Amazon’s Weak Q3 Performance Fails To Match Investor Expectations

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Amazon (NASDAQ:AMZN) posted disappointing results in the third quarter, sending its shares down by over 8%. This investor reaction suggests that the market will no longer ignore Amazon’s bottom-line misses in its quest to gain top-line growth. While net sales rose by 20% to $20.6 billion in Q3, the operating loss of $544 million unnerved market participants with its size. This compared to an operating loss of $25 million in the same period a year ago. Heavy investments in diverse areas such as infrastructure development, content production, hardware development, and geographical expansion continued to weigh on the company’s earnings. A loss of around $170 million was incurred due to Fire phone inventory write-down and supplier commitment costs. [1]

The company’s management also gave a weak outlook for the holiday quarter, with discouraging revenue and profitability guidance. Net sales are expected to be between $27.3 billion and $30.3 billion in Q4, representing an annual growth rate of 7% to 18%. We believe the recent earnings should nudge the company to undertake a better analysis of its growth strategy – analysts during the conference call were prompted to ask which financial measures were important to the company and its board. Though we continue to remain optimistic on Amazon’s revenue outlook, we believe it should start focusing more on improving its bottom-line. Amazon is investing in a series of diverse businesses, and enhancing its focus on a few key ones could help enhance its margins to more sustainable levels.

Based on the earnings report, we have changed our price estimate for Amazon’s stock to $303, which implies around 5% premium to the current market price.

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Lack Of Profitability A Cause Of Concern

Amazon’s GAAP operating margin fell from -0.1% in Q3 2013 to -2.6% in the latest quarter. While cost of sales showed 130 basis point improvement, all other expense items increased year-over-year during the quarter. Technology and content costs rose by the maximum (160 basis points) followed by fulfillment costs, marketing expenses and general and administrative expenses which rose by 90 basis points, 80 basis points and 30 basis points respectively. For the fourth quarter, Amazon’s management forecasts operating income (loss) in the range of $(570) million and $430 million, compared to $510 million in Q4 2013. We believe low profitability will continue to be a concern in the fourth quarter as well due to heavy investments in fulfillment centers, technology infrastructure, original content, hardware development and geographical expansion.

The write-down of Fire phone inventory during the third quarter indicates that Amazon’s investments on the hardware side have failed to pay-off. Fire phone inventory was worth $83 million at the end of Q3 and we won’t be surprised if a significant portion of this investment gets written off in the fourth quarter as well. [1]

Electronics And General Merchandise And Amazon Web Services Continue To Drive Growth

As we had expected in our pre-earnings note, the worldwide sales of electronics and other general merchandise (EGM) and ‘Other’ category grew by 26% and 37% respectively and carried the earnings during the quarter. EGM sales rose by 31% and 20% in the U.S. and international region respectively, and comprised for 68% of the total revenue. We believe EGM sales will continue to rise at a healthy rate in the future, as the company continues to leverage its size, strong vendor network and technological advantage to expand its presence in the worldwide e-commerce market.

The revenue growth in the ‘Other’ category, was fueled by high demand for Amazon Web Services. These services continued to see solid usage growth in volume of around 90% during the third quarter. [1] We expect usage growth to stay robust in this segment driven by increased innovation and  lower pricing There is a huge market opportunity for Amazon to sell its services to smaller, more nimble companies most inclined to outsource infrastructure.

Media Segment And International Sales Under-Performed

The revenue growth within the international geography segment slowed down during the third quarter. International sales growth slowed down from 18% each in the first two quarters to 14% in the third quarter. Weaker sales in Japan due to the imposition of consumption tax in April was cited as one of the reasons for this decline. Amazon is investing heavily on geographical expansion to expand its presence in markets such as China, India, Italy and Spain. While we expect these investments to boost revenue growth, however, this strategy will also raise margin pressure. Amazon will invest $2 billion on its Indian operations, but since the country’s e-commerce market is highly competitive, we believe it will be difficult for Amazon to attain profitability in the region for a couple of years atleast.

Sales growth in the media segment was recorded at 4% in Q3 as compared to 8% and 10% in Q1 and Q2 respectively. Tougher year-over-year comparisons and the trend towards book rental (as compared to outright purchase) contributed to this slowdown. We will be keeping a close track on demand within this segment in the coming quarters to understand whether the current lower growth rates are indicative of the future as well.

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Notes:
  1. Amazon.com (AMZN) Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 23, 2014 [] [] []