Amazon Can Take the Fight to Apple

Our upbeat long-term view of  Amazon.com (AMZN) is intact following third-quarter results. While skeptics will point to the company's first reported operating loss since the third quarter of 2002, we remain confident in the company's ability to monetize the ongoing shift from physical to online retail over a longer horizon based on impressive customer growth (active users increased 24% to 188 million), increasing third-party sales, and segment-level operating margin gains in North America. 

Management's Cadillac-size consolidated segment operating income (CSOI) forecast for the fourth quarter--ranging from a loss of $200 million to a gain of $600 million--confirms that the company is still in an investment phase and that there are several macro and competitive unknowns Amazon must contend with this holiday season. Nevertheless, we view an increasingly uncertain global macroeconomic environment as a positive, as consumers tend to gravitate toward low-cost providers like Amazon to stretch household budgets. More important, the building blocks of our long-term operating margin targets in the mid-single-digit range--namely, increased adoption rates for Amazon Prime memberships and other subscription-based services, robust digital content sales stemming from the Kindle Fire ecosystem, an expanded Amazon Web Services presence, and improving capacity utilization trends from new fulfillment centers--remain squarely in place. There is no change to our fair value estimate following the third-quarter update, and we find the shares modestly undervalued at current levels.

Consolidated revenue grew 27% to $13.8 billion, just below our internal and consensus expectations of $13.9 billion. Foreign currency continued to have a negative impact on the top line (representing a 3% drag during the quarter), but we also chalk up some of the shortfall to accelerating third-party unit sales (which increased to 41% of all unit sales compared with 38% a year ago), where the company only records a portion of revenue from the overall sale but also yields higher returns. Third-quarter revenue outpaced broader global e-commerce industry growth trends, which we estimate in the midteens during the quarter, suggesting continued market share gains. Technology, content, and infrastructure investments--including the technology behind the Kindle Fire HD family, increased video content offerings, and international infrastructure investments (particularly in China)--weighed down consolidated operating margins (a modest decline on a GAAP basis and 2.0% excluding stock-based compensation and the amortization of intangibles, representing declines of 90 and 40 basis points, respectively). Still, CSOI of $275 million came in $50 million ahead of management's guidance range for the quarter (which called for a loss of $75 million to a gain of $225 million). GAAP earnings were a loss of $0.60 per share, but were hurt by roughly $0.37 due to impairment charges related to the company's equity method stake in LivingSocial.

Despite the decline in consolidated operating margins, we believe the 180-basis-point increase in consolidated gross margins to 25.3% and the 130-basis-point increase in North American segment operating margins to 3.7% (helped in part by a decrease in shipping costs as a percentage of sales) support our longer-term investment thesis. Much of the gross margin gains can be traced back to the increase in third-party sales (including increased third-party digital offerings, including e-books), which we continue to believe will be a meaningful free cash flow contributor in the periods to come. 

We also continue to focus on the 50-basis-point decrease in net shipping costs as a percentage of sales (4.6% from 5.1%), which we attribute to increased capacity utilization after two years of heavy fulfillment center investments. Delivery speed is a key competitive advantage that Amazon holds over its brick-and-mortar rivals, and we believe the benefits of being "closer to customers" will become more pronounced over the next several periods, especially as the company expands same-day delivery options. Our long-term valuation assumptions assume greater free cash flow contribution from Prime memberships and other subscription-based services and continued AWS momentum, but third-quarter North America segment margins support our views that fulfillment center investments can have a positive impact on returns over time.

Based on the improved functionality of the various Kindle Fire HD devices, competitive price points, and an expanding library of content offerings, we are also gaining confidence that Amazon not only remains well-positioned to defend its turf from new low-cost tablet entrants and other e-readers, but can also take the fight to  Apple (AAPL) (as evidenced by the direct functionality and price comparisons with the recently unveiled iPad Mini in the third-quarter press release). We believe the Kindle Fire HD will not only serve as a powerful customer-acquisition tool, but more important, give Amazon more opportunities to monetize digital content while also expanding subscription-based services (include Amazon Prime, Instant Video, Amazon Web Services, and the new 4G LTE plan). In fact, while management wouldn't provide specific purchase and usage statistics, it noted that customers continued to purchase "a lot" of digital content (while also noting that Prime customers were particularly active in watching free content--a direct result of the licensing agreement with EPIX, in our view). While we don't expect Amazon to overtake Apple's dominance in the tablet category, we believe the versatility of Kindle Fire HD device at least narrows the hardware gap and gives consumers another tablet device from which to choose.

We plan only modest changes to our model based on third-quarter results and management's fourth-quarter outlook. Fundamentals are likely to remain choppy during the next few quarters amid foreign currency movements, increased brick-and-mortar competition ( Wal-Mart Stores (WMT),  Target (TGT), and  Best Buy (BBY) have all announced price-matching plans to various degrees this holiday season) and further fulfillment center, technology/AWS, and content investments. This can be seen in management's wide fourth-quarter forecast ranges, including revenue of $20.3 billion-$22.8 billion (up 16%-31%) and CSOI between a loss of $200 million and a gain of $600 million.

For 2012, we still forecast revenue just over $62 billion (implying top-line growth around 30%), which suggests fourth-quarter revenue results near the high end of management's outlook. The fourth-quarter CSOI forecast incorporates a bit more international fulfillment and content investments than we had previously assumed, and we plan a modest reduction to our full-year operating margin assumptions to roughly break-even (1.8% excluding stock-based compensation and amortization of intangibles). That said, the third-quarter results also give us greater comfort with our forecast of average annual revenue growth of 20% during the next five years and CSOI margins approaching the 4% range by 2015.

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