [↩] [↩] [↩]