While the market appears fixated on slowing unit sales and decelerating international revenue growth, these concerns are overblown, and Amazon has fortified its economic moat, says Morningstar's R.J. Hottovy.
Amazon.com (AMZN) continued to build a case as one of the most disruptive and diverse players in the consumer universe in the first quarter, while also layering in a steadily improving margin expansion story.
Active users grew 21% to 209 million, total units sold grew 30%, and third party units were up 33%, driving revenue growth of 21% (24% excluding currency). Although these trends represent a nominal deceleration on a sequential basis, they keep Amazon well ahead of global e-commerce sales trends as well as comparable sales trends among most bricks-and-mortar retailers. This implies market share gains, and reinforces our views about Amazon's ability to price below peers through structural cost advantages as well as its strong network effect.
Gross margin grew 260 basis points, to 26.6%, which we attribute to third-party digital content sales, Amazon Prime memberships, and Amazon Web Services, each of which is a building block of our longer-term cash flow forecasts. The strong gross margins drove consolidated segment operating income, or CSOI, of $441 million, well ahead of the high end of guidance ($350 million). The CSOI figure was a modest contraction as a percentage of sales (down 30 basis points to 2.7%) due to increased fulfillment, AWS, and content costs (particularly in international markets). However, North American CSOI came in at $457 million, or 4.9% of segment revenue, which gives us increased comfort with our five-year consolidated CSOI margin target of approximately 6%.
We plan to make minor model adjustments based on the first quarter, but they won't sway our current fair value estimate. We'd prefer a bit more margin of safety, but still find Amazon to be one of the more intriguing long-term growth stories in our consumer coverage universe. Near-term fundamentals could remain choppy amid further fulfillment center, AWS, and content investments (largely to support emerging market growth). We project a small contraction in CSOI margins during the second quarter (versus 2.8% posted in the second quarter of 2012), with revenue comfortably within the $14.5-$16.2 billion guidance range (representing 13%-26% growth, or 16%-29% excluding currency). However, as the year progresses, modest CSOI margin gains could offer a possible upside catalyst.
While the market appears fixated on slowing unit sales (which declined 2% to 30% on a sequential basis from the fourth quarter and was lapping 49% growth in the year ago period) and decelerating international revenue growth (which increased 16% compared to 21% last quarter, but was affected 5 percentage points due to unfavorable currency movements), we think these concerns are overblown, and walked away from the first-quarter update believing Amazon had fortified its already-wide economic moat. We believe the global e-commerce industry is still very much a land grab, and we believe the company is taking appropriate steps to keep its customers coming back to Amazon.com, Two customer-centric items in particular stood out to us during the quarter: one, Amazon's continuously improving content library; and two, getting "closer to consumers" through recent fulfillment center investments.
Like previous quarters, we believe much of the gross margin improvement can be traced back to third-party digital content sales, which is partly a function of sales from the Kindle family of products and eBooks (management noted that each of its top ten selling items during the first quarter was either a Kindle or digital product). Though digital content competition remains fierce, a vastly expanded digital media library (38,000 Prime Instant Video movies and television shows, a MP3 catalog of 22 million songs, and 300,000 books available in the Kindle Owners' lending library), competitive pricing, and more recently, the debut of 14 original comedy and children’s pilots under Amazon Studios, solidify the company’s position as vital digital media shopping destination. We believe digital content will become an increasing meaningful free cash flow contributor in the periods to come.
For the second straight quarter, Amazon also saw shipping costs decrease as a percentage of sales, falling by 40 basis points to 4.7% of consolidated sales. After more than two years of investing heavily in fulfillment centers (which now stand at approximately 42 locations in North America exceeding 32.4 million square feet, excluding subsidiary fulfillment centers), we believe Amazon has the capacity necessary to facilitate the increased demand from its active user base (we estimate that trailing 12-month gross merchandise volume per active customer increased 6% to approximately $540 during the quarter). Delivery speed is a key competitive advantage that Amazon holds over its bricks-and-mortar rivals, and something that can potentially mute the impact of proposed online sales tax collection legislation. We believe the benefits of expedited shipping will become more apparent over the next several periods. We also believe a wide-reaching fulfillment center network will help to facilitate new growth avenues such as Amazon Supply (whose end customers often require expedited shipping due to the specialized nature of the products) as well as AmazonFresh (a same-day delivery pilot program in Seattle for a wide range of products, including groceries).
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