Amazon (AMZN) Q3 Earnings Hurt By Investments, AWS Solid

Amazon.com’s (NASDAQ:AMZN) third-quarter 2016 earnings per share (EPS) of 52 cents were way behind the Zacks Consensus Estimate of 85 cents.

The earnings miss was primarily due to a spike in operating expenses, which increased mainly as a result of buildout of fulfillment centers in preparation for the holiday season. Costs also escalated due to the company’s increased spending on original TV shows and movies. Amazon Web Services (AWS) and India expansion-related expenses also resulted in higher spending.

The North America and AWS segments contributed to profits while investments in international continued.

Improvements in AWS were the result of operating efficiencies and increased utilization of assets. However, margins are likely to stay lumpy because of high levels of investing, price reductions and cost efficiencies.

The numbers in detail-

Revenues

Amazon reported revenues of $32.7 billion, up 7.6% sequentially and 29% from the year-ago quarter. Revenues were within the guidance range of $31-33.5 billion (up 6.1% sequentially and 27.2% year over year at the mid-point) and ahead of the Zacks Consensus Estimate of $32.6 billion.

Both product and service sales were up sequentially and year over year. Services grew much stronger than product sales from the year-ago quarter (up 50.5% compared to product sales growth of 21%). Revenue distribution between the two was 68%/32%.

In devices, Amazon increased Alexa integration with Fire TV, introduced a thinner, lighter and more feature-rich Kindle costing $79.99; added 50 new brands to the Dash Button, and started running exclusive offers for unlocked Android phones BLU R1 HD for $49.99 and Moto G4 for $149.99.

AMAZON.COM INC Price, Consensus and EPS Surprise

Segment Details

The North America segment accounted for around 58% of sales, representing a sequential and year-over-year increase of 6.8% and 25.8%, respectively. The International segment accounted for 32%, up 7.8% sequentially and 28.3% year over year. The AWS segment was up 12% sequentially and a massive 55% year over year with the revenue share at nearly 10%.

North America: Media was up 10.56% sequentially and 9.2% year over year. Electronics and Other General Merchandise (EGM) was up 6% sequentially and 29.5% year over year. Other was up 4.9% sequentially and 52.7% year over year.

International: Media was up 9.1% sequentially and 7.4% from last year. Sales from EGM were up 7.4% sequentially and 36.5% from last year. Other revenue was up 8.8% sequentially and 34.8% year over year.

AWS: The business contributed $3.2 billion in the third quarter. SAP business-critical applications are gaining momentum on AWS with customers including GE Oil & Gas, Kellogg’s, Brooks Brothers, Ferrara Candy Company, GPT Group, Hoya Corporation, Lionsgate, Macmillan Publishers India, RWE Czech Republic, and Bart & Associates Inc. An important customer win in the last quarter was Salesforce, which selected AWS as its preferred public cloud infrastructure provider to run its core services like Sales Cloud, Service Cloud, App Cloud, Community Cloud, and Analytics Cloud. Amazon ended the quarter with 35 available zones across 13 infrastructure regions. The Mumbai (India) region was added this quarter, which became the sixth region in the Asia Pacific. Amazon remains the cloud infrastructure leader, well ahead of Microsoft (NASDAQ:MSFT) and Alphabet (NASDAQ:GOOGL) .

Gross Margin

Gross margin was down 190 basis points (bps) sequentially but up 109 bps year over year to 35%. Sequential variations in gross margins were usually largely mix-related, although increased investments were also a factor. Growth in AWS had a positive impact on margin. Pricing is also an important factor, given the increase in product categories all over the world and Amazon’s strategy of heavily discounting products and services while building a position in any market. Third party sites did better than retail, which was also a positive.

Gross profit dollars were up 35% from last year. The consistently rising gross profit dollars from the year-ago periods reflects the success of Amazon’s strategy.

Net income was down 70.6% sequentially but up 219% year over year.

Operating Metrics

Amazon’s operating expenses of $10.88 billion were up 9.5% sequentially and 32.7% from the year-ago quarter. Amazon’s heavy investing activities (headcount, fulfillment centers, content, etc) over the past few quarters have been driving up its costs. While all except COGS increased sequentially as a percentage of sales, the most significant increase was in marketing (up 55 bps) and fulfillment expenses (up 30 bps). General and administrative expenses increased 12 bps while technology and content remained flat. All other expenses declined as a percentage of sales.

The net result was an operating margin of 1.8%, down 247 bps sequentially but up 16 bps from the year-ago quarter. Amazon reported an operating profit of $575 million compared with $1.29 billion in the previous quarter and $406 million in the year-ago quarter.

North America segment operating margin of 1.4% dropped 262 bps sequentially and stayed flat year over year. The International segment operating margin of -5.1% shrank 370 bps sequentially and 260 bps from the year-ago quarter. Operating margin of AWS was 26.6%, up 170 bps sequentially and 608 bps year over year.

Consolidated segment operating income (CSOI) was down 246 bps sequentially but up 16 basis points from the year-ago quarter.

Net Income

Amazon generated third quarter net income of $252 million, or 0.8% of sales, compared with $857 million, or 2.8% in the previous quarter and $79 million, or 0.3% of sales in the same quarter last year. There were no one-time items in the last quarter. Therefore, the GAAP EPS was the same as the pro forma EPS of 52 cents compared with $1.77 in the previous quarter and 17 cents in the year-ago quarter.

Balance Sheet and Cash Flow

Amazon ended the quarter with cash and short-term investments balance of $18.35 billion, down $146 million sequentially. The company generated $4.49 billion of cash from operations, spending $1.84 billion on fixed assets (including internal-use software and website development costs) and $84 million on acquisitions. Principal repayments of capital lease obligations were $1.12 billion in the third quarter.

Guidance

Management provided guidance for the fourth quarter of 2016. Revenue are expected to include a 60 bps positive FX impact and come in around $42-45.5 billion. The Zacks Consensus Estimate is pegged at $44.7 billion. Operating income is expected to come in a range of $0 to $1.25 billion.

Key Takeaways

Retail: Amazon’s retail business remains very hard to beat on price, choice, convenience, you name it. The company has a solid loyalty system in Prime and its FBA strategy, and content addition continues to add selection to Prime memberships. If Amazon is able to replicate its domestic success internationally, investors could see far more growth. At the moment, international contributes a third of revenue but generates just a fraction of profits.

AWS: Amazon Web Services on the other hand is the cash cow for Amazon. The business generates much higher margins than retail, so it has a positive impact on Amazon’s profitability. We remain optimistic about the functionality, partner ecosystem and the experience AWS offers and believe this will lead to continued customer wins.

IoT: One area of potential growth is devices and IoT. And it’s probably not right to ignore the growing capabilities of Echo and Alexa in this regard and how they are being received by hardware partners.

IoT devices/technologies is unlikely to have a very big impact on results right now (revenue contribution won’t be material near term), but it could very well support the rest of the business by making it easier to buy from Amazon.

Zacks Rank and Stocks to Consider

Currently Amazon has a Zacks Rank #2 (Buy). Another stock in the wider technology sector worth investing is Veeco Instruments Inc. (NASDAQ:VECO) , sporting Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

For the current year, the consensus estimate for Veeco has gone up by 5% in the past 30 days, thanks to seven upward revisions and no downward revisions.

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