Amazon.com, Inc.
Q4 2006 Earnings Call Transcript

Published: 2 Feb 2007

[Operator:]

Good day, everyone and welcome to the Amazon.com fourth quarter 2006 financial results conference call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to the Director of Investor Relations, Ms. Kim Nelson. Please go ahead, ma'am.

[Kim Nelson:]

Hello and welcome to our Q4 2006 financial results conference call. Joining us today is Tom Szkutak, our CFO. Jeff Bezos, our founder and CEO, and Tom will both be available for Q&A. The following discussion and responses to your questions reflect management's views as of today, February 1, 2007, only and will include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results is included in today's press release and our filings with the SEC, including our 2005 annual report on Form 10-K. As you listen to today's call, we encourage you to have our press release in front of you, which includes our financial results as well as metrics and commentary on the quarter. During this call, we will discuss certain non-GAAP financial measures. In our press release, slides accompanying this webcast and our filings with the SEC, each of which is posted on our IR website, you will find additional disclosures regarding these non-GAAP measures, including reconciliations of these measures with comparable GAAP measures. Finally, unless otherwise stated, all comparisons in this call will be against our results for the comparable period of 2005. Now, I will turn the call over to Tom.

[Tom Szkutak:]

Thanks, Kim. We demonstrated significant sequential improvement in operating leverage, achieving 4% positive leverage in Q4 from negative 11% in Q3. Operating leverage is the change in consolidated segment operating income relative to the change in sales. We increased Q4 CSOI by 24% year over year, as we grew gross profit by $183 million but operating costs by only $139 million. This marks a substantial improvement in leverage versus the other three quarters of 2006, as we lapped the higher spending in technology and content and gross profit dollars grew faster than operating expenses, driven by accelerated revenue growth. In 2006, free cash flow decreased 8% to $486 million, largely reflective of our negative operating leverage during the first three quarters of the year. Sequentially, trailing 12 month free cash flow increased $119 million compared with Q3, an improvement of 33%. Worldwide revenue grew 34% to $3.99 billion or 30% excluding the $122 million favorable impact from year-over-year changes in exchange rates. Worldwide unit growth was 23%, and active customer accounts exceeded 64 million, up 16%. Media revenue increased to $2.5 billion, up 25% or 21% excluding foreign exchange rates. EGM revenue increased to $1.4 billion, up 55% or 51% excluding FX. Worldwide EGM increased to 35% of worldwide sales, up from 30%. For the first time, non-media dollar growth exceeded media dollar growth, even though media grew 25% in the quarter. Worldwide gross profit increased $183 million or grew 27% to $850 million in Q4. Gross margin decreased 108 basis points to 21.3% from product and third-party mix, lowering prices for customers in Amazon Prime. Worldwide active seller accounts were over 1.1 million, and third-party units representing marketplace and merchants@ units sold on Amazon sites, or 25% of total units versus 28% in the prior year. Third-party mix decreased as we transitioned to our new toys, baby and video games stores in the US which are now, like most of our stores, a combination of Amazon retail and third-party sales. Worldwide revenue growth benefited by approximately 160 basis points year over year from sales in these categories and excluding these categories, third-party units as a percentage of total units increased year over year. From an OpEx standpoint, we achieved the slowest growth rate in total segment operating expenses in over two years. G&A declined year over year, which reflects a benefit related to insurance recoveries of $8 million. Now, I will talk about our segment results and consistent with prior periods, we do not allocate the segments or stock-based compensation or other operating expense line items. In the North America segment, revenue grew 31% to $2.21 billion, setting a six-year growth rate record. Media revenue grew 21% to $1.25 billion, fueled by double-digit growth across all categories

[Operator:]

(Operator Instructions) Your first question comes from Justin Post - Merrill Lynch.

[Justin Post:]

Could you talk a little bit about your gross margin trends embedded in your outlook for next year? Also, can you talk a little bit about this quarter? If we look at year-over-year incremental gross margins as around 18% on a year-over-year basis, why was it down versus your overall gross margin? Can you tell us what the Toys-R-Us impact was this quarter?

[Tom Szkutak:]

Sure. As you look at our total year guidance for next year, we are not splitting out the individual pieces, giving guidance on the individual line items -- so we're not giving guidance on gross margin, for example. But the way you should think about it is we will certainly have lower prices next year, continued COGS reductions, as well as we think certainly we're going to be adding more third-party sellers. So again, I think those are some of the key dynamics as you look at our gross margins next year. Could you repeat the second part of your question, Justin? I couldn't hear that.

[Justin Post:]

Sure. When we look at the year-over-year incremental gross margin, it seems to be around 18%, based on the numbers you report. But some of that was probably due to Toys-R-Us. So I'm wondering if you could help us understand what the impact was on this year's or last year's gross margin from Toys-R-Us.

[Tom Szkutak:]

Yes. In terms of the Toys-R-Us impact, I can't help you, but I can say, from a revenue perspective, we certainly had both retail and third parties as it relates to toys, baby and video games; that impacted our total revenue by approximately 160 basis points. But in terms of the margin, we are not disclosing the specific margin related to that part of the business.

[Justin Post:]

Thanks. Good media sales.

[Operator:]

Your next question comes from Anthony Noto - Goldman Sachs.

[Anthony Noto:]

A comment on two things. One, your new active customers totaled 2 million in the quarter, which is a decline year over year of about 38%, and last quarter was also a decline of about 13%. So we see an acceleration there. I'm just wondering, do you think that the new active customer growth will continue to decline in 2007? Second, I know that 2006 was an investment year. But if I look at 2005 versus your outlook for 2007, it appears at the midpoint that you'll add about $4.9 billion of incremental revenue and only about $31 million of incremental operating income. I just wonder, when do you think the model will show leverage, where an incremental dollar of revenue will really drive incremental operating income and free cash flow? Thank you.

[Tom Szkutak:]

Sure. If you look at the active customers, it's actually up 16% year over year. What you're seeing is -- certainly we're seeing, with the revenue growth year over year excluding exchange rates, you're seeing a 30% growth. So we're getting more share of wallet from customers. If you could just repeat, sorry, the second part of the questions, related to the leverage? That was from 2005 to 2007?

[Anthony Noto:]

Yes. I'm really just trying to understand, I know that 2006 was an investment year, and I think a lot of investors, including us, were hoping for some leverage in 2007. But now it appears that your operating income margins will be down in 2007 at the midpoint versus 2006 after an investment year. So I went back to 2005 and said, what has happened over that time period? It looks like you revenue will grow almost $5 billion, but your operating income would not have increased at all over that time period.

[Tom Szkutak:]

Right. What you're seeing is we had an increase in our cost base both in 2005 and 2006. Certainly, we spent a lot of time talking about technology and content over the past few calls. You've seen that that growth rate has slowed, and so when you look at 2007, you should expect that our growth from an annual basis will be significantly less than it was in 2006. But what certainly has happened from 2006 to 2005 is on top of that, you had gross margins coming down. The primary reason for that, there's certainly a lot of different factors, but certainly lower prices, the mix of categories that we're in; we entered a lot of new categories with new selection, and so that is driving it, as well as we were certainly helped throughout the course of the year by third-party sales. So as you think about it going forward, even though you have seen the gross margins come down, a lot of these newer categories are becoming much more meaningful for us and over time, we will be able to get those margins to be very solid within our business. Today, as you can imagine, with some of the new categories that we have, what we're trying to do is get to scale. When we get to scale on those particular categories, good things happen. Think about particularly in international, where we are very, very small within EGM just a few years ago, and now it's become a much more meaningful part of our business. When that happens, we're able to get a lot more traffic to those particular categories. When that happens, you get a lot more third-party sellers coming to sell on our detail pages. We also get better prices with suppliers as their volume grows. So again, our strategy is to grow those businesses. Even though you see the gross margin going down, and that being one contributor of it, it's something that we are very happy with, because we need to get the scale in those businesses. Over time, that will be very beneficial to shareholders.

[Operator:]

Your next question comes from Brian Pitz - Banc of America.

[Brian Pitz:]

Thank you. A couple of questions. On operating margins, the split between US and international, can you talk about how we should think about that going forward? Are they pretty close to parity? It looks like in the current quarter they are, but just any thoughts on 2007 and beyond? And then, web services, can you comment on the revenue opportunity there and potential timing? Are you factoring in any revenue from web services for 2007 in your guidance? Any kind of update on that would be great. Thanks.

[Tom Szkutak:]

Sure. First, on the segments, the operating margins and how you should think about them, in addition to the comments I made about many of the categories that make up EGM in terms of that scale, we're certainly further ahead in scale in our North America segment in some of those categories, particularly, say, in consumer electronics. We have been selling in that category for a longer period of time. But certainly, as you think about the two different segments, one thing that you should be aware of

[Jeff Bezos:]

The Amazon Web Services team has a number of different web services. They have the simple storage service, which allows you to store data in the Internet cloud, and then it's securely stored and you can retrieve it. It's self-service, it's very inexpensive; developers really like it. There's also EC2, which is the Elastic Compute Cloud. It does the same thing, but with compute instead of data. There's also e-commerce services, there's Mechanical Turk. So there are a number of things. There's Alexa Web Services. These services are getting a lot of adoption, and developers really love them, getting a lot of buzz in the blogsphere, being heavily used by startup companies. As far as their impact on the financials, it will take some time before they have enough scale to have a meaningful impact that becomes visible, given the scale of our other businesses. So with a $10 billion business, even though these businesses are doing very well, it's going to take some number of years before they become meaningful. But we're thrilled with the progress, and that team is just doing a bang-up job.

[Operator:]

Your next question comes from Scott Devitt - Stifel Nicolaus.

[Scott Devitt:]

Thank you. The domestic business, revenue growth accelerated from 21% last quarter to 31% this quarter. I understand a component that is the toys. So I was wondering if you could give us a normalized domestic growth rate. But beyond that, there was still acceleration, so if you could categorize where the growth was coming from -- new categories, the loyalty related to Prime, new customers or otherwise?

[Tom Szkutak:]

The impact worldwide of toys, baby and videogames was approximately 160 basis points, and that translates into approximately 300 basis points for North America. So if you adjust that from the 31% you get about 28%.You are right, we did see very nice sequential growth versus third quarter, and really all of the quarters was the best growth rate overall in six years. There was a number of different reasons for that, but certainly Prime adoption was certainly one. The fact that we, as you noticed, we worked very hard during the year, in terms of making sure that we had great low prices. We expanded unique selection considerably year over year. In addition to the unique selection, we improved a lot, particularly in the second half, on our in-stock levels. So the combination of all these factors is really what helped the North America growth in Q4.

[Scott Devitt:]

Thank you.

[Operator:]

Your next question comes from Mark Mahaney - Citigroup.

[Mark Mahaney:]

Thank you very much. It looks like there has been a fair number of small merchants coming over and trying third-party sales on Amazon. What are you going to get those? Is that purely inbounds, or are you also trying to go out to other marketplaces and attract third-party sellers? Any quick comments on the product results so far for Amazon Unbox, and maybe implications that could have for broader digital downloading strategies? Thank you very much.

[Tom Szkutak:]

I think from a third-party perspective, one of the things you're seeing is when we add the amount of unique selection that we continue to add, and just some of the category expansion and the traffic to those category expansions, that's naturally attracting more third-party sellers. So that's something I talked about a little bit earlier and something that we want to continue to do.

[Jeff Bezos:]

We do have an outreach program, and it's very effective. But most of that activity is inbound. It's people just knowing, they see other sellers on the website, and they want to get their selection into that competitive mix so the website sort of serves as its own advertisement for sellers. That's a very effective and obviously very low-cost way of attracting new sellers. But the outbound reach is also very effective.

[Tom Szkutak:]

Then on digital, the second part of your question, there's still a bunch of things in our pipeline that we will be rolling out over time. So I encourage you to stay tuned.

[Mark Mahaney:]

Thank you very much.

[Operator:]

Your next question comes from Safa Rashtchy - Piper Jaffray.

[Safa Rashtchy:]

Thank you and good afternoon. Could you give us a little bit more color on the dynamics of the gross margins, in particular? As I see it, this is the lowest gross margins you have recorded in the past five years. I understand the rationale you're giving, that you're growing the top line. But the dynamics that you mentioned like the partnerships, the third-party sales, the lower prices on Prime, have been with you, certainly throughout the past year and yet the margins have not been this low. So to what degree are you getting the growth from the lower prices? Also, what can we expect, how low can we expect the margins going forward? Tied to that, do you still have any goals of double-digit operating margins?

[Tom Szkutak:]

In terms of gross margin, I briefly mentioned this earlier in the call. There's a number of different dynamics, and you mentioned some of them. Lower prices were certainly one of them. But I think the one that you should certainly take a look at is the mix of products. Again, I think that's something that we actually like. Our non-media dollar growth worldwide for the first time was actually higher than our media growth, from a dollar standpoint. Again, what that is telling us, as we look at it, is it's helping us get to scale in a lot of these individual categories. We still have a lot of work to do, to do that, but again, we're starting to see some meaningful changes with such high growth rates, with growth rates over 50% in EGM worldwide. So very, very strong across the board growth rates in a lot of categories. So those growth rates are going to help us. Then compounded on top of that, as we continue to grow in those categories, is really going to help us get to scale, help us to continue to get better traffic, which will help us get third parties. Certainly, the third parties will help us expand margins, as well as get better prices as our volume gets bigger with many of these suppliers. So again, that's what's going on there. That's something that we're trying to do to try to get that improving over time.

[Safa Rashtchy:]

Any target on the operating margin going forward?

[Tom Szkutak:]

The operating margin certainly, as we said before, we focus on operating profit dollars. We start first with free cash flow dollars, then operating profit dollars. But certainly, we still think there's a lot of room, from an operating margin standpoint.

[Jeff Bezos:]

We haven't changed our long-term view about what the model can be.

[Tom Szkutak:]

Correct.

[Safa Rashtchy:]

Thank you.

[Operator:]

Your next question comes from Robert Peck - Bear Stearns.

[Robert Peck:]

My question sort of ties into Brian's a little bit there. He was talking about the revenue opportunity from Amapedia, EC2, Askville, et cetera. Could you tell us a little bit about what is being invested into that, and when we may see a pare back of some of that? As part of that question, Endless.com, you are doing the negative shipping offers. Some believe that could be a testing ground for Amazon.com someday. Is negative shipping one of the options of where Amazon could go?

[Jeff Bezos:]

Well, you are referring to our new shoe site, Endless.com. Endless.com, as a standard practice, offers free overnight shipping as well as a 110% price guarantee, 365-day returns and pre-return shipping, too. So that's the standard practice. But through February, Endless is offering negative $5 overnight shipping. It's an unusual promotion that we're doing to draw attention to Endless.com, so that we can introduce it to our customers and that's working very effectively.

[Robert Peck:]

Is that's something that's on the table that, should it be successful, could be ported to Amazon.com?

[Jeff Bezos:]

You know, that's not something that we have considered. This is a special promotion just through the month of February. We're getting such great traction with our standard practices of Free Super Saver Shipping on Amazon for orders over $25, as well as we have equivalent programs around the world. Also, of course, for Amazon Prime members, you pay $79 a year for unlimited free two-day shipping. That program, as you know, has also been met with a lot of adoption. So we are very excited about those, and we haven't considered the negative shipping beyond Endless.com.

[Robert Peck:]

The first part of that question was the investment. Can you give us any sort of gauge of what's the investment into all of these endeavors, and when we may get to see some leverage on it?

[Jeff Bezos:]

Well, the big investments are in digital and web services. Other things that you mentioned are very minor investments.

[Robert Peck:]

Thank you.

[Operator:]

Your next question comes from Jeetil Patel - Deutsche Bank Securities.

[Jeetil Patel:]

Great, thank you. Two questions. As you look at your technology and content investment, about $600 million, that's what you spent in 2006, but what is intended for the growth of the existing business versus new businesses and ventures? Second question, if you look on a contribution profit basis, do you think that just broadly, the ecommerce industry unit economics mirror what you're doing or do you think you're artificially surpassing overall the unit economics of the business by using a low price strategy? I'm trying to figure out whether your view is that the industry's profitability moves to your model, or you actually have been holding it back for the past couple of years.

[Tom Szkutak:]

In terms of the first question, in terms of technology and content, we have not given a split in terms of what, if I understood the question, what is for the core part of the business and what is for future. But certainly, it's being spent on a number of different initiatives. Jeff mentioned a few of them. Certainly, we're making investments in terms of the incremental spend, which we're spending that largely on web services, digital, new categories as we launch them, seller platforms, making it easier for sellers to sell. So those are certainly key investment areas for the business. Could you maybe repeat or restate the second part of the question?

[Jeetil Patel:]

Yes. If you look at the overall variable profitability in your business, is your thesis on your aggressive pricing strategy to end customers that overall unit economics will migrate across the ecommerce market towards your model, in terms of, call it about a couple of dollars per transaction? Or do you think that you've been holding it back as a way to grow your volume in the near term in this growth environment?

[Jeff Bezos:]

I suspect that what we will see over time is that there will be multiple winners of different scales pursuing different strategies in that regard. So you may see that it probably doesn't end up being one size fits all.

[Operator:]

Your next question comes from Douglas Anmuth - Lehman Brothers.

[Douglas Anmuth:]

Thank you. Your results suggest that Prime is really doing what you would like it to do, based on the top line growth, the lower gross margins and also the flattish shipping revenues, despite the 34% increase in sales. So this is a program that has been in place for almost two years now. Can you give us some sense of metrics around Prime, and also discuss the usage patterns during the holiday? Then can you also talk about to what degree Prime customers are more or less price-sensitive than other shoppers? Thank you.

[Jeff Bezos:]

Sure. In terms of Prime customers, what we're seeing right now is adoption is very strong, Prime customers are certainly buying more from us, so we're getting a bigger share of wallet from those particular customers. They're also doing more cross-shopping. Beyond that, at this time, we're not disclosing other statistics or metrics around Prime. That said, though, it's something that from a business perspective, we do spend a lot of time on and continue to look at very closely. We like what we see, and so that's something that we think we certainly want to continue to grow that business and subscribers continue to grow nicely. We look forward to having more Prime customers because we think over the long term it's a great win for customers. Customers are seeing that today, and we think it will be great for shareholders over the long term as well.

[Operator:]

Your next question comes from Paul Keung - CIBC World Markets.

[Paul Keung:]

I hate to ask the question again, but it's important, I guess, when you look at Amazon Prime, is the economics of a Prime customer very different than that of the average customer on the platform? I'm trying to understand whether this in itself long-term is going to be accretive to the overall platform.

[Jeff Bezos:]

Yes. We certainly believe that it is, and we like the trends that we see. They are very positive, and we think certainly would be very helpful over the long term.

[Paul Keung:]

So it's equal or better for the economics then, is probably the right way to think about it on a transactional basis?

[Jeff Bezos:]

Again, the way we're looking at it today, we were very pleased at the start of Prime, when we launched it. We continue to see favorable trends. We have found ways to become more productive with some of the volume we're getting with Prime customers. There's things that we think we can do over the long term to make it even better from an economic standpoint. So we're continuing to try to innovate on behalf of both customers and make it better for shareholders over time. But we like what we see so far, and we need to continue to make it even better.

[Paul Keung:]

The toys category, how fast did that category grow year over year this quarter?

[Jeff Bezos:]

We're not breaking out any subcategory details. But again, the impact of toys, video games and baby was 160 basis points on our total revenue year over year.

[Operator:]

Your next question comes from Imran Khan – JP Morgan.

[Imran Khan:]

Thank you for taking my question. I have a couple of questions. Your inventory was up 51% year over year, which is a slight deceleration from last quarter’s growth rate, but still pretty strong growth. So I am trying to understand where this growth is coming from. Is it toy category or some other categories? Secondly, I was wondering if you could give us some color what kind of user impact you're seeing from the introduction of the Unbox product?

[Jeff Bezos:]

In terms of the inventory question, we continued to add a lot of selection, a lot of unique selection during 2006. So that was certainly a driver. We also worked on improving in-stock selection over the course of 2006, which is why you are seeing the growth that you're seeing. Certainly, this is something that will have some volatility over time, but certainly you should expect that over time it will flatten off to potentially trickle upwards from a turn perspective. So that's how we're thinking about it. In terms of Unbox, we continue to add selection at Unbox. We're getting very good repeat customer performance back to our site. So we are very pleased from that perspective. The team is seeing especially strong performance amongst television episodes, as well as hard to find video. As Tom said, of all of our category offerings, it has amongst the highest repeat rates so we're very encouraged by that.

[Imran Khan:]

Thank you.

[Operator:]

Your final question comes from Mark Rowen - Prudential.

[Mark Rowen:]

Thanks. Tom, could you tell us how much video game consoles helped the North American media growth, given the strength in Xbox and your allocation in Wii's PS3's? Then on the gross margin, just a follow-up on that. It looks like the free shipping as a percent of revenue wasn't really any greater than it was a year ago. So my question is, was it primarily the promotional environment where you had to match competitive prices from other retailers, or was it primarily mix shift to lower margin categories that caused the gross margin erosion year over year?

[Tom Szkutak:]

In terms of any specific product details on the consoles, we just don't break out that level of detail from a disclosure standpoint. In terms of the net shipping margin, you are right, it was flat at 3.1%. Certainly, the shift to our new toys, baby and video category impacted that. We talked about Prime impacting that as well. Offsetting that, we had some very good productivity as well, so those were the key drivers.

[Mark Rowen:]

I'm sorry? Productivity in --?

[Tom Szkutak:]

Within transportation.

[Mark Rowen:]

I see. I'm not asking for the number on video games, but just directionally, did that help the growth rate to a material degree?

[Tom Szkutak:]

I would say it this way. We are certainly not breaking that out, and within our media categories as well as our EGM categories, as you can see from the release, both from North America and from international, we had very strong growth across the board. Beyond that, there's not a lot I can share with you.

[Mark Rowen:]

Okay, thanks.

[Kim Nelson:]

Thanks, Mark. Thank you for joining us on the call today and for your questions. A replay will be available on our Investor Relations website at least through the end of the quarter. We appreciate your interest in Amazon, and look forward to talking with you again next quarter.