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Amazon.com 10-Q 2005 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
Form 10-Q
(Mark One)
For the quarterly period ended September 30, 2005
or
For the transition period from to .
Commission File No. 000-22513
Amazon.com, Inc. (Exact Name of Registrant as Specified in its Charter)
1200 12th Avenue South, Suite 1200, Seattle, Washington 98144-2734 (206) 266-1000 (Address and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
414,472,558 shares of common stock, par value $0.01 per share, outstanding as of October 20, 2005
Table of Contents
FORM 10-Q For the Quarterly Period Ended September 30, 2005
INDEX
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Item 1. Financial Statements
CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) (unaudited)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS (in millions, except per share data) (unaudited)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED BALANCE SHEETS (in millions, except per share data)
See accompanying notes to consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
Note 1 — Accounting Policies
Unaudited Interim Financial Information
We have prepared the accompanying consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated financial statements are unaudited and, in our opinion, include all adjustments, consisting of normal recurring adjustments and accruals necessary for a fair presentation of the consolidated balance sheets, operating results, and cash flows for the periods presented. Operating results for the periods presented are not necessarily indicative of the results that may be expected for 2005 due to seasonal and other factors. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been omitted in accordance with the rules and regulations of the SEC. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our 2004 Annual Report on Form 10-K. On January 1, 2005, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment.” Certain prior period amounts have been reclassified to conform to the current period presentation.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, and those entities relating to www.joyo.com in which we have a variable interest. Intercompany balances and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, internally-developed software, stock-based compensation, taxes, inventory valuation, receivables valuation, sales returns, restructuring-related liabilities, incentive discount offers, depreciable lives, valuation of investments, valuation of acquired intangibles, and contingencies. Actual results could differ materially from those estimates.
Earnings per Share
Basic earnings per share is calculated using our weighted-average outstanding common shares. Diluted earnings per share is calculated using our weighted-average outstanding common shares including the dilutive effect of stock awards. Using the treasury stock method, the weighted average effect of stock awards on diluted earnings per share was 15 million and 18 million shares for Q3 2005 and Q3 2004 and was 15 million and 19 million shares for the three quarters ended September 30, 2005 and 2004.
Our convertible debt instruments are excluded from the calculation of diluted earnings per share as their effect is antidilutive.
Business Combinations
We acquired certain companies during the three quarters ended September 30, 2005 for an aggregate cash purchase price of $29 million. Acquired intangibles totaled $10 million and have estimated useful lives of between one and three years. The excess of purchase price over the fair value of the net assets acquired was $19
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) (unaudited)
million and is classified as “Goodwill” on our consolidated balance sheets. The results of operations of each of the acquired businesses have been included in our consolidated results from each transaction closing date forward. The effect of these acquisitions on consolidated net sales and operating income during Q3 2005 and the three quarters ended September 30, 2005 was not significant.
In the third quarter of 2004, we acquired all of the outstanding shares of Joyo.com Limited (“Joyo.com”), a British Virgin Islands company that operates an Internet retail website in the People’s Republic of China (“PRC”) in cooperation with a PRC subsidiary and PRC affiliates, at a purchase price of $75 million. Acquired intangibles were $6 million with estimated useful lives of between one and four years. The excess of purchase price over the fair value of the net assets acquired was $70 million and is classified as “Goodwill” on our consolidated balance sheets.
Accounts Receivable, Net and Other Current Assets
Included in “Accounts receivable, net and other current assets” are prepaid expenses of $20 million and $12 million at September 30, 2005 and December 31, 2004, representing advance payments for insurance, licenses, and other miscellaneous expenses.
Goodwill
We perform our annual analysis of goodwill during the fourth quarter of each year, and we update our analysis whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Based on our 2004 analysis, no impairments were present, and no indicators of impairment were identified in the three quarters ended September 30, 2005.
Other Assets
Included in “Other assets” on our consolidated balance sheets are amounts primarily related to deferred issuance charges on our long-term debt, certain equity investments, and other intangibles. At September 30, 2005 and December 31, 2004, deferred issuance charges were $13 million and $19 million; equity investments were $9 million and $15 million; and other intangibles, net were $13 million and $5 million.
Income Taxes
Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested.
Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. See Note 9 — “Income Taxes.” SFAS No. 109, “Accounting for Income Taxes,” requires deferred tax assets be evaluated for future realization and be reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Significant judgment is required in making this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of our deferred tax assets are realizable.
Classification of deferred tax assets between current and long-term categories is based on the expected timing of realization, and the valuation allowance is allocated on a pro-rata basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) (unaudited)
Shipping Activities
Outbound shipping charges to customers are included in “Net sales” and were $112 million and $87 million for Q3 2005 and Q3 2004 and $323 million and $264 million for the three quarters ended September 30, 2005 and 2004. Outbound shipping-related costs are included in “Cost of sales” and totaled $159 million and $128 million for Q3 2005 and Q3 2004 and $471 million and $383 million for the three quarters ended September 30, 2005 and 2004. The net cost to us of shipping activities was $47 million and $41 million for Q3 2005 and Q3 2004 and $148 million and $119 million for the three quarters ended September 30, 2005 and 2004.
Internal-use Software and Website Development
Costs incurred to develop software for internal use are required to be capitalized and amortized over the estimated useful life of the software in accordance with SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Costs related to design or maintenance of internal-use software are expensed as incurred. During Q3 2005 and Q3 2004, we capitalized $25 million (including $3 million of stock-based compensation) and $12 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $14 million and $8 million. For the three quarters ended September 30, 2005 and 2004, we capitalized $65 million (including $8 million of stock-based compensation) and $29 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $35 million and $22 million.
Depreciation of Fixed Assets
Fixed assets include assets such as furniture and fixtures, heavy equipment, technology infrastructure, internal-use software and website development, and our DVD rental library. Depreciation is recorded on a straight-line basis over the estimated useful lives of the assets (generally two years or less for assets such as internal-use software and our DVD rental library, three years for our technology infrastructure, five years for furniture and fixtures, and ten years for heavy equipment). Depreciation expense is generally classified within the corresponding operating expense categories on the consolidated statements of operations, and certain assets, such as our DVD rental library, are amortized as “Cost of sales.” Depreciation expense for fixed assets was $29 million and $19 million for Q3 2005 and Q3 2004 and $78 million and $54 million for the three quarters ended September 30, 2005 and 2004.
Stock-Based Compensation
Effect of Early Adoption of SFAS 123(R), Share-Based Payment
Prior to January 1, 2005, we accounted for stock awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The intrinsic value method of accounting resulted in compensation expense for restricted stock and restricted stock units at their estimated fair value on date of grant based on the number of shares granted and the quoted price of our common stock, and for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were subject to an exchange offer, other modifications, or performance criteria, such awards were subject to variable accounting treatment. To the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.
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As of January 1, 2005, we adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Such value is recognized as expense over the service period, net of estimated forfeitures, using the accelerated method under SFAS 123(R). The estimation of stock awards that will ultimately vest requires significant judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. Because we implemented SFAS 123(R), we no longer have employee stock awards subject to variable accounting treatment.
The adoption of SFAS 123(R) resulted in a cumulative benefit from accounting change of $26 million in Q1 2005, which reflects the net cumulative impact of estimating future forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted.
Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based compensation was presented in operating cash flows, along with other tax cash flows, in accordance with the provisions of the Emerging Issues Task Force (“EITF”) Issue No. 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123(R) supersedes EITF 00-15, amends SFAS 95, “Statement of Cash Flows,” and requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows. Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $2 million and $4 million for Q3 2005 and the three quarters ended September 30, 2005.
On March 29, 2005, the SEC published Staff Accounting Bulletin (“SAB”) No. 107, which provides the Staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. We have reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense line items as cash compensation paid to employees.
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The application of SFAS 123(R) had the following effect on reported amounts relative to amounts that would have been reported using the intrinsic value method under previous accounting (in millions, except per share amounts):
Valuation Assumptions for Stock Options
Less than two thousand stock options were granted during Q3 2005. The fair value for each stock option granted was estimated at the date of grant using a Black-Scholes option-pricing model, assuming no dividends and the following assumptions.
Expected volatilities are based on historical volatilities of our common stock; the expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.
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Fair Value Disclosures — Prior to SFAS 123(R) Adoption
Stock-based compensation for the three quarters ended September 30, 2004 was determined using the intrinsic value method. The following table provides supplemental information for Q3 2004 and the three quarters ended September 30, 2004 as if stock-based compensation had been computed under SFAS 123 (in millions, except per share data):
Note 2 — Cash, Cash Equivalents, and Marketable Securities
As of September 30, 2005 and December 31, 2004 our cash, cash equivalents, and marketable securities of $1.4 billion and $1.8 billion, at fair value, primarily consist of cash, investment grade securities and AAA-rated money market mutual funds. At September 30, 2005 and December 31, 2004 amounts held in foreign currencies were $687 million and $970 million, primarily Euros, British Pounds, and Yen.
At September 30, 2005, gross unrealized gains and losses on cash equivalents and marketable securities were not significant.
We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. See “Note 4 — Commitments and Contingencies.”
Note 3 — Long-Term Debt and Other
Our long-term debt and other long-term liabilities are summarized as follows:
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Note 4 — Commitments and Contingencies
Commitments
We lease office and fulfillment center facilities and fixed assets under non-cancelable operating and capital leases. Rental expense under operating lease agreements was $20 million and $14 million for Q3 2005 and Q3 2004, and $53 million and $41 million for the three quarters ended September 30, 2005 and 2004.
The following summarizes our principal contractual commitments, excluding open orders for purchases that support normal operations, as of September 30, 2005:
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Pledged Securities
We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. The amount required to be pledged for real estate lease agreements changes over the life of our leases and with fluctuations in our market capitalization, which is common shares outstanding multiplied by the closing price of our common stock, and based on our credit-rating. Information about collateral required to be pledged under these agreements is as follows:
Legal Proceedings
A number of purported class action complaints were filed by holders of our equity and debt securities against us, our directors, and certain of our senior officers during 2001, in the United States District Court for the Western District of Washington, alleging violations of the Securities Act of 1933 (the “1933 Act”) and/or the Securities Exchange Act of 1934 (the “1934 Act”). In August 2003, plaintiffs in the 1934 Act cases filed a second consolidated amended complaint alleging that we, together with certain of our officers and directors, made false or misleading statements during the period from October 29, 1998 through October 23, 2001 concerning our business, financial condition and results, inventories, future prospects, and strategic alliance transactions. The 1933 Act complaint alleges that the defendants made false or misleading statements in connection with our February 2000 offering of the 6.875% PEACS. The complaints seek damages and injunctive
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relief against all defendants. We dispute the allegations of wrongdoing in these complaints and have been vigorously defending ourselves in these matters. In March 2005, we signed a Stipulation of Settlement with counsel representing the plaintiff class with respect to the 1934 Act claims. In July 2005, we signed a Stipulation of Settlement with counsel representing the plaintiff class with respect to the 1933 Act claims. If finalized and approved by the Court, these settlements would dispose of all claims asserted in these lawsuits in exchange for payments totaling $48 million, substantially all of which we expect to be funded by our insurers.
In October 2002, Gary Gerlinger, individually and on behalf of all other similarly situated consumers in the United States who, during the period from August 1, 2001 to the present, purchased books online from either Amazon.com or Borders.com, instituted an action against us and Borders in the United States District Court for the Northern District of California. The complaint alleges that the agreement pursuant to which an affiliate of Amazon.com operates Borders.com as a co-branded site violates federal anti-trust laws, California statutory law, and the common law of unjust enrichment. The complaint seeks injunctive relief, damages, including treble damages or statutory damages where applicable, attorneys’ fees, costs, and disbursements, disgorgement of all sums obtained by allegedly wrongful acts, interest, and declaratory relief. We dispute the allegations of wrongdoing in this complaint, and intend to vigorously defend ourselves in this matter.
Beginning in March 2003, we were served with complaints filed in several different states, including Illinois and Nevada, by a private litigant purportedly on behalf of the state governments under various state False Claims Acts. The complaints allege that we (along with other companies with which we have commercial agreements) wrongfully failed to collect and remit sales and use taxes for sales of personal property to customers in those states and knowingly created records and statements falsely stating we were not required to collect or remit such taxes. The complaints seek injunctive relief, unpaid taxes, interest, attorneys’ fees, civil penalties of up to $10,000 per violation, and treble or punitive damages under the various state False Claims Acts. It is possible that we have been or will be named in similar cases in other states as well. We do not believe that we are liable under existing laws and regulations for any failure to collect sales or other taxes relating to Internet sales and intend to vigorously defend ourselves in these matters.
In January 2004, Soverain Software LLC filed a complaint against us for patent infringement in the United States District Court for the Eastern District of Texas. The complaint alleged that our website technology infringed several patents obtained by Soverain purporting to cover “Internet Server Access Control and Monitoring Systems” (U.S. Patent No. 5,708,780) and “Network Sales Systems” (U.S. Patent Nos. 5,715,314 and 5,909,492) and sought injunctive relief, monetary damages in an amount no less than a reasonable royalty, treble damages for alleged willful infringement, prejudgment interest, and attorneys’ fees. In October 2004, Soverain filed an amended complaint alleging that we infringed two additional patents purporting to cover “Digital Active Advertising” (U.S. Patent No. 6,195,649) and an “Open Network Payment System for Providing Real-Time Authorization of Payment and Purchase Transactions” (U.S. Patent No. 6,205,437). In August 2005, Amazon.com announced that it entered into a settlement of the litigation that included, among other things, a one-time payment of $40 million in Q3 2005, mutual releases, and a non-exclusive license to Soverain’s patent portfolio.
In January 2004, IPXL Holdings, LLC brought an action against us for patent infringement in the United States District Court for the Eastern District of Virginia. The complaint alleges that aspects of our online ordering technology, including 1-Click® ordering, infringe a patent obtained by IPXL purporting to cover an “Electronic Fund Transfer or Transaction System” (U.S. Patent No. 6,149,055) and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, and attorneys’ fees. In August 2004, the Court entered a judgment in Amazon.com’s favor on the grounds that the patent claims asserted by the plaintiff were invalid and that Amazon.com’s technology did not infringe those claims in any event. The Court also awarded Amazon.com its attorneys’ fees and costs. Plaintiff is appealing that judgment.
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In April 2004, we learned that the French authorities are investigating our DVD sales practices in France, and we are cooperating.
In May 2004, Toysrus.com LLC filed a complaint against us for breach of contract in the Superior Court of New Jersey. The complaint alleges that we breached our commercial agreement with Toysrus.com LLC by selling, and by permitting other third parties to sell, products that Toysrus.com LLC alleges it has an exclusive right to sell on our website. The complaint seeks injunctive relief, declaratory judgment, termination of the agreement, and monetary damages in excess of $65 million. We dispute the allegations of wrongdoing in this complaint and have brought counterclaims alleging breach of contract and seeking damages and declaratory relief. We are vigorously defending ourselves in this matter.
In September 2004, BTG International Inc. filed a complaint against us for patent infringement in the United States District Court for the District of Delaware. The complaint alleges that our website technology, including our Associates program, infringes two patents obtained by BTG purporting to cover methods and apparatuses for “Attaching Navigational History Information to Universal Resource Locator Links on a World Wide Web Page” (U.S. Patent No. 5,712,979) and for “Tracking the Navigation Path of a User on the World Wide Web” (U.S. Patent No. 5,717,860) and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, treble damages for alleged willful infringement, prejudgment interest, costs, and attorneys’ fees. We dispute the allegations of wrongdoing in this complaint and intend to vigorously defend ourselves in this matter.
In October 2004 Cendant Publishing, Inc. filed a complaint against us for patent infringement in the United States District Court for the District of Delaware. The complaint alleged that our website technology, including our recommendations features, infringes a patent obtained by Cendant purporting to cover a “System and Method for Providing Recommendation of Goods or Services Based on Recorded Purchasing History” (U.S. Patent No. 6,782,370) and sought injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, costs, and attorneys’ fees. In February 2005, Cendant voluntarily withdrew the complaint without prejudice. In June 2005, however, Cendant re-filed a new complaint containing substantially the same claims. In response, we filed a countersuit in the United States District Court for the Western District of Washington alleging that Cendant’s parent, Cendant Corporation, and its affiliates Orbitz, Inc., Budget Rent A Car System, Inc., Avis Rent A Car System, Inc., and Trilegiant Corporation infringe certain patents owned by us and our subsidiary, A9.com. We dispute Cendant’s allegations of wrongdoing in its complaint and intend to vigorously defend ourselves in these matters.
Depending on the amount and the timing, an unfavorable resolution of some or all of these matters could materially affect our business, results of operations, financial position, or cash flows in a particular period.
Note 5 — Stockholders’ Equity (Deficit)
Stock Award Plans and Shares Reserved for Future Issuance
Common stock reserved for future issuance was as follows (in millions):
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Stock Award Activity
Employees vest in restricted stock unit awards and stock options ratably over the service term, generally between two and five years. Outstanding stock options generally have a term of 10 years from the date of grant.
We granted stock awards, which since October 2002 have consisted primarily of restricted stock units, representing 1.0 million and 0.7 million shares of common stock during Q3 2005 and Q3 2004 with a per share weighted average fair value of $40.11 and $40.12. For the three quarters ended September 30, 2005 and comparable period in 2004 we granted stock awards representing 5.5 million and 2.7 million shares of common stock with per share weighted average fair values of $35.90 and $44.59.
Common shares underlying outstanding stock awards were as follows:
Common shares outstanding (which includes restricted stock), plus shares underlying outstanding stock options and restricted stock units totaled 438 million and 434 million at September 30, 2005 and December 31, 2004. These totals include all stock-based awards outstanding, without regard for estimated forfeitures, consisting of vested and unvested awards, and in-the-money and out-of-the-money stock options. Common shares outstanding increased by 2.3 million shares and 0.8 million shares during Q3 2005 and Q3 2004 and by 4.3 million and 4.1 million shares during the three quarters ended September 30, 2005 and 2004, due to exercises of stock options, vesting of restricted stock units, and matching contributions under our 401(k) savings plan.
The following table summarizes our restricted stock unit activity for the three quarters ended September 30, 2005 (in millions):
The aggregate intrinsic value of restricted stock units as of September 30, 2005 was $439 million. Intrinsic value for restricted stock units is calculated based on the number of awards outstanding and the quoted price of our common stock as of the reporting date.
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Scheduled vesting for outstanding restricted stock units at September 30, 2005 is as follows (in millions):
The following table summarizes our stock option activity for the three quarters ended September 30, 2005:
The following table summarizes information about stock options outstanding at September 30, 2005:
The aggregate intrinsic value of stock options outstanding at September 30, 2005 was $451 million, of which $236 million relates to vested awards. Intrinsic value for stock options is calculated based on the difference between the exercise price of the underlying awards and the quoted price of our common stock as of the reporting date.
As matching contributions under our 401(k) savings plan, we granted 0.07 million shares of common stock for the three quarters ended September 30, 2005. Shares granted as matching contributions under our 401(k) plan and shares of restricted stock are included in outstanding common stock when issued.
As of September 30, 2005, there was $198 million of total unrecognized compensation cost, net of estimated forfeitures of $98 million, related to unvested stock-based compensation arrangements. This compensation is recognized on an accelerated basis resulting in approximately half of the compensation expected to be expensed in the next twelve months, and a weighted average recognition period of 1.3 years.
During Q3 2005 and Q3 2004, the fair value of restricted stock units and restricted stock awards vested was $8 million and $1 million, and the intrinsic value of options exercised was $71 million and $22 million. The fair value of restricted stock units and restricted stock awards vested in the three quarters ended September 30, 2005 and 2004 was $22 million and $19 million, and the intrinsic value of options exercised was $111 million and $162 million.
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Note 6 — Other Comprehensive Income (Loss)
Comprehensive income was $16 million and $53 million for Q3 2005 and Q3 2004, and $141 million and $232 million for the three quarters ended September 30, 2005 and 2004. The primary differences between net income as reported and comprehensive income are foreign currency translation adjustments and changes in unrealized gains and losses on available-for-sale securities.
Note 7 — Other Operating Expense (Income)
In Q3 2005 we settled a patent lawsuit on terms that include, among other things, a one-time payment of $40 million in Q3 2005 that was recorded to “Other operating expense (income)” on the consolidated statements of operations.
In Q3 2004 severance terms were finalized to eliminate certain managerial, professional, clerical and technical positions in France. The corresponding costs of $4 million were recorded in the third quarter of 2004 and classified in “Other operating expense (income)” on the consolidated statements of operations.
“Other operating expense (income)” for the three quarters ended September 30, 2004 includes a gain of $8 million related to the reduction of our restructuring-related liability due to our occupation of certain office space previously vacated as part of our 2001 restructuring.
Note 8 — Remeasurements and Other
Remeasurements and other consisted of the following:
Note 9 — Income Taxes
Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, with the cumulative effect of a change to the estimated annual rate being recorded in the interim period such a change is made. The Q3 2005 tax provision includes a cumulative adjustment benefit of $4 million, with a corresponding benefit to diluted earnings per share of $0.01, to reflect our current estimate of our annual effective tax rate of
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50%. Our effective tax rate for Q3 2005 and for the three quarters ended September 30, 2005 remains higher than the 35% statutory rate associated with taxable income resulting from the Q1 2005 transfer of certain operating assets from the U.S. to international locations. We expect these asset transfers to result in tax expense for financial reporting purposes above the statutory rate throughout 2005. Since we have Net Operating Losses (“NOLs”) these asset transfers will not have a significant effect on cash taxes paid in 2005. Cash paid for income taxes was $6 million and $2 million in Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 was $11 million and $3 million.
At September 30, 2005, approximately $720 million of our gross deferred tax assets were related to approximately $2.3 billion of NOLs. Our NOL deferred tax assets are reduced by a valuation allowance of approximately $510 million due to uncertainty about their future realization. The remainder of our deferred tax assets relate to temporary timing differences between tax and financial reporting. The majority of our NOLs expire after 2016, and utilization of NOLs may be subject to certain limitations under Sections 382 and 1502 of the Internal Revenue Code of 1986 (“Internal Revenue Code”), and other limitations under state and foreign tax laws.
Note 10 — Segment Information
We have organized our operations into two principal segments: North America and International. We present our segment information along the same lines that our chief executive reviews our operating results in assessing performance and allocating resources.
We allocate to segment results the operating expenses “Fulfillment,” “Marketing,” “Technology and content,” and “General and administrative,” but exclude from our allocations the portions of these expense lines attributable to stock-based compensation. Additionally, we do not allocate the line item “Other operating income (expense)” to our segment operating results. A significant majority of our costs for “Technology and content” are incurred in the United States and most of these costs are allocated to our North America segment. There are no internal revenue transactions between our reporting segments.
North America
The North America segment consists of amounts earned from retail sales of consumer products (including from third-party sellers) and subscriptions through North America-focused websites, such as www.amazon.com and www.amazon.ca, from North America-focused Syndicated Stores and mail-order catalogs, and from non-retail activities such as North America-focused Amazon Services’ Merchant.com program, marketing, and promotional agreements.
International
The International segment consists of amounts earned from retail sales of consumer products (including from third-party sellers) and subscriptions through internationally-focused websites, such as www.amazon.co.uk, www.amazon.de, www.amazon.fr, www.amazon.co.jp, and www.joyo.com, from internationally-focused Syndicated Stores and from non-retail activities such as internationally-focused marketing and promotional agreements. This segment includes export sales from www.amazon.co.uk, www.amazon.de, www.amazon.fr, www.amazon.co.jp, and www.joyo.com (including export sales from these sites to customers in the U.S. and Canada), but excludes export sales from www.amazon.com and www.amazon.ca.
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Table of ContentsAMAZON.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) (unaudited)
Information on reportable segments and reconciliation to consolidated net income is as follows (in millions):
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Table of ContentsItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding guidance, industry prospects or future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward-looking. We use words such as anticipates, believes, expects, future, intends, and similar expressions to identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Actual results could differ materially for a variety of reasons, including, among others, fluctuations in foreign exchange rates, changes in global economic conditions and consumer spending, world events, the rate of growth of the Internet and online commerce, the amount that Amazon.com invests in new business opportunities and the timing of those investments, the mix of products sold to customers, the mix of net sales derived from products as compared with services, competition, management of growth, potential fluctuations in operating results, international growth and expansion, outcomes of legal proceedings and claims, fulfillment center optimization, risks of inventory management, seasonality, the degree to which the Company enters into, maintains, and develops commercial agreements, acquisitions, and strategic transactions, and risks of fulfillment throughput and productivity. These risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in “Additional Factors That May Affect Future Results,” which, along with the previous discussion, describes some, but not all, of the factors that could cause actual results to differ significantly from management’s expectations.
Overview
Our primary source of revenue is the sale of a wide range of products and services to customers of our global websites. The products offered on our websites include products we have purchased from distributors, publishers, and manufacturers and products offered by third parties. Generally, we recognize gross revenue from items we sell from our inventory and recognize our net share of revenue of items sold by third parties.
Our financial focus is on long-term, sustainable growth in free cash flow1. Free cash flow is driven primarily by increasing operating income and efficiently managing working capital and capital expenditures. Increases in operating income result from increases in sales through our websites and a focus on keeping our operating costs low, offset by investments we make in longer-term strategic initiatives including hiring additional software engineers and computer scientists. To increase sales, we focus on improving all aspects of the customer experience, including lowering prices, improving availability, offering faster delivery times, increasing selection, expanding product information, improving ease of use, and earning customer trust. We generally focus on gross profit and operating profit dollars rather than margin percentages. Because we have net operating loss carryforwards, the free cash flow impact from income taxes paid is less than our income tax provision.
We also seek to efficiently manage shareholder dilution while maintaining the flexibility to issue shares for strategic purposes, such as financings and aligning employee interests with shareholders. We moved to restricted stock units as our primary vehicle for equity compensation in late 2002 because we believe they better align the interests of our shareholders and employees. Restricted stock units result in charges to our income statement based on the fair value of the awards at the grant date recorded over the underlying service periods, net of estimated cancellations. Total shares outstanding plus outstanding stock awards were 438 million and 434 million at September 30, 2005 and December 31, 2004. These totals include all stock awards outstanding, without regard for estimated forfeitures, consisting of vested and unvested awards, and in-the-money and out-of-the-money stock options.
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Table of ContentsWe seek to leverage our fixed customer experience costs and work to reduce our variable costs per unit. Our customer experience costs, specifically the costs necessary to build, enhance, and add features to our websites and build and optimize our fulfillment centers, are largely fixed in that they do not vary directly with sales. The customer experience costs that remain largely variable as a percentage of sales include product costs; credit-card processing fees; bad debt; picking, packaging, and preparing orders for shipment; transportation; customer service support; and most aspects of our marketing costs. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct to publisher and manufacturer sourcing; seek to maximize volume discounts available to us from suppliers; and focus on maintaining a lean culture, including by reducing defects in our processes.
Because of our model we are able to turn our inventory quickly and have a negative operating cycle2. On average, our high inventory velocity means we generally collect from our customers before our payments to suppliers come due. Inventory turnover3 was 15 and 17 for Q3 2005 and Q3 2004. We expect some variability in inventory turnover over time since it is affected by several factors, including our product mix, our mix of third-party sales, our continuing focus on in-stock inventory availability, our future investment in new geographies and product lines, and the extent we choose to utilize outsource fulfillment providers. Accounts payable days4 were 58 and 57 for Q3 2005 and Q3 2004. We expect some variability in accounts payable days over time since it is affected by several factors, including the mix of product sales, the mix of third-party sales, the mix of suppliers, seasonality, and changes in payment terms over time, including the effect of negotiating better pricing from our suppliers in exchange for shorter payment terms.
Our spending in technology and content will increase as we add computer scientists and software engineers to continue to improve our process efficiency and enhance the customer experience on our websites. We believe that advances in technology, specifically the speed and reduced cost of processing power, the improved consumer experience of the Internet outside of the workplace through lower-cost broadband service to the home, and the advances of wireless connectivity, will continue to improve the consumer experience on the Internet and increase its ubiquity in people’s lives. Our challenge will be to continue to build and deploy innovative and efficient software that will best take advantage of continued advances in technology.
Our financial reporting currency is the U.S. Dollar and changes in exchange rates significantly affect our reported results and consolidated trends. For example, if the U.S. Dollar weakens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit, and operating expenses will be higher than if currencies had remained constant. Likewise, if the U.S. Dollar strengthens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit, and operating expenses will be lower than if currencies had remained constant. We believe that our increasing diversification beyond the U.S. economy through our growing international businesses benefits our shareholders over the long term. We also believe it is important to evaluate our operating results and growth rates before and after the effect of currency changes.
In addition, the remeasurement of our 6.875% PEACS and intercompany balances can result in significant gains and charges associated with the effect of movements in currency exchange rates. Currency volatilities will likely continue, which may significantly impact (either positively or negatively) our reported results and consolidated trends and comparisons. Assuming exchange rates remain at recent levels, we expect an over $100 million year-over-year negative impact to consolidated net sales in the fourth quarter from foreign exchange.
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Table of ContentsCritical Accounting Judgments
The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require it to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business and Accounting Policies,” of our 2004 Annual Report on Form 10-K. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.
Revenue Recognition
We recognize revenue from product sales or services rendered when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. Additionally, revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: the delivered item has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of undelivered items; and delivery of any undelivered item is probable.
We evaluate the criteria of EITF 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not primarily obligated and amounts earned are determined using a percentage, a fixed-payment schedule, or a combination of the two, we generally record the net amounts as commissions earned. Under our Syndicated Stores arrangements, we record gross product sales and costs since we own the inventory, set prices, and are responsible for fulfillment and customer service, and the other business earns a sales commission.
Product sales and shipping revenues, net of promotional discounts, rebates, and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to sales contracts that generally provide for transfer of both title and risk of loss upon our delivery to the carrier. Return allowances, which reduce product revenue by our best estimate of expected product returns, are estimated using historical experience. Amounts paid in advance for subscription services, including amounts received for online DVD rentals, Amazon Prime, and other membership programs, are deferred and classified in “Unearned revenue” on our consolidated balance sheets and recognized as revenue over the subscription term.
We periodically provide incentive offers to our customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases, inducement offers, such as offers for future discounts subject to a minimum current purchase, and other similar offers. Current discount offers, when accepted by our customers, are treated as a reduction to the purchase price of the related transaction, while inducement offers, when accepted by our customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using our historical experience for similar inducement offers. Current discount offers and inducement offers are classified as an offsetting amount in “Net sales.”
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Table of ContentsCommissions and per-unit fees received from third-party sellers and similar amounts earned through our Amazon Services’ Merchant.com program are recognized when the item is sold by the third-party seller and our collectibility is reasonably assured. When we are responsible for fulfillment-related services, commissions are recognized when risk of loss and title transfer to the customer. We record an allowance for estimated refunds on such commissions using historical experience.
Inventories
Inventories, consisting of products available for sale, are accounted for using the first-in first-out (“FIFO”) method, and are valued at the lower of cost or market value. This valuation requires us to make judgments, based on currently-available information, about the likely method of disposition, such as through sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each disposition category. Based on this evaluation, we adjust the carrying amount of our inventories to lower of cost or market value.
We provide fulfillment-related services in connection with certain of our Amazon Services’ Merchants@ and Merchant.com programs. In those arrangements, as well as other product sales by third parties, the third-party maintains ownership of the related products.
Internal-Use Software and Website Development
Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our websites and processes supporting our business. As required by Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” we capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of two years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.
During Q3 2005 and Q3 2004, we capitalized $25 million (including $3 million of stock-based compensation) and $12 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $14 million and $8 million. For the three quarters ended September 30, 2005 and 2004, we capitalized $65 million (including $8 million of stock-based compensation) and $29 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $35 million and $22 million.
Valuation of Deferred Tax Assets
SFAS 109, “Accounting for Income Taxes,” requires that deferred tax assets be evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Significant judgment is required in making this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of our deferred tax assets are realizable.
Stock-Based Compensation
As of January 1, 2005, we adopted SFAS 123(R), which requires us to measure compensation cost for stock awards at fair value and recognize compensation over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.
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Table of ContentsWhen the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), they encouraged early adoption of the standard. After we early-adopted SFAS 123(R), the FASB deferred the required implementation date. Additionally, the FASB continues to discuss implementation issues with industry leaders and the large accounting firms, and this may result in clarifications or modifications of rules affecting the application of the standard. If additional clarifications or conclusions affecting implementation are reached that differ from our application of the standard, this may have an impact, either positive or negative, on our reported results.
Liquidity and Capital Resources
Our financial focus is on long-term, sustainable growth in free cash flow. Free cash flow was $475 million for the trailing twelve months ended September 30, 2005, which includes the effect of a $40 million patent litigation settlement in Q3 2005, compared to $420 million for the trailing twelve months ended September 30, 2004, an increase of 13%. Operating cash flows and free cash flows can be volatile and are sensitive to many factors, including changes in working capital and timing of capital expenditures. Working capital at any specific point in time is subject to many variables, including seasonality, the timing of expense payments, discounts offered by vendors, vendor payment terms, and fluctuations in foreign exchange rates.
Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, which, at fair value, were $1.4 billion and $1.8 billion at September 30, 2005 and December 31, 2004. Amounts held in foreign currencies were $687 million and $970 million at September 30, 2005 and December 31, 2004, and were primarily Euros, British Pounds, and Yen.
Cash provided by operating activities was $153 million and $117 million for Q3 2005 and Q3 2004 and was $103 million and $9 million for the three quarters ended September 30, 2005 and 2004. Our operating cash flows result primarily from cash received from our customers, third-party sellers, and from non-retail activities such as our Amazon Services’ Merchant.com program, and miscellaneous marketing and promotional agreements, offset by cash payments we make to suppliers of products and services, employee compensation, credit card transaction fees, operating leases, bad debt, and interest payments on our long-term debt obligations. Cash received from customers and third-party sellers generally corresponds to our net sales. Because our customers primarily use credit cards to buy from us, our receivables from customers settle quickly. Cash paid to inventory and transportation suppliers generally corresponds with cost of sales, adjusted for increases or decreases in inventory and payable levels. During Q3 2005, payments to product merchandise suppliers, which do not include payments to transportation suppliers, totaled $1.2 billion, a 24% increase over Q3 2004. Payments to product merchandise suppliers correspond with cost of sales, and are also affected by our efforts to add product categories, increase selection of products we offer for sale, improve availability in both existing and new product categories, and take advantage of additional discounts offered to us by suppliers, and by foreign exchange rates. Cash provided by operating activities in Q3 2005 and the three quarters ended September 30, 2005 were negatively affected by the $40 million patent litigation settlement in Q3 2005. See “Note 7 — Other Operating Expense (Income).”
Cash used in investing activities corresponds with purchases, sales, and maturities of marketable securities, net cash flows from acquisitions, and purchases of fixed assets, including internal-use software and website development costs. Cash used in investing activities was $206 million and $85 million during Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 cash used in investing activities was $547 million and $252 million. Capital expenditures were $76 million and $29 million during Q3 2005 and Q3 2004 and were $149 million and $52 million during the three quarters ended September 30, 2005 and 2004, with the increases reflecting additional investment in development of new features and product offerings on our websites, as well as investments in fulfillment-related assets and technology infrastructure. Capital expenditures included $21 million and $12 million for internal-use software and website development during Q3 2005 and Q3 2004, and $57 million and $29 million for the three quarters ended September 30, 2005 and 2004. Stock-based compensation capitalized for internal-use software and website development costs does not affect cash flows. We purchased certain companies in the three quarters ended September 30, 2005 and 2004 resulting in cash payments, net of acquired cash, of $24 million and $71 million. We believe our expenditures for repairs and improvements are sufficient to keep our facilities and equipment in suitable operating condition.
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Table of ContentsCash provided by financing activities was $30 million and $7 million during Q3 2005 and Q3 2004, and cash used in financing activities was $217 million and $114 million for the three quarters ended September 30, 2005 and 2004. In Q1 2005, we repaid €200 million of our 6.875% PEACS for $265 million. In Q1 2004, we repaid $150 million of our 4.75% Convertible Subordinated Notes for $154 million. Cash inflows from financing activities primarily result from proceeds from exercises of employee stock options, which were $23 million and $8 million for Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 were $42 million and $43 million. We expect cash proceeds from exercises of stock options will decline over time as we continue issuing restricted stock units as our primary vehicle for stock-based awards.
Since our 6.875% PEACS, which are due in 2010, are denominated in Euros, our U.S. Dollar equivalent interest payments and principal obligations fluctuate with the Euro to U.S. Dollar exchange rate. We currently do not hedge our exposure to foreign currency effects on our interest or principal obligations relating to the 6.875% PEACS, and, as a result, any fluctuations in the exchange rate will have an effect on our interest expense and, to the extent we make principal payments, the amount of U.S. Dollar equivalents necessary for principal settlement. Additionally, since our interest payable on our 6.875% PEACS is due in Euros, the balance of interest payable is subject to gains or losses on currency movements until the date of the interest payment. Gains or losses on the remeasurement of our Euro-denominated interest payable are classified as “Other income, net” on our consolidated statements of operations.
The following summarizes our principal contractual commitments as of September 30, 2005:
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Table of ContentsPledged Securities
We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. The amount required to be pledged for real estate lease agreements changes over the life of our leases and with fluctuations in our market capitalization, which is common shares outstanding multiplied by the closing price of our common stock, and based on our credit rating. Information about collateral required to be pledged under these agreements is as follows:
We believe that current cash, cash equivalents, and marketable securities balances will be sufficient to meet our anticipated operating cash needs for at least the next 12 months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See “Additional Factors That May Affect Future Results.” We continually evaluate opportunities to sell additional equity or debt securities, obtain credit facilities from lenders, repurchase common stock, pay dividends, or repurchase, refinance, or otherwise restructure our long-term debt for strategic reasons or to further strengthen our financial position. The sale of additional equity or convertible debt securities would likely be dilutive to our shareholders. In addition, we will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services, and technologies, which might affect our liquidity requirements or cause us to issue additional equity or debt securities. There can be no assurance that additional lines-of-credit or financing instruments will be available in amounts or on terms acceptable to us, if at all.
Results of Operations
We have organized our operations into two principal segments: North America and International. We present our segment information along the same lines that our chief executive reviews our operating results in assessing performance and allocating resources.
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Table of ContentsNet Sales and Gross Profit
Net sales information is as follows:
Revenue growth is due primarily to increased demand driven by increased selection, lower prices, including from our free shipping offers, and improved features and services available on our websites. Revenue growth is also affected by general economic conditions and by changes in exchange rates — see “Effect of Exchange Rates” below. The Q3 2005 and three quarters ended September 30, 2005 growth rates include the effects of the Q3 2005 release of Harry Potter and the Half-Blood Prince, for which we sold over 1.6 million copies during Q3 2005. Additionally, the year-over-year growth rates for the three quarters ended September 30, 2004 were affected by the previous year release of Harry Potter and the Order of the Phoenix, for which we sold over 1.4 million copies in Q2 2003.
North America revenue growth rates for Q3 2005 and the three quarters ended September 30, 2005 were higher than the comparable periods in 2004, which reflects several current-year factors such as our continued efforts to reduce prices for our customers, including from our free shipping offers, additions to our product categories and selection available on our websites, and increases in our Amazon Services’ Merchant.com program and marketing and promotional-related revenues including from our co-branded credit card agreement.
International revenue growth rates for Q3 2005 and the three quarters ended September 30, 2005 were lower than the comparable periods in 2004. This primarily reflects the increasing size of our International business, which creates a larger revenue base against which future growth is measured, offset partially by our customer experience initiatives including new category introductions; increased selection; third-party offerings; and our efforts to reduce prices for our customers, including from our free shipping offers. Additionally, changes in currency exchange rates negatively affected Q3 2005 revenue growth rates, and positively affected growth rates for Q3 2004 and the three quarters ended September 30, 2005 and 2004.
We expect that, over time, our International segment will represent 50% or more of our consolidated total. Additionally, as we continue to offer increased selection, lower prices, and additional product lines in our Electronics and other general merchandise category, we expect to see the relative mix of sales from this category increase. See “Supplemental Information” below.
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Table of ContentsGross profit information is as follows:
The increase in gross profit in absolute terms during Q3 2005 and the three quarters ended September 30, 2005 compared to 2004 corresponds with increases in sales, including increases in sales by third-party sellers, increases in amounts earned from our co-branded credit card agreement, and increases in amounts earned from our Amazon Services’ Merchant.com program, offset by our free shipping offers and lower prices for customers. Generally, our gross margins fluctuate based on several factors, including our product, service, and geographic mix of sales; sales volumes by third-party sellers; changes in vendor pricing, including the extent to which we receive discounts and allowances; lowering prices for customers, including from competitive pricing decisions; improvements in product sourcing and inventory management; and the extent to which our customers accept our free shipping and membership offers. Free shipping and membership offers reduce shipping revenue and reduce our gross margins on retail sales. We view our shipping offers as an effective worldwide marketing tool and intend to continue offering them indefinitely. Amazon Prime, introduced in Q1 2005, is a new shipping membership program in which members receive free two-day shipping and discounted overnight shipping.
Sales of products by third-party sellers on our websites continue to increase, representing 30% and 28% of unit sales in Q3 2005 and Q3 2004, and 29% and 25% in the three quarters ended September 30, 2005 and 2004. Since revenues from these sales are recorded as a net amount, they generally result in lower revenues but higher gross margin per unit. If product sales by third-party sellers continue to increase, the higher gross margin attributes of these sales will offset decreases in our gross margins due to lowering prices for customers over time by offering price reductions, free shipping offers, and promotions.
Gross profit growth is also affected by changes in exchange rates — see “Effect of Exchange Rates” below.
North America segment gross margins in Q3 2005 and the three quarters ended September 30, 2005 improved by 71 basis points and 81 basis points over the comparable periods in 2004 resulting primarily from increases in sales by third-party sellers, increases in amounts earned from our co-branded credit card agreement, and increases in amounts earned from our Amazon Services’ Merchant.com program.
International segment gross margins in Q3 2005 and the three quarters ended September 30, 2005 improved by 47 basis points and 85 basis points over the comparable periods in 2004 resulting from several factors including increasing sales by third-party sellers and increases in discounts we receive from our product suppliers, offset partially by changes in mix of product sales and our efforts to continue reducing prices for customers, including from our year-round free shipping offers.
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Table of ContentsSupplemental Information
Supplemental information about shipping results is as follows:
We believe that offering low prices to our customers is fundamental to our future success. One way we offer lower prices is through free-shipping offers that result in a net cost to us in delivering products, as well as through membership in Amazon Prime. We seek to partially mitigate the costs of lowering prices over time through achieving higher sales volumes, negotiating better terms with our suppliers, and achieving better operating efficiencies, including by reducing split-shipments. In addition, we anticipate that the costs of lowering prices over time will be partially mitigated to the extent product sales by third-party sellers continue to increase.
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Table of ContentsSupplemental information about our net sales is as follows:
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Table of ContentsOperating Expenses
Supplemental Information about Stock-Based Compensation
Prior to January 1, 2005, we accounted for stock-based awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The intrinsic value method of accounting resulted in compensation expense for restricted stock and restricted stock units at fair value on date of grant based on the number of shares granted and the quoted price of our common stock, and for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were subject to an exchange offer, other modifications, or performance criteria, such awards were subject to variable accounting treatment. To the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.
As of January 1, 2005, we adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Such value is recognized as expense over the service period, net of estimated forfeitures, using the accelerated method under SFAS 123(R). The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. Because we implemented SFAS 123(R), we no longer have employee stock awards subject to variable accounting treatment.
The adoption of SFAS 123(R) resulted in a cumulative benefit from accounting change of $26 million in Q1 2005, which reflects the net cumulative impact of estimating forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted.
Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $2 million and $4 million for Q3 2005 and the three quarters ended September 30, 2005. Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based compensation was presented in operating cash flows, along with other tax cash flows, in accordance with the provisions of EITF 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123(R) supersedes EITF 00-15, amends SFAS 95, “Statement of Cash Flows,” and requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows.
On March 29, 2005, the SEC published SAB 107, which provides the SEC staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. We have reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense categories as cash compensation paid to employees.
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Table of ContentsInformation about operating expenses with and without stock-based compensation was as follows:
See Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies — Stock-Based Compensation.”
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Table of ContentsFulfillment
The increase in fulfillment costs in absolute dollars during Q3 2005 and for the three quarters ended September 30, 2005 in comparison with the prior year relates primarily to variable costs corresponding with sales and inventory volumes; our mix of product sales; costs associated with credit card fees; bad debt costs, including costs of our guarantee for certain third-party seller transactions; expanding fulfillment capacity; and stock-based compensation. Fulfillment includes stock-based compensation of $5 million and $2 million for Q3 2005 and Q3 2004, and $13 million and $6 million for the three quarters ended September 30, 2005 and 2004.
Fulfillment costs as a percentage of net sales may vary due to several factors, such as costs associated with bad debt, including costs of our guarantee for certain third-party seller transactions, our level of productivity and accuracy, changes in volume of units received and fulfilled, the extent we utilize fulfillment services provided by third parties, and our ability to reduce customer service contacts per unit by implementing improvements in our operations and enhancements to our customer self-service features. The mix of product sales affects fulfillment costs per shipment based on variations in shape and weight of products we sell. Additionally, since credit card fees associated with third-party seller transactions are based on the gross purchase price of underlying transactions, and bad debt costs associated with these transactions are higher as a percentage of revenue versus our retail sales, our increasing third-party sales have higher fulfillment costs as a percent of net sales.
We expanded our fulfillment capacity in 2004 and the three quarters ended September 30, 2005 through gains in efficiencies as well as increases in leased warehouse space. We plan to continue expanding our world-wide fulfillment capacity in order to meet anticipated shipment volumes from sales of our own products as well as sales by third parties where we provide the fulfillment. We expect absolute amounts spent in fulfillment and fulfillment-related cost of sales to increase over time.
Marketing
We direct customers to our websites primarily through a number of targeted online marketing channels, such as our Associates and Syndicated Stores programs, sponsored search, portal advertising, e-mail campaigns, and other initiatives. Our marketing expenses are largely variable, based on growth in sales and changes in rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing expense. Marketing includes stock-based compensation of $2 million for Q3 2005, and $5 million and $3 million for the three quarters ended September 30, 2005 and 2004. Stock-based compensation included in Marketing in Q3 2004 was not significant.
Marketing costs increased in absolute terms in Q3 2005 and the three quarters ended September 30, 2005 compared to comparable prior year periods. These increases correspond with revenue growth as we utilized variable online marketing channels, such as our Associates program, sponsored search, and other variable marketing initiatives.
While costs associated with free shipping are not included in marketing expense, we view free shipping offers as an effective worldwide marketing tool, and intend to continue offering them indefinitely. We expect absolute amounts spent in marketing to increase over time.
Technology and Content
Our spending in technology and content has primarily increased because we are adding computer scientists and software engineers to continue to enhance the customer experience on our websites and those websites powered by us, to improve our process efficiency, and to continue to invest in several areas of technology including seller platforms, search, web services, and digital initiatives. As we have done throughout the year, we intend to continue investing in areas of technology and content, and expect absolute amounts spent in technology
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Table of Contentsand content to increase over time as we continue to add computer scientists and software engineers to our staff. Technology and content includes stock-based compensation of $13 million and $4 million for Q3 2005 and Q3 2004, and $36 million and $21 million for the three quarters ended September 30, 2005 and 2004.
A significant majority of our technology costs are incurred in the U.S. and most of them are allocated to our North America segment.
General and Administrative
The increase in spending in general and administrative in Q3 2005 and for the three quarters ended September 30, 2005 versus comparable prior year periods is primarily due to increases in payroll and related expenses, professional fees, and legal costs, offset by a $12 million credit in Q3 2005 for actual and expected reimbursement by an insurer of certain legal costs previously incurred by us. General and administrative includes stock-based compensation of $6 million and $3 million for Q3 2005 and Q3 2004, and $17 million and $8 million in the three quarters ended September 30, 2005 and 2004. We expect absolute amounts spent in general and administrative to increase over time.
Other Operating Expense (Income)
In Q3 2005 we settled a patent lawsuit on terms that include, among other things, a one-time payment of $40 million in Q3 2005 that was recorded to “Other operating expense (income)” on the consolidated statements of operations.
In Q3 2004 severance terms were finalized to eliminate certain managerial, professional, clerical and technical positions in France. The corresponding costs of $4 million were recorded in the third quarter of 2004 and classified in “Other operating expense (income)” on the consolidated statements of operations.
“Other operating expense (income)” for the three quarters ended September 30, 2004 includes a gain of $8 million related to the reduction of our restructure-related liability due to our occupation of certain office space previously vacated as part of our 2001 restructuring.
Net Interest Expense
The primary component of our net interest expense is the interest we incur on our long-term debt instruments, including $900 million principal balance of our 4.75% Convertible Subordinated Notes and €490 million ($589 million based on the exchange rate at September 30, 2005) of our 6.875% PEACS at September 30, 2005. Interest expense was $22 million and $26 million in Q3 2005 and Q3 2004, and $70 million and $80 million for the three quarters ended September 30, 2005 and 2004, with declines primarily relating to principal repayments of our long-term debt.
At September 30, 2005, our total long-term debt was $1.5 billion compared to $1.8 billion at September 30, 2004. See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”
We generally invest our excess cash in investment grade short- to intermediate-term fixed income securities and AAA-rated money market mutual funds. Our interest income corresponds with the average balance of invested funds and the prevailing rates we are earning on them, which vary depending on the geographies in which they are invested.
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Table of ContentsRemeasurements and Other
Remeasurements and other consisted of the following:
Income Taxes
Our tax provision for interim periods is determined using an estimate of the annual effective tax rate, with the cumulative effect of a change to the estimated annual rate being recorded in the interim period such a change is made. The Q3 2005 tax provision includes a cumulative adjustment benefit of $4 million, with a corresponding benefit to diluted earnings per share of $0.01, to reflect our current estimate of our annual effective tax rate of 50%. Our effective tax rate for Q3 2005 and for the three quarters ended September 30, 2005 remains higher than the 35% statutory rate associated with taxable income resulting from the Q1 2005 transfer of certain operating assets from the U.S. to international locations. We expect these asset transfers to result in tax expense for financial reporting purposes above the statutory rate throughout 2005 and to beneficially impact our effective tax rate over time. Since we have NOLs, these asset transfers will not have a significant effect on cash taxes paid, which we expect to be approximately $25 million in 2005, compared with $4 million in 2004. Cash paid for income taxes was $6 million and $2 million in Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 was $11 million and $3 million.
At September 30, 2005, approximately $720 million of our gross deferred tax assets were related to approximately $2.3 billion of NOLs. Our NOL deferred tax assets are reduced by a valuation allowance of approximately $510 million due to uncertainty about their future realization. The remainder of our deferred tax assets relate to temporary timing differences between tax and financial reporting. The majority of our NOLs expire after 2016, and utilization of NOLs may be subject to certain limitations under Sections 382 and 1502 of the Internal Revenue Code, and other limitations under state and foreign tax laws.
Net Income
Income before income taxes was $51 million and $57 million for Q3 2005 and Q3 2004, and was $267 million and $ 248 million for the three quarters ended September 30, 2005 and 2004. The year-over-year changes include the effect of the patent lawsuit settlement, which resulted in a one-time payment of $40 million. Net income was $30 million and $54 million for Q3 2005 and Q3 2004, and was $160 million and $242 million for the three quarters ended September 30, 2005 and 2004. The year-over-year declines in net income are primarily
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Table of Contentsrelated to the Q3 2005 patent lawsuit settlement, $20 million net of tax, and the increase in our effective tax rate and corresponding provision for income taxes, which increased $18 million and $128 million for Q3 2005 and the three quarters ended September 30, 2005 in comparison with the prior year periods. See “Income Taxes” above for a discussion of our tax provision.
Effect of Exchange Rates
The effect on our consolidated statements of operations from changes in exchange rates versus the U.S. Dollar is as follows:
Non-GAAP Financial Measure: Free Cash Flow
Regulation G, Conditions for Use of Non-GAAP Financial Measures, and other provisions of the 1934 Act define and prescribe the conditions for use of certain non-GAAP financial information. Our measure of “Free
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Table of Contentscash flow” meets the definition of a non-GAAP financial measure. Free cash flow is used in addition to and in conjunction with results presented in accordance with GAAP and free cash flow should not be relied upon to the exclusion of GAAP financial measures. Free cash flow reflects an additional way of viewing our liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our cash flows. Management strongly encourages investors to review our financial statements and publicly-filed reports in their entirety and to not rely on any single financial measure.
Free cash flow, which we reconcile to “Net cash provided by operating activities,” is cash flow from operations reduced by “Purchases of fixed assets, including internal-use software and website development.” We use free cash flow, and ratios based on it, to conduct and evaluate our business because, although it is similar to cash flow from operations, we believe it is a useful measure of cash flows since purchases of fixed assets are a necessary component of ongoing operations. In limited circumstances in which proceeds from sales of fixed assets exceed purchases, free cash flow would exceed cash flow from operations. However, since we do not anticipate being a net seller of fixed assets, we expect free cash flow to be less than operating cash flows.
Free cash flow has limitations due to the fact that it does not represent the residual cash flow available for discretionary expenditures. For example, free cash flow does not incorporate payments made on capital lease obligations or cash payments for business acquisitions. Therefore, we believe it is important to view free cash flow as a complement to our entire consolidated statements of cash flows.
The following is a reconciliation of free cash flow to the most comparable GAAP measure, “Net cash provided by operating activities” for the trailing twelve months ended September 30, 2005 and 2004 (in millions):
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