Amazon Beats 2Q Earnings Estimates Courtesy AWS

Amazon.com’s (NASDAQ:AMZN) second-quarter EPS of 1.78 was way ahead of the Zacks Consensus Estimate of $1.14. The North America and AWS segments were strong contributors to profits while investments in international continued. Operating efficiencies continued in the last quarter and the tax rate also continued to decline. Shares were up 2.03% in extended trading after climbing 2.16% during the day 12.6%.

Highlights

FX: The positive FX impact on revenues was small in the last quarter at around $166 million. FX was positive to operating income across all segments. Impact on AWS was because revenues were dollar-denominated while a lot of the assets were located in low-cost regions.

International/North America/AWS Mix: The segment contribution to revenues was positive in the highest-margin AWS business growing 68 basis points, while North America and International segments declined 22 and 46 bps, respectively. This resulted in a positive mix of business and contributed to Amazon’s increased profitability in the last quarter. As far as the retail business is concerned, the North America business being mature, generates higher margins, while the international business, being accompanied by expansion costs including infrastructure, headcount and inventory currently generates operating losses. AWS contributed 9% of revenues and 56% of profits in the last quarter. Combined segment operating income grew 19.5% from last year.

Prime: The Prime membership has been rolled out to some international markets like the UK and Japan where product selection is limited, and in the last quarter, the company added India (100 cities in India now can avail of the service, with Amazon planning to add Prime video soon). It remains in various stages of implementation in other geographies. FBA is increasing third-party sales and also increasing selection for Prime members, but it tends to pressure fulfillment centers in heavy selling seasons, which is why Amazon will be adding 18 new centers in the third quarter.Prime Now (one-hour and two-hour delivery of a curated list of key products that people need in a short period of time) has been extended to more than 40 metro areas worldwide, with Germany, Spain and France being added in the last quarter.

Cash Flow: TTM cash flow and FCF as reduced by lease principal repayments jumped 42% and 65% on a year over year basis.

The numbers in detail-

Revenues

Amazon reported revenues of $30.40 billion, up 4.4% sequentially and 31.1% from the year-ago quarter. Excluding the $166 million favorable FX impact, revenues were up 30% year over year. This was better than the guidance range of $28.0-30.5 billion (up 0.4% sequentially and 26.2% year over year at the mid-point) and ahead of the Zacks Consensus Estimate of $29.73 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 (they were up 52.7% compared to product sales growth of 23.5%). Revenue distribution between the two was 69%/31%.

Management stopped giving details about active customer accounts which were over 300 million in the last quarter (last quarter, they said the number was 310 million). Third-party units were 49% of total units in the quarter, up 1 percentage point from the previous quarter.

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.

Segment Details

The North America segment accounted for around 59% of sales, representing a sequential and year-over-year increase of 4.0% and 28.1%, respectively. The International segment accounted for 33%, up 2.9% sequentially and 30.1% year over year (up 28% excluding $184 million favorable currency impact). The AWS segment was flat sequentially and up 40.7% year over year with the revenue share at 9%.

North America: Media was down 8.7% sequentially and up 11.8% year over year. EGM was up 7.0% sequentially and 31.6% year over year. Other was up 3.6% sequentially and 51.9% year over year.

International: Media was down 7.9% sequentially and up 9.0% from last year. EGM sales were up 6.7% sequentially and up 38.3% from last year. Other revenue was up 9.6% sequentially and 23.9% year over year.

AWS: The business contributed $2.89 billion in the last quarter, taking the revenue runrate to over $11.5 billion, representing sequential and year-over-year growth of 12.5% and 58.2%, respectively. 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., are running SAP on AWS. 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, Analytics Cloud.Amazon ended the quarter with 35 available zones across 13 infrastructure regions. The Mumbai (India) region was added in the last quarter, which is 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

The gross margin expanded 169 bps sequentially and 230 bps year over year to 36.9%. Sequential variations in gross margins are usually largely mix-related, although increased investments are also a factor. AWS growth is having a positive impact. 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 when it is building a position in any market. Third party sites are doing better than retail, which is also having a positive impact.

Net shipping costs of 4.5% of sales were up from 2.7% in the March quarter and 43.7% from last year.

Gross profit dollars were up 9.4% sequentially and 39.9% from last year. The consistently rising gross profit dollars from year-ago periods is evidence of the success of Amazon’s strategy.

Operating Metrics

Amazon’s operating expenses of $9.94 billion were up 8.1% sequentially and 31.5% 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 technology and content (up 66 bps) and G&A (up 20 bps). The sequential decline in sales in the last quarter had a negative impact on all expenses, with only COGS declining significantly as a percentage of sales. Fulfillment and marketing increased 35 bps and 12 bps from the year-ago quarter, with all other expenses declining as a percentage of sales.

The net result was an operating margin of 4.2%, up 55 bps sequentially and 223 bps from the year-ago quarter. Amazon reported an operating profit of $1.29 billion compared to $1.07 billion in the previous quarter and $464 million in the year-ago quarter.

The North America segment operating margin of 4.0% dropped 146 bps sequentially and 112 bps from the year-ago quarter. The International segment operating margin of -1.4% shrank 158 bps sequentially and 112 bps from the year-ago quarter. The AWS operating margin of 24.9% shrank 302 bps sequentially but expanded 344 bps year over year. AWS improvements come from operating efficiencies and increased utilization of assets but margins will tend to be lumpy according to management because of levels of investing, price reductions and cost efficiencies.

Consolidated segment operating income (CSOI) was down 22.6% sequentially but up 19.5% from the year-ago quarter.

Net Income

Amazon generated second-quarter net income of $857 million, or 2.8% of sales, compared to $513 million, or 1.8% in the previous quarter and loss of $92 million, or 0.4% 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 $1.77 compared to $1.07 in the previous quarter and $0.19 in the year-ago quarter.

Balance Sheet and Cash Flow

Amazon ended with a cash and short-term investments balance of $16.54 billion, up $681 million during the quarter. The company generated $3.47 billion of cash from operations, spending $1.71 billion on fixed assets (including internal-use software and website development costs) and $14 million on acquisitions. Principal repayments of capital lease obligations were $1.12 billion in the last quarter.

Amazon saw inventories up 0.1% sequentially, with turns up from 7.9X to 8.0X. Receivables increased in the quarter, with DSOs up from around 16 to around 18.

Guidance

Management provided guidance for the third quarter of 2016. Accordingly, revenue including 30 bps positive FX impact is expected to come in at around $31-33.5 billion (up 6.1% sequentially and 27.2% year over year at the mid-point, better than the Zacks Consensus Estimate of $31.6 billion).

Operating income is expected to come in at approximately $50 to $650 million. Management said that there is typically a spike in operating expenses in the third quarter due to increased buildout of fulfillment centers in preparation for the holiday season. Next quarter, the company expects to add 18 fulfillment centers to deal with increased demand and also to cater to FBA. The second reason for higher cost in the second half of this year is because the company is doubling its spending on original TV shows and movies to triple the total number of shows to be launched in the second half of this year. AWS and India expansion-related expenses will also remain.

Recommendation

From the second quarter numbers is it evident that Amazon is driving value across all its businesses. So 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 on the other hand is the cash cow for Amazon. The business generates much higher margins than retail, so it has a very positive impact on Amazon’s profitability. Current margin expansion rates don’t look sustainable (margins are declining quite rapidly on a sequential basis), and management said this could be somewhat lumpy going forward. Management remains optimistic about the functionality, partner ecosystem and experience AWS offers and believes this will lead to continued customer wins.

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 aren’t likely to have a very big impact on results right now (revenue contribution won’t be material near term), but they could very well supplement the rest of the business by making it that much easier to buy from Amazon.

Amazon shares carry a Zacks Rank #3 (Hold). Better-ranked stocks in the sector are PetMed Express (NASDAQ:PETS) or Stamps.com (NASDAQ:STMP) , since both have a Zacks Rank #1 (Strong Buy).