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Market Update

Amazon's 3Q No Big Disappointment

Fulfillment and content investments pressured third-quarter margins, but Amazon is poised for continued share gains.

Softer-than-expected profits garnered much of the attention in  Amazon's  (AMZN) third-quarter update, but instead of viewing the results as a disappointment, we consider higher content, technology, and fulfillment costs as prudent customer acquisition and infrastructure capacity investments that will protect the company's wide economic moat for years to come.

Amazon's top-line growth trajectory continues to impress, but we plan to modestly trim our $235 fair value estimate to compensate for the near-term cash flow impact of our revised margin forecasts. Though the market has taken a dim view of the third-quarter results, our view of Amazon as one of the most disruptive forces facing traditional and online retailers over the next decade remains fully intact, and a pullback could present long-term investors with a compelling entry point. Content, technology, and fulfillment costs may weigh down the stock over the next few quarters, but as these investments moderate, we expect Amazon to add margin expansion to an already compelling growth story.

For the quarter, operating margins tumbled almost 300 basis points to 2.4%, driven by 130-basis-point increases in both fulfillment (10% of revenue) and technology and content expenses (6.4% of revenue). Management set the stage for essentially break-even results in the fourth quarter, guiding to between an operating loss of $200 million and operating profit of $250 million. Nevertheless, with consolidated revenue increasing 44% to $10.9 billion--including 24% and 59% increases in media and electronics and other general merchandise categories, respectively--Amazon annexed considerable market share from traditional brick-and-mortar retailers during the quarter and remains well positioned to continue this trend in the periods to come. Low prices, a rapidly expanding assortment, and timely delivery (facilitated by the aforementioned fulfillment center investments) are a powerful combination in a value-conscious consumer environment, and we believe the launch of the Kindle Fire this quarter will only exacerbate customer acquisition trends, particularly at the Prime level.

There is no change to our full-year revenue growth outlook of $48.6 billion (representing 42% growth year over year), which assumes 39% growth to $18.0 billion in the fourth quarter (near the high end of management's conservative guidance range of $16.5 billion-$18.7 billion). We also remain comfortable with our five-year annual average revenue growth forecast of 28%, which includes increased penetration of international markets (namely China) and contribution from Amazon Web Services. We believe present-day technology, content, and infrastructure investments are critical to support these levels of growth, though the near-term costs associated with these efforts will probably be heavier than our model had originally anticipated. For 2011, we now anticipate operating margins just north of 1% (compared to estimates in the mid-2% range) and have also adjusted our 2012 operating margin assumptions to reflect only mild expansion. Still, we believe mid-single-digit operating margins are achievable over the course of the next decade through economies of scale.

Details were sparse, but we were encouraged by several indications of strong consumer demand for the Kindle Fire, which will begin shipping Nov. 15. CEO Jeff Bezos said that based on preorders, the company is "increasing capacity and building millions more than planned." We previously estimated that Amazon would sell 4 million-5 million Kindle Fire units in the fourth quarter (representing $800 million-$1 billion in incremental revenue before any digital media sales), and we believe management's comments indicate that unit sales are on pace to meet or even exceed our previous expectations. Though we expect the Fire to have an initially dilutive impact on margins, we continue to view the tablet device as an meaningful customer acquisition tool that adds multiple layers of upside to our base-case assumptions, including additional Prime memberships, accelerating digital media sales, and a positive halo effect on general merchandise sales.

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