10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

Form 10-Q

 


 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2004

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             .

 

Commission File No. 000-22513

 


 

Amazon.com, Inc.

(Exact Name of Registrant as Specified in its Charter)

 


 

Delaware   91-1646860

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

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  ¨

 

408,051,981 shares of common stock, par value $0.01 per share outstanding as of October 14, 2004

 



Table of Contents

AMAZON.COM, INC.

 

FORM 10-Q

For the Three Months Ended September 30, 2004

 

INDEX

 

          Page

     PART I. FINANCIAL INFORMATION     

Item 1.

  

Financial Statements

   3
    

Consolidated Statements of Cash Flows — Three months and nine months ended September 30, 2004 and 2003

   3
    

Consolidated Statements of Cash Flows — Twelve months ended September 30, 2004 and 2003

   4
    

Consolidated Statements of Operations — Three months and nine months ended September 30, 2004 and 2003

   5
    

Consolidated Balance Sheets — September 30, 2004 and December 31, 2003

   6
    

Notes to Consolidated Financial Statements — September 30, 2004

   7

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   23

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   57

Item 4.

  

Controls and Procedures

   58
     PART II. OTHER INFORMATION     

Item 1.

  

Legal Proceedings

   59

Item 2.

  

Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

   59

Item 3.

  

Defaults Upon Senior Securities

   59

Item 4.

  

Submission of Matters to a Vote of Security Holders

   59

Item 5.

  

Other Information

   59

Item 6.

  

Exhibits and Reports on Form 8-K

   60

Signatures

   61

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AMAZON.COM, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Three Months Ended
September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

   $ 701,150     $ 641,728     $ 1,102,273     $ 738,254  

OPERATING ACTIVITIES:

                                

Net income (loss)

     54,147       15,563       241,763       (37,872 )

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

                                

Depreciation of fixed assets, including internal-use software and website development, and other amortization

     19,083       18,338       54,893       57,091  

Stock-based compensation

     9,274       20,936       38,073       72,712  

Other operating expense (income)

     4,505       786       (3,187 )     2,611  

Losses (gains) on sales of marketable securities, net

     220       (141 )     (790 )     (9,393 )

Remeasurements and other

     5,441       11,142       (31,221 )     93,592  

Non-cash interest expense and other

     1,140       1,343       3,402       12,752  

Changes in operating assets and liabilities:

                                

Inventories

     (69,626 )     (62,147 )     (61,172 )     (34,001 )

Accounts receivable, net and other current assets

     (22,868 )     (14,844 )     (15,842 )     18,303  

Accounts payable

     95,529       49,535       (137,853 )     (131,584 )

Accrued expenses and other current liabilities

     8,668       (5,109 )     (58,240 )     (99,312 )

Additions to unearned revenue

     33,707       29,932       84,469       78,652  

Amortization of previously unearned revenue

     (27,029 )     (27,816 )     (76,154 )     (85,719 )

Interest payable

     4,454       (701 )     (29,148 )     (26,773 )
    


 


 


 


Net cash provided by (used in) operating activities

     116,645       36,817       8,993       (88,941 )

INVESTING ACTIVITIES:

                                

Sales and maturities of marketable securities and other investments

     395,087       21,988       1,007,411       581,011  

Purchases of marketable securities

     (380,651 )     (71,880 )     (1,136,032 )     (414,194 )

Purchases of fixed assets, including internal-use software and website development

     (28,722 )     (15,192 )     (52,378 )     (28,727 )

Proceeds from sale of subsidiary and other

     —         5,072       —         5,072  

Acquisition, net of cash acquired

     (71,195 )     —         (71,195 )     —    
    


 


 


 


Net cash provided by (used in) investing activities

     (85,481 )     (60,012 )     (252,194 )     143,162  

FINANCING ACTIVITIES:

                                

Proceeds from exercises of stock options and other

     7,727       41,235       42,618       132,832  

Repayments of long-term debt, capital lease obligations, and other

     (550 )     (3,437 )     (156,842 )     (287,576 )
    


 


 


 


Net cash provided by (used in) financing activities

     7,177       37,798       (114,224 )     (154,744 )

Foreign-currency effect on cash and cash equivalents

     6,117       10,087       760       28,687  
    


 


 


 


Net increase (decrease) in cash and cash equivalents

     44,458       24,690       (356,665 )     (71,836 )
    


 


 


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 745,608     $ 666,418     $ 745,608     $ 666,418  
    


 


 


 


SUPPLEMENTAL CASH FLOW INFORMATION:

                                

Fixed assets acquired under capital leases and other financing arrangements

   $ 135     $ 1,572     $ 658     $ 2,648  

Cash paid for interest

     21,497       30,019       107,565       116,835  

Cash paid for income taxes

     1,651       1,019       2,659       1,628  

 

See accompanying notes to consolidated financial statements.

 

3


Table of Contents

AMAZON.COM, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

    

Twelve Months Ended

September 30,


 
     2004

    2003

 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

   $ 666,418     $ 327,564  

OPERATING ACTIVITIES:

                

Net income (loss)

     314,917       (35,221 )

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                

Depreciation of fixed assets, including internal-use software and website development, and other amortization

     73,360       76,955  

Stock-based compensation

     53,112       108,392  

Other operating expense (income)

     (3,046 )     4,624  

Gains on sales of marketable securities, net

     (995 )     (11,260 )

Remeasurements and other

     5,284       134,888  

Non-cash interest expense and other

     3,568       19,902  

Changes in operating assets and liabilities:

                

Inventories

     (103,957 )     (82,369 )

Accounts receivable, net and other current assets

     (33,840 )     16,775  

Accounts payable

     161,463       131,254  

Accrued expenses and other current liabilities

     15,332       (57,366 )

Additions to unearned revenue

     107,458       98,415  

Amortization of previously unearned revenue

     (102,175 )     (123,444 )

Interest payable

     (525 )     2,093  
    


 


Net cash provided by operating activities

     489,956       283,638  

INVESTING ACTIVITIES:

                

Sales and maturities of marketable securities and other investments

     1,239,584       733,768  

Purchases of marketable securities

     (1,257,480 )     (587,714 )

Purchases of fixed assets, including internal-use software and website development

     (69,614 )     (44,243 )

Proceeds from sale of subsidiary and other

     —         5,072  

Acquisition, net of cash acquired

     (71,195 )     —    
    


 


Net cash provided by (used in) investing activities

     (158,705 )     106,883  

FINANCING ACTIVITIES:

                

Proceeds from exercises of stock options and other

     73,108       198,208  

Repayments of long-term debt, capital lease obligations, and other

     (364,574 )     (290,250 )
    


 


Net cash used in financing activities

     (291,466 )     (92,042 )

Foreign-currency effect on cash and cash equivalents

     39,405       40,375  
    


 


Net increase in cash and cash equivalents

     79,190       338,854  
    


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 745,608     $ 666,418  
    


 


SUPPLEMENTAL CASH FLOW INFORMATION:

                

Fixed assets acquired under capital leases and other financing arrangements

   $ 687     $ 3,374  

Cash paid for interest

     110,677       117,477  

Cash paid for income taxes

     2,856       1,613  

 

See accompanying notes to consolidated financial statements.

 

4


Table of Contents

AMAZON.COM, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 

Net sales

   $ 1,462,475     $ 1,134,456     $ 4,380,165     $ 3,317,927  

Cost of sales

     1,106,824       848,635       3,322,634       2,487,596  
    


 


 


 


Gross profit

     355,651       285,821       1,057,531       830,331  

Operating expenses:

                                

Fulfillment

     135,521       107,057       385,943       318,217  

Marketing

     34,347       28,943       99,822       82,496  

Technology and content

     64,823       53,775       178,374       155,998  

General and administrative

     25,907       22,393       80,523       65,318  

Stock-based compensation (1)

     9,274       20,936       38,073       72,712  

Other operating expense (income)

     4,505       786       (3,187 )     2,611  
    


 


 


 


Total operating expenses

     274,377       233,890       779,548       697,352  
    


 


 


 


Income from operations

     81,274       51,931       277,983       132,979  

Interest income

     7,553       4,324       18,419       16,625  

Interest expense

     (26,307 )     (29,802 )     (80,093 )     (100,680 )

Other income (expense), net

     (2,932 )     252       (5,767 )     6,796  

Remeasurements and other

     (5,441 )     (11,142 )     31,221       (93,592 )
    


 


 


 


Total non-operating expense, net

     (27,127 )     (36,368 )     (36,220 )     (170,851 )
    


 


 


 


Net income (loss)

   $ 54,147     $ 15,563     $ 241,763     $ (37,872 )
    


 


 


 


Basic earnings (loss) per share

   $ 0.13     $ 0.04     $ 0.60     $ (0.10 )
    


 


 


 


Diluted earnings (loss) per share

   $ 0.13     $ 0.04     $ 0.57     $ (0.10 )
    


 


 


 


Weighted average shares used in computation of earnings (loss) per share:

                                

Basic

     406,647       397,912       405,153       393,477  
    


 


 


 


Diluted

     424,777       422,802       423,924       393,477  
    


 


 


 



(1)    Components of stock-based compensation:

                                

Fulfillment

   $ 2,001     $ 4,374     $ 6,294     $ 16,221  

Marketing

     67       1,582       2,770       4,167  

Technology and content

     4,408       12,013       20,541       39,807  

General and administrative

     2,798       2,967       8,468       12,517  
    


 


 


 


     $ 9,274     $ 20,936     $ 38,073     $ 72,712  
    


 


 


 


 

See accompanying notes to consolidated financial statements.

 

5


Table of Contents

AMAZON.COM, INC.

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

    

September 30,

2004


    December 31,
2003


 
     (unaudited)        
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 745,608     $ 1,102,273  

Marketable securities

     439,092       292,550  
    


 


Cash, cash equivalents, and marketable securities

     1,184,700       1,394,823  

Inventories

     357,320       293,917  

Accounts receivable, net and other current assets

     150,764       132,069  
    


 


Total current assets

     1,692,784       1,820,809  

Fixed assets, net

     226,762       224,285  

Goodwill

     137,584       69,121  

Other assets

     51,538       47,818  
    


 


Total assets

   $ 2,108,668     $ 2,162,033  
    


 


LIABILITIES AND STOCKHOLDERS’ DEFICIT                 

Current liabilities:

                

Accounts payable

   $ 688,297     $ 819,811  

Accrued expenses and other current liabilities

     269,178       317,730  

Unearned revenue

     46,144       37,844  

Interest payable

     43,952       73,100  

Current portion of long-term debt and other

     3,452       4,216  
    


 


Total current liabilities

     1,051,023       1,252,701  

Long-term debt and other

     1,778,722       1,945,439  

Commitments and contingencies

                

Stockholders’ deficit:

                

Preferred stock, $0.01 par value:

                

Authorized shares — 500,000
Issued and outstanding shares — none

     —         —    

Common stock, $0.01 par value:

                

Authorized shares — 5,000,000
Issued and outstanding shares — 407,464 and 403,354 shares

     4,075       4,034  

Additional paid-in capital

     1,981,659       1,899,398  

Deferred stock-based compensation

     (2,529 )     (2,850 )

Accumulated other comprehensive income

     28,383       37,739  

Accumulated deficit

     (2,732,665 )     (2,974,428 )
    


 


Total stockholders’ deficit

     (721,077 )     (1,036,107 )
    


 


Total liabilities and stockholders’ deficit

   $ 2,108,668     $ 2,162,033  
    


 


 

See accompanying notes to consolidated financial statements.

 

6


Table of Contents

AMAZON.COM, INC.

 

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 the year ending December 31, 2004 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 Annual Report on Form 10-K for the year ended December 31, 2003. 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 and its wholly-owned subsidiaries. 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, inventory valuation, depreciable lives, sales returns, receivables valuation, restructuring-related liabilities, incentive discount offers, valuation of investments, acquired intangibles, taxes, and contingencies. Actual results could differ materially from those estimates.

 

Business Acquisition

 

On September 7, 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 $74.2 million, including a cash payment of $72.4 million, the assumption of employee stock options, and transaction-related costs. Acquired intangibles were $5.9 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 $68.4 million and is classified as “Goodwill” on the consolidated balance sheets. The results of operations of Joyo.com have been included in our consolidated results from the acquisition date forward. The effect on consolidated net sales and operating income was not significant for the third quarter of 2004.

 

Joyo.com does not own any capital stock of the PRC affiliates, but is the primary beneficiary of future losses or profits through contractual rights. As a result, we consolidate the results of the PRC affiliates in accordance with FIN 46R, “Consolidation of Variable Interest Entities.” The net assets and operating results for the PRC affiliates were not significant.

 

The intrinsic value of the unvested employee stock options that were assumed in connection with the Joyo.com acquisition is recorded to “Deferred stock-based compensation” on the consolidated balance sheets and will be expensed over the remaining service period. Amortization of these amounts is classified in “Stock-based compensation” on the consolidated statements of operations.

 

7


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

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 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.

 

Goodwill

 

We have elected to perform our annual analysis of goodwill during the fourth quarter of each year. Based on our 2003 analysis, no impairments were present, and no indicators of impairment were identified during the nine months ended September 30, 2004.

 

Other Assets

 

Included in “Other assets” on our consolidated balance sheets are amounts primarily related to deferred issuance charges on our long-term debt, which are amortized over the life of the debt; certain equity investments; and intangible assets, net of amortization. At September 30, 2004 and December 31, 2003, deferred issuance charges were $20 million and $25 million; and equity investments were $12 million and $15 million; and intangibles, net of amortization, were $6 million and $0.5 million.

 

Other intangibles consist of the following:

 

     September 30, 2004

   December 31, 2003

    

Other

Intangibles
Gross


   Accumulated
Amortization


   

Other

Intangibles
Net (1)


  

Other

Intangibles
Gross


   Accumulated
Amortization


   

Other

Intangibles

Net


     (in thousands)

Contract-based

   $ 15,972    $ (13,509 )   $ 2,463    $ 13,469    $ (13,469 )   $ —  

Marketing-related

     8,821      (5,626 )     3,195      5,617      (5,326 )     291

Technology-based

     4,607      (4,396 )     211      4,386      (4,360 )     26

Customer-based

     2,021      (1,984 )     37      2,021      (1,820 )     201
    

  


 

  

  


 

Other intangibles

   $ 31,421    $ (25,515 )   $ 5,906    $ 25,493    $ (24,975 )   $ 518
    

  


 

  

  


 


(1) The net carrying amount of intangible assets at September 30, 2004 is scheduled to be fully amortized over the next four years as follows: $0.6 million for the remainder of 2004; $1.7 million in 2005; $1.4 million in 2006; $1.3 million in 2007; and $0.9 million in 2008. The weighted-average amortization period is 3.6 years based on useful life assumptions between one and four years.

 

Income Taxes

 

We have provided for current and deferred U.S. federal, state, and foreign income taxes for all periods presented. Current and deferred income taxes were provided with respect to jurisdictions where certain of our subsidiaries produce taxable income. As of September 30, 2004, we have recorded a net deferred tax asset of $6 million, classified in “Other assets,” which consists of certain state jurisdiction net operating loss carryforwards. We have provided a valuation allowance for the remainder of our deferred tax asset, consisting primarily of net operating loss carryforwards, because of uncertainty regarding its realization.

 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

At September 30, 2004, we have net operating loss carryforwards (“NOLs”) of $2.8 billion, primarily related to U.S. federal taxes. Utilization of NOLs, which begin to expire at various times starting in 2010, may be subject to certain limitations. Approximately $1 billion of our NOLs are attributable to continuing operations and the related tax benefits, if realized, will be credited to results of operations for both financial reporting and tax reporting purposes. The remaining portion of approximately $1.8 billion relates to tax deductible stock-based compensation in excess of amounts recognized for financial reporting purposes and the related tax benefits, if realized, will be credited to stockholders’ equity rather than to results of operations for financial reporting purposes.

 

Additionally, we have approximately $228 million of capital loss carryforwards that begin to expire in 2005.

 

Revenue

 

Product sales, net of promotional discounts, rebates, and return allowances, are recorded when the products are shipped and title passes to customers. Retail sales to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss upon our delivery to the carrier, which is commonly referred to as “F.O.B. Shipping Point.” Return allowances, which reduce product revenue, are estimated using historical experience.

 

Commissions and per-unit fees received from third-party sellers and similar amounts earned through our Merchant.com program are recognized when the item is sold by the third-party seller and our collectibility is reasonably assured. We record an allowance for estimated refunds on such commissions using historical experience. We also record an allowance, using historical experience, for losses we incur on our payment guarantee from disputes by customers against third-party sellers.

 

Outbound shipping charges to customers are included in “Net sales” and amounted to $87 million and $77 million for the three months ended September 30, 2004 and 2003, and $264 million and $235 million for the nine months ended September 30, 2004 and 2003.

 

Cost of Sales

 

Cost of sales consists of the purchase price of consumer products sold by us, inbound and outbound shipping charges to us, packaging supplies, and costs incurred in operating and staffing our fulfillment and customer service centers on behalf of other businesses, such as Toysrus.com and Target. All credit card fees and bad debt costs, including those associated with our guarantee for certain third-party seller transactions, are classified in “Fulfillment” on the consolidated statements of operations.

 

Outbound shipping-related costs totaled $128 million and $104 million for the three months ended September 30, 2004 and 2003, and $383 million and $315 million for the nine months ended September 30, 2004 and 2003.

 

Vendor Agreements

 

We have agreements to receive cash consideration from certain of our vendors, including rebates and cooperative marketing reimbursements. We generally presume amounts received from our vendors are a reduction of the prices we pay for their products, and therefore, we reflect such amounts as either a reduction of “Cost of sales” on our consolidated statements of operations, or, if the product inventory is still on hand at the reporting date, it is reflected as a reduction of “Inventories” on our consolidated balance sheets. When we receive direct reimbursements for costs incurred by us in advertising the vendor’s product or service, the amount we receive is recorded as an offset to “Marketing” on our consolidated statements of operations.

 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Vendor rebates are typically dependent upon reaching minimum purchase thresholds. We evaluate the likelihood of reaching purchase thresholds using past experience and current year forecasts. When rebates can be reasonably estimated, we record a portion of the rebate as we make progress towards the purchase threshold.

 

Depreciation of Fixed Assets

 

Fixed assets are depreciated on a straight-line basis over the estimated useful lives of the assets (generally two to ten years). Depreciation expense is classified within the corresponding operating expense categories on the consolidated statements of operations. Depreciation expense on fixed assets, including internal-use software and website development, was $19 million and $54 million for the three months and nine months ended September 30, 2004, and $18 million and $52 million for the three months and nine months ended September 30, 2003.

 

Stock-Based Compensation

 

Stock-based compensation consisted of the following:

 

    

Three Months Ended

September 30,


  

Nine Months Ended

September 30,


     2004

    2003

   2004

   2003

     (in thousands)

Stock awards — variable accounting (1)

   $ (5,722 )   $ 10,449    $ 649    $ 46,172

Fixed accounting (2):

                            

Restricted stock units and stock options

     14,076       9,323      33,836      22,493

Restricted stock (3)

     920       1,164      3,588      4,047
    


 

  

  

Total stock-based compensation

   $ 9,274     $ 20,936    $ 38,073    $ 72,712
    


 

  

  


(1) Variable accounting treatment results in expense or contra-expense recognition using the cumulative expense method, calculated based on the quoted price of our common stock and vesting schedules of underlying awards.
(2) The fair value of awards is determined at grant date and recognized as expense over the service period. To the extent awards are forfeited prior to vesting, the corresponding previously recognized expense is reversed as an offset to stock-based compensation.
(3) Includes expense associated with matching contributions of 15,651 and 51,901 shares of our common stock under our 401(k) savings plan during the three and nine months ended September 30, 2004, and 11,229 and 26,354 shares of our common stock during the three and nine months ended September 30, 2003.

 

We granted stock awards, primarily restricted stock units, representing 0.7 million and 0.3 million shares of common stock during the three months ended September 30, 2004 and 2003, and 2.7 million and 2.0 million shares of common stock during the nine months ended September 30, 2004 and 2003. The per share weighted average fair value of stock awards, including restricted stock units, granted was $40.12 and $41.78 during the three months ended September 30, 2004 and 2003, and $44.59 and $27.90 during the nine months ended September 30, 2004 and 2003. Stock-based awards generally fully vest over service periods of between three and six years.

 

Common shares outstanding (which includes restricted stock), plus shares underlying outstanding stock options and restricted stock units totaled 434 million and 433 million at September 30, 2004 and 2003. Common shares outstanding increased by 0.8 million shares during the three months ended September 30, 2004, and 4.1 million shares during the nine months ended September 30, 2004, due to exercises of stock options, vesting of restricted stock units, and matching contributions under our 401(k) savings plan.

 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Outstanding stock awards were as follows:

 

     September 30,

     2004

   2003

     (in thousands)

Stock options (1)(2)

   20,319    27,841

Restricted stock units (3)

   6,368    4,694
    
  

Outstanding stock awards, excluded from common stock outstanding

   26,687    32,535

Restricted stock (4)

   490    831
    
  

Total outstanding stock awards

   27,177    33,366
    
  

(1) The weighted average per share exercise price was $12.90 and $12.37 at September 30, 2004 and 2003.
(2) Includes 1.0 million and 0.9 million options at September 30, 2004 and 2003 subject to variable accounting treatment.
(3) Includes 0.4 million and 0.3 million restricted stock units subject to variable accounting treatment at September 30, 2004 and 2003.
(4) Included in issued and outstanding common stock.

 

The following table summarizes relevant information as if the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, had been applied to all stock-based awards (in thousands, except per share data):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 

Net income (loss) — as reported

   $ 54,147     $ 15,563     $ 241,763     $ (37,872 )

Add: Stock-based compensation, as reported

     9,274       20,936       38,073       72,712  

Deduct: Total stock-based compensation determined under fair value based method for all awards

     (21,995 )     (22,449 )     (60,450 )     (72,525 )
    


 


 


 


Net income (loss) — SFAS No. 123 adjusted

   $ 41,426     $ 14,050     $ 219,386     $ (37,685 )
    


 


 


 


Basic earnings (loss) per share — as reported

   $ 0.13     $ 0.04     $ 0.60     $ (0.10 )

Diluted earnings (loss) per share — as reported

     0.13       0.04       0.57       (0.10 )

Basic earnings (loss) per share — SFAS No. 123 adjusted

     0.10       0.04       0.54       (0.10 )

Diluted earnings (loss) per share — SFAS No. 123 adjusted

     0.10       0.03       0.52       (0.10 )

 

The fair value for restricted stock and restricted stock units is based on the intrinsic value of those awards at grant date. The fair value for option awards is estimated at the date of grant using a Black-Scholes option-pricing model, assuming no dividends and the following assumptions:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Average risk-free interest rate

   2.9 %   2.1 %   2.6 %   2.5 %

Average expected life (in years)

   3.3     3.3     3.3     3.3  

Volatility

   53.3 %   73.2 %   58.0 %   78.3 %

 

11


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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Restructuring Estimates

 

Restructuring-related liabilities include estimates for, among other things, anticipated disposition of lease obligations. Key variables in determining such estimates include anticipated timing of sublease rentals, estimates of sublease rental payment amounts and tenant improvement costs, and estimates for brokerage and other related costs. We periodically evaluate and, if necessary, adjust our estimates based on currently-available information. Additionally, we may determine that certain of the office space previously vacated as part of our 2001 restructuring, which we have been unable to sublease due to poor real estate market conditions, may be necessary for our future needs. To the extent we elect to utilize this office space, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, we will adjust our restructuring-related liability and classify future payments to the corresponding operating expense categories on the consolidated statements of operations. See “Note 6 — Other Operating Expense (Income).”

 

Foreign Currency

 

A provision of SFAS No. 52, Foreign Currency Translation, requires that gains and losses arising from intercompany foreign currency transactions considered long-term investments, where settlement is not planned or anticipated in the foreseeable future, be excluded in the determination of net income. Our international operations are financed, in part, by the U.S. parent company. In periods ending prior to the fourth quarter of 2003, currency adjustments for these intercompany balances were recorded to stockholders’ deficit as translation adjustments and not included in the determination of net income because we intended to permanently invest such amounts. During the fourth quarter of 2003, we made the decision that these amounts would be repaid among the entities and, accordingly, upon consolidation, any exchange gain or loss arising from remeasurements of intercompany balances is required to be recorded in the determination of net income. In accordance with SFAS No. 52, currency adjustments arising before the fourth quarter of 2003 continue to be included as a component of “Accumulated other comprehensive income” on our consolidated balance sheets. In connection with the remeasurement of intercompany balances, we recorded a gain of $7 million for the three months ended September 30, 2004, and a loss of $3 million for the nine months ended September 30, 2004. During the nine months ended September 30, 2004, $192 million was repaid among the entities.

 

Earnings (Loss) per Share

 

In accordance with SFAS No. 128, Earnings per Share, the weighted-average number of shares used to calculate basic earnings (loss) per share excludes shares of restricted stock since they are subject to repurchase or forfeiture.

 

For periods when we have net income, the dilutive effect of outstanding stock awards, including restricted stock, is included in the calculation of diluted earnings per share using the treasury stock method for assumed proceeds, if any. For periods when we have a net loss, the effect of outstanding stock awards, including restricted stock, is antidilutive and therefore excluded from the calculation of diluted loss per share.

 

Stock issuable upon conversion of our convertible debt instruments is excluded from the calculation of diluted earnings per share as its effect is antidilutive. See “Note 3 — Long-Term Debt and Other.”

 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Note 2 — Cash, Cash Equivalents, and Marketable Securities

 

The following table summarizes, by major security type, our cash, cash equivalents, and marketable securities at fair value:

    

September 30,

2004


  

December 31,

2003


       
     (in thousands)

Cash

   $ 195,172    $ 427,306

Cash equivalents pledged as collateral (See Note 4)

     8,536      —  

Commercial paper and short-term securities (1)

     541,900      674,967
    

  

Cash and cash equivalents

     745,608      1,102,273

U.S. Treasury notes and bonds

     186,819      145,778

Asset-backed and agency securities

     116,196      85,692

Certificates of deposit

     98,614      27,395

Corporate notes and bonds

     27,378      24,997

Commercial paper and short-term securities

     2,076      94

Equity securities

     8,009      8,594
    

  

Marketable securities (1)

     439,092      292,550
    

  

Total cash, cash equivalents, and marketable securities (2)

   $ 1,184,700    $ 1,394,823
    

  


(1) At September 30, 2004, gross unrealized losses were not significant.
(2) Includes amounts held in foreign currencies of $693 million and $764 million at September 30, 2004 and December 31, 2003. Amounts held in foreign currencies at September 30, 2004 and December 31, 2003 were primarily Euros, British Pounds, and Yen.

 

We are required to pledge a portion of our marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations and for 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:

 

    

September 30,

2004


   

December 31,

2003


 
     (in thousands)  

4.75% Convertible Subordinated Notes due February 2009 (1)(2)

   $ 899,760     $ 1,049,760  

6.875% PEACS due February 2010 (3)

     858,084       869,711  

Long-term restructuring liabilities (see Note 6)

     10,750       20,066  

Capital lease obligations

     1,907       2,717  

Other long-term debt

     11,673       7,401  
    


 


       1,782,174       1,949,655  

Less current portion of capital lease obligations

     (1,238 )     (1,558 )

Less current portion of other long-term debt

     (2,214 )     (2,658 )
    


 


Total long-term debt and other

   $ 1,778,722     $ 1,945,439  
    


 



(1)

During the nine months ended September 30, 2004, we redeemed an aggregate principal amount of $150 million of our outstanding 4.75% Convertible Subordinated Notes due February 2009 (“4.75% Convertible Subordinated Notes”). As provided in the underlying indenture, the redemption price of $154 million included a $4 million (2.375%) premium over the face amount of the redeemed notes. We recorded a charge

 

13


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

 

in the first quarter of 2004, classified in “Remeasurements and other,” of approximately $6 million related to the redemption, consisting of the $4 million premium and approximately $2 million in unamortized deferred issuance charges. Accrued and unpaid interest of $0.5 million, from February 1, 2004 through February 25, 2004, was also paid at redemption and recorded to “Interest expense.”

(2) The 4.75% Convertible Subordinated Notes are convertible into our common stock at the holders’ option at a conversion price of $78.0275 per share. Total common stock issuable upon conversion of our outstanding 4.75% Convertible Subordinated Notes is 11.5 million shares. We have the right to redeem the 4.75% Convertible Subordinated Notes, in whole or in part, by paying the principal and a premium of 2.375% of the principal, as of September 30, 2004, which decreases by 47.5 basis points on February 1 of each year until maturity, plus any accrued and unpaid interest.
(3) The 6.875% Premium Adjustable Convertible Securities due February 2010 (“6.875% PEACS”) are convertible into our common stock at the holders’ option at a conversion price of 84.883 Euros per share ($105.56, based on the exchange rate as of September 30, 2004). Total common stock issuable upon conversion of our outstanding 6.875% PEACS is 8.1 million shares. The U.S. Dollar equivalent principal, interest, and conversion price fluctuates based on the Euro/U.S. Dollar exchange ratio. We have the right to redeem the 6.875% PEACS, in whole or in part, by paying the principal, plus any accrued and unpaid interest. No premium payment is required for early redemption.

 

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 $14 million and $13 million for the three months ended September 30, 2004 and 2003, and $41 million and $39 million for the nine months ended September 30, 2004 and 2003.

 

The following summarizes our principal contractual commitments, excluding open orders for inventory purchases that support normal operations, as of September 30, 2004:

 

   

Three Months

Ending

December 31,

2004


  2005

  2006

  2007

  2008

  Thereafter

  Total

    (in thousands)

Operating and capital commitments:

                                         

Debt principal and other (1)

  $ 330   $ 128   $ 1,247   $ 340   $ 351   $ 1,773,483   $ 1,775,879

Debt interest (1)

    —       108,857     108,857     108,857     108,857     142,918     578,346

Capital leases

    385     1,178     420     20     —       —       2,003

Operating leases (2)

    14,857     57,040     59,876     51,596     49,307     217,483     450,159
   

 

 

 

 

 

 

Total operating and capital commitments

    15,572     167,203     170,400     160,813     158,515     2,133,884     2,806,387
   

 

 

 

 

 

 

Restructuring-related commitments:

                                         

Operating leases, net of estimated sublease
income

    863     6,993     1,999     1,961     1,614     2,952     16,382

Other

    3,902     1,201     —       —       —       —       5,103
   

 

 

 

 

 

 

Total restructuring-related commitments

    4,765     8,194     1,999     1,961     1,614     2,952     21,485
   

 

 

 

 

 

 

Total commitments

  $ 20,337   $ 175,397   $ 172,399   $ 162,774   $ 160,129   $ 2,136,836   $ 2,827,872
   

 

 

 

 

 

 

 

14


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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 


(1) The principal payment due in 2010 and the annual interest payments due under our 6.875% PEACS fluctuate based on the Euro/U.S. Dollar exchange ratio. At September 30, 2004, the Euro to U.S. Dollar exchange rate was 1.2436. Due to fluctuations in the Euro/U.S. Dollar exchange ratio, which we cannot predict, our principal debt obligation under this instrument since issuance in February 2000 has increased by $178 million as of September 30, 2004.
(2) Pursuant to SFAS No. 13, Accounting for Leases, lease agreements are categorized at their inception as either operating or capital leases depending on certain defined criteria. Although operating leases represent obligations for us, pursuant to SFAS No. 13 they are not reflected on the balance sheet. As of September 30, 2004, we have remaining obligations under operating leases for equipment and real estate of $450 million. If we had applied to our operating leases the same convention used for capital leases, which, however, would not be in accordance with GAAP, we would have recorded approximately $323 million of additional assets and obligations on our balance sheet at September 30, 2004.

 

See “Note 6 — Operating Expense (Income)” for additional information on restructuring-related lease obligations.

 

Pledged Securities

 

We are required to pledge a portion of our marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations and for 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 credit-rating. The change in the total amount of collateral required to be pledged under these agreements is as follows:

 

    

Standby

Letters of

Credit (1)


   

Real Estate

Leases (2)


   Total

 
     (in thousands)  

Balance at December 31, 2003

   $ 60,799     $ 25,936    $ 86,735  

Net change in collateral pledged

     (12,758 )     1,995      (10,763 )
    


 

  


Balance at September 30, 2004 (3)

   $ 48,041     $ 27,931    $ 75,972  
    


 

  



(1) Pursuant to available standby letter-of-credit facilities totaling $151 million.
(2) At September 30, 2004, our market capitalization was $16.6 billion. The required amount of collateral to be pledged increases $6 million if our market capitalization is equal to or below $13 billion, and decreases by $5 million if our market capitalization exceeds $18 billion.
(3) Includes $9 million of cash equivalents pledged as collateral. See “Note 2 — Cash, Cash Equivalents, and Marketable Securities.”

 

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”). On August 1, 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 recissionary and/or compensatory damages and injunctive relief against all defendants. We dispute the allegations of wrongdoing in these complaints and intend to vigorously defend ourselves in these matters.

 

15


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

On October 29, 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 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.

 

On July 17, 2003, Pinpoint, Inc. filed a complaint for patent infringement in the United States District Court for the Northern District of Illinois against us and several other companies with which we have commercial agreements. The complaint alleges that our personalization technology infringes several patents obtained by Pinpoint and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, and attorneys’ fees against all defendants. We dispute the allegations of wrongdoing in this complaint and intend to vigorously defend ourselves in this matter.

 

On January 12, 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 alleges that our website technology infringes 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 seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, treble damages for alleged willful infringement, prejudgment interest, and attorneys’ fees. On October 6, 2004, Soverain filed an amended complaint alleging that we infringe 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). We dispute the allegations of wrongdoing in this complaint and intend to vigorously defend ourselves in this matter.

 

On January 22, 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. On August 25, 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.

 

16


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

In April 2004, we learned that the French authorities are investigating our DVD sales practices in France, and we are cooperating.

 

On May 21, 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 and either monetary damages of an unspecified amount or rescission of the commercial agreement and return of specific amounts paid under the agreement totaling $200 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 intend to vigorously defend ourselves in this matter.

 

On September 14, 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.

 

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 — Comprehensive Income (Loss)

 

Comprehensive income (loss) was as follows:

 

    

Three Months Ended

September 30,


  

Nine Months Ended

September 30,


 
     2004

    2003

   2004

    2003

 
     (in thousands)  

Net income (loss)

   $ 54,147     $ 15,563    $ 241,763     $ (37,872 )

Foreign currency translation gains (losses), net

     (2,757 )     8,174      686       21,537  

Net unrealized gains (losses) on available-for-sale securities

     1,273       2,457      (11,370 )     (4,898 )

Net activity of Euro Currency Swap (1)

     450       422      1,328       10,460  
    


 

  


 


Other comprehensive income (loss)

     (1,034 )     11,053      (9,356 )     27,099  
    


 

  


 


Comprehensive income (loss)

   $ 53,113     $ 26,616    $ 232,407     $ (10,773 )
    


 

  


 


 

Accumulated balances within other comprehensive income were as follows:

 

    

September 30,

2004


   

December 31,

2003


 
     (in thousands)  

Net unrealized gains on foreign currency translation

   $ 31,136     $ 30,450  

Net unrealized gains on available-for-sale securities

     8,957       20,327  

Net unrealized losses on Euro Currency Swap

     (11,710 )     (13,038 )
    


 


Total accumulated other comprehensive income

   $ 28,383     $ 37,739  
    


 


 

17


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 


(1) Due to the termination in 2003 of our currency swap to hedge a portion of our 6.875% PEACS (“Euro Currency Swap”), future reclassifications of cumulative losses on the Euro Currency Swap from “Accumulated other comprehensive income” to “Remeasurements and other” will be recorded using the effective interest method over the remaining life of the 6.875% PEACS.

 

Note 6 — Other Operating Expense (Income)

 

Included in “Other operating expense (income)” are restructuring-related expenses and amortization of other intangibles. Amortization of other intangibles was $0.3 million and $0.8 million for the three months ended September 30, 2004 and 2003, and $0.5 million and $2.6 million for the nine months ended September 30, 2004 and 2003.

 

During the first and second quarters of 2004, we determined that certain of the office space previously vacated as part of our 2001 restructuring, which we had been unable to sublease due to poor real estate market conditions, was necessary for our future needs. In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, we reduced our restructuring-related liability, resulting in a gain of $8 million for the nine months ended September 30, 2004 ($1 million in the first quarter and $7 million in the second quarter). Lease payments for this office space are expensed over the lease period and classified to the corresponding operating expense categories on the consolidated statements of operations. No restructuring-related amounts were recorded during the nine months ended September 30, 2003.

 

As previously disclosed, we streamlined our organizational structure in France to reduce our operating costs. These efforts were primarily focused on eliminating French-office positions in managerial, professional, clerical and technical roles. The number of employees affected totaled 52 and severance terms were finalized in the third quarter of 2004 and will be paid in the fourth quarter of 2004. 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.

 

At September 30, 2004, the accrued liability associated with restructuring-related and other charges was $21 million and consisted of the following:

 

   

Balance at

December 31,

2003


 

Subsequent

Accruals

(Credits), net


    Payments

   

Balance at

September 30,

2004


 

Due Within

12 Months (1)


 

Due After

12 Months (1)


    (in thousands)

Lease obligations, net of estimated sublease income

  $ 29,343   $ (8,160 )   $ (4,801 )   $ 16,382   $ 5,968   $ 10,414

Termination benefits

    —       4,352       (450 )     3,902     3,902     —  

Broker commissions, professional fees and other miscellaneous restructuring costs

    1,197     82       (78 )     1,201     865     336
   

 


 


 

 

 

Total restructuring-related liability

  $ 30,540   $ (3,726 )   $ (5,329 )   $ 21,485   $ 10,735   $ 10,750
   

 


 


 

 

 


(1) Restructuring-related liabilities due within 12 months are classified in “Accrued expenses and other current liabilities” and liabilities due after 12 months are classified in “Long-term debt and other” on our consolidated balance sheets.

 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Restructuring-related lease obligations are as follows:

 

   

Three Months

Ending

December 31,
2004


    2005

    2006

    2007

    2008

    Thereafter

    Total

 
    (in thousands)  

Gross lease obligations

  $ 1,605     $ 10,197     $ 6,155     $ 6,158     $ 5,319     $ 11,742     $ 41,176  

Estimated sublease income (1)

    (742 )     (3,204 )     (4,156 )     (4,197 )     (3,705 )     (8,790 )     (24,794 )
   


 


 


 


 


 


 


Estimated net lease obligations

  $ 863     $ 6,993     $ 1,999     $ 1,961     $ 1,614     $ 2,952     $ 16,382  
   


 


 


 


 


 


 



(1) At September 30, 2004, we had signed contractual sublease agreements covering $13 million in future payments.

 

Note 7 — Other Income (Expense), Net

 

Other income (expense), net consisted of the following:

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Gains (losses) on sales of marketable securities, net

   $ (220 )   $ 141     $ 790     $ 9,393  

Foreign-currency transaction losses, net

     (685 )     (1,021 )     (1,990 )     (1,189 )

Foreign, state, and other income taxes (1)

     (2,692 )     1,360       (6,086 )     (1,338 )

Other miscellaneous gains, net

     665       (228 )     1,519       (70 )
    


 


 


 


Total other income (expense), net

   $ (2,932 )   $ 252     $ (5,767 )   $ 6,796  
    


 


 


 



(1) We have provided for current and deferred foreign, state, and other income taxes for all periods presented. Current and deferred income taxes were provided with respect to jurisdictions where certain of our subsidiaries produce taxable income. Due primarily to the existence of net operating loss carryforwards, our effective tax rate is substantially less than the statutory rates in effect.

 

Note 8 — Remeasurements and Other

 

Remeasurements and other consisted of the following:

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Foreign-currency gains (losses) on remeasurement of 6.875% PEACS (1)

   $ (16,767 )   $ (12,213 )   $ 11,627     $ (74,993 )

Currency-related gains on sales of Euro-denominated
investments, net

     4,100       —         9,469       5,827  

Loss on redemption of long-term debt

     —         —         (5,672 )     (15,176 )

Loss on termination of Euro Currency Swap (2)

     —         —         —         (5,880 )

Foreign-currency effect on intercompany balances (3)

     7,087       —         (3,328 )     —    

Other-than-temporary impairments and other (4)

     139       1,071       19,125       (3,370 )
    


 


 


 


Total remeasurements and other

   $ (5,441 )   $ (11,142 )   $ 31,221     $ (93,592 )
    


 


 


 


 

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Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 


(1) Each period the remeasurement of our 6.875% PEACS from Euros to U.S. Dollars results in gains or losses recorded to “Remeasurements and other” on our consolidated statements of operations.
(2) During the second quarter of 2003, we terminated our Euro Currency Swap and, although neither party made cash payments to terminate, we recorded a loss of $6 million to “Remeasurements and Other” representing the remaining basis in our swap asset.
(3) Represents the loss associated with the remeasurement of intercompany balances due to changes in foreign exchange rates. See “Note 1 — Accounting Policies.”
(4) Included in the nine months ended September 30, 2004, is a gain of $14 million associated with the sale of one of our equity investments and a gain of $6 million relating to the settlement of a contractual dispute. Included in the nine months ended September 30, 2003, is equity in losses of equity-method investees of less than $1 million. There were no losses from equity method investees during the nine months ended September 30, 2004.

 

Note 9 — 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 operating decision maker reviews our operating results in assessing performance and allocating resources.

 

We measure operating results of our segments using an internal performance measure of direct segment operating expenses that excludes stock-based compensation, and other operating expense (income), each of which is not allocated to segment results. All other centrally-incurred operating costs are fully allocated to segment 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) through 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 Merchant.com, marketing, and promotional agreements.

 

International

 

The International segment consists of amounts earned from retail sales of consumer products (including from third-party sellers) 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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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Information on reportable segments and reconciliation to consolidated net income (loss) is as follows:

 

Three Months Ended September 30, 2004:

 

    

North

America


   International

   Consolidated

 
     (in thousands)  

Net sales

   $ 816,088    $ 646,387    $ 1,462,475  

Cost of sales

     592,747      514,077      1,106,824  
    

  

  


Gross profit

     223,341      132,310      355,651  

Direct segment operating expenses

     165,901      94,697      260,598  
    

  

  


Segment operating income

     57,440      37,613      95,053  

Stock-based compensation

                   9,274  

Other operating expense

                   4,505  
                  


Income from operations

                   81,274  

Total non-operating expense, net

                   (27,127 )
                  


Net income

                 $ 54,147  
                  


 

Three Months Ended September 30, 2003:

 

    

North

America


   International

   Consolidated

 
     (in thousands)  

Net sales

   $ 709,271    $ 425,185    $ 1,134,456  

Cost of sales

     508,150      340,485      848,635  
    

  

  


Gross profit

     201,121      84,700      285,821  

Direct segment operating expenses

     138,606      73,562      212,168  
    

  

  


Segment operating income

     62,515      11,138      73,653  

Stock-based compensation

                   20,936  

Other operating expense

                   786  
                  


Income from operations

                   51,931  

Total non-operating expense, net

                   (36,368 )
                  


Net income

                 $ 15,563  
                  


 

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AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Nine Months Ended September 30, 2004:

 

    

North

America


   International

   Consolidated

 
     (in thousands)  

Net sales

   $ 2,455,061    $ 1,925,104    $ 4,380,165  

Cost of sales

     1,786,133      1,536,501      3,322,634  
    

  

  


Gross profit

     668,928      388,603      1,057,531  

Direct segment operating expenses

     470,058      274,604      744,662  
    

  

  


Segment operating income

     198,870      113,999      312,869  

Stock-based compensation

                   38,073  

Other operating income

                   (3,187 )
                  


Income from operations

                   277,983  

Total non-operating expense, net

                   (36,220 )
                  


Net income

                 $ 241,763  
                  


 

Nine Months Ended September 30, 2003:

 

    

North

America


   International

   Consolidated

 
     (in thousands)  

Net sales

   $ 2,116,506    $ 1,201,421    $ 3,317,927  

Cost of sales

     1,538,496      949,100      2,487,596  
    

  

  


Gross profit

     578,010      252,321      830,331  

Direct segment operating expenses

     409,236      212,793      622,029  
    

  

  


Segment operating income

     168,774      39,528      208,302  

Stock-based compensation

                   72,712  

Other operating expense

                   2,611  
                  


Income from operations

                   132,979  

Total non-operating expense, net

                   (170,851 )
                  


Net loss

                 $ (37,872 )
                  


 

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Table of Contents

Item 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, 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, international growth and expansion, 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 and manufacturers and products sold by third parties on our websites. Generally, we recognize revenue as the seller of record from items we offer from our inventory and recognize our net share of revenue of items offered by third parties.

 

Our financial focus is on long-term, sustainable growth in free cash flow1. We also seek to minimize shareholder dilution while maintaining the flexibility to issue shares for strategic purposes, such as financings and aligning employee interests with shareholders.

 

Free cash flow is driven primarily by increasing consolidated segment operating income and efficiently managing working capital and capital expenditures. Increases in consolidated segment operating income result from increases in sales through our websites and a focus on keeping costs low. To increase sales, we focus on improving all aspects of the customer experience, including lowering prices, improving availability, increasing selection, expanding product information, improving ease of use, and earning customer trust. Our price reductions take several forms: we reduce the sales prices of products we sell, we recruit third-party sellers to compete with us on product detail pages, and we reduce or eliminate the cost of shipping to the consumer.

 

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. Total shares outstanding plus outstanding stock awards are essentially unchanged as of September 30, 2004 compared to September 30, 2003.

 

We leverage our fixed customer experience costs and work to reduce our variable cost per unit. Our customer experience costs, specifically the costs necessary to build, enhance, and add features to our websites and build and

 


1 Free cash flow is defined as net cash provided by operating activities less purchases of fixed assets, including capitalized internal-use software and website development, both of which are presented on our statements of cash flows.

 

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optimize our fulfillment centers, are largely fixed. The customer experience costs that remain variable as a percentage of sales include product costs, credit-card processing fees, picking, packaging, and preparing orders for shipment, transportation, customer service support, and certain aspects of our marketing costs. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we obtain volume discounts from suppliers and focus on maintaining a lean culture, including by reducing defects in our processes.

 

Because we are able to turn our inventory quickly, we have a negative operating cycle that is a source of cash flow2. On average, our high inventory velocity means we generally collect from our customers before our payments to suppliers come due. Inventory turnover3 was 17 and 19 for the three months ended September 30, 2004 and 2003. We expect some variability in inventory turnover over time since it is affected by several factors, including our product mix, 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 57 for the three months ended September 30, 2004 and 54 for the three months ended September 30, 2003. We expect some variability in accounts payable days over time since they are affected by several factors, including the mix of product sales, the mix of suppliers, 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 broad-band service to the home, and the advances of wireless connectivity will continue to improve the consumer experience on the Internet and increase the ubiquity of computers 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.

 

We do not believe that our reported net income for the three months and nine months ended September 30, 2004 should be viewed, on its own, as a material positive event or should be considered predictive of future results. The nature and volatility of the operating expenses “Remeasurements and other” and “Stock-based compensation” may create significant variation in operating results from period to period. For example, changes in currency exchange between the Euro and the U.S. Dollar create potentially significant gains or losses on remeasurement of our 6.875% PEACS, which are inherently difficult to predict. Also, due to variable accounting treatment on certain of our stock-based awards, “Stock-based compensation” is affected by increases or decreases in the quoted price of our common stock. In the third quarter of 2004, variable accounting treatment resulted in a credit to our operating results of $6 million due to a decline in the quoted price of our common stock. Comparisons to the prior year quarter and year-to-date periods show improvement in operating income of $16 million and $46 million resulting from the effect of changing stock prices on variable accounting treatment.

 

In addition, as our financial reporting currency is the U.S. Dollar, our total revenue, profit, and operating and free cash flow have recently benefited significantly from weakness in the U.S. Dollar in comparison to the currencies of our international websites. While we believe that our increasing diversification beyond the U.S. economy through our fast growing international businesses benefits our shareholders, it is important to also evaluate our growth rates after the effect of currency changes. For example, our revenues increased 29% during the three months ended September 30, 2004 in comparison with the prior year, and holding currency exchange constant with the prior year our growth would have been 24%. In the future, this trend may reverse, and our consolidated U.S. Dollar revenue growth rates would be less than our local-currency growth rates.

 

For additional information about each line item summarized below, refer to Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies.”

 


2 The operating cycle is number of days of sales in inventory plus number of days of sales in accounts receivable minus accounts payable days.
3 Inventory turnover is the quotient of annualized cost of sales to average inventory.
4 Accounts payable days, calculated as the quotient of accounts payable to cost of sales, multiplied by the number of days in the period.

 

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Critical 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 the company 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 1 of Part I, “Financial Statements — Note 1 — Accounting Policies,” of this Quarterly Report on Form 10-Q and Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business and Accounting Policies,” of our Annual Report on Form 10-K for the year ended December 31, 2003. 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.

 

Significant Accounting Policies

 

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: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of undelivered items; and (3) delivery of any undelivered item is probable.

 

We evaluate the criteria of EITF Issue No. 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 obligor 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 the primary obligor and amounts earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the two, we generally record the net amounts as commissions earned.

 

Product sales, 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 a sales contract that provides 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.

 

Commissions and per-unit fees received from third-party sellers and similar amounts earned through our Merchant.com program are recognized when the item is sold by the third-party seller and our collectibility is reasonably assured. We record an allowance for estimated refunds on such commissions using historical experience. We also record an allowance, using historical experience, for losses we incur on our payment guarantee from disputes by customers against third-party sellers.

 

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

 

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Table of Contents

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 presented as a net amount in “Net sales.”

 

Inventories

 

Inventories, consisting of products available for sale, are accounted for using the 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 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

 

Included in fixed assets is the cost of internal-use software and website development, including software used to upgrade and enhance our websites. We expense all costs related to the development of internal-use software other than those incurred during the application development stage. Costs incurred during the application development stage are capitalized and amortized over the estimated useful life of the software, generally two years.

 

For the three months ended September 30, 2004 and 2003, we capitalized $12 million and $9 million of costs associated with development of internal-use software, which is offset by amortization of previously capitalized amounts of $8 million and $6 million. For the nine months ended September 30, 2004 and 2003, we capitalized $29 million and $21 million, which was offset by amortization of previously capitalized amounts of $22 million and $17 million.

 

Currency Effect on Intercompany Balances

 

A provision of SFAS No. 52, Foreign Currency Translation, requires that gains and losses arising from intercompany foreign currency transactions considered long-term investments, where settlement is not planned or anticipated in the foreseeable future, be excluded in the determination of net income. Our international operations are financed, in part, by the U.S. parent company. Prior to the fourth quarter of 2003, currency adjustments for these intercompany balances were recorded to stockholders’ deficit as translation adjustments and not included in the determination of net income because we intended to permanently invest such amounts. During the fourth quarter of 2003, we made the decision that these amounts would be repaid among the entities and, accordingly, upon consolidation, any exchange gain or loss arising from remeasurements of intercompany balances is required to be recorded in the determination of net income. In accordance with SFAS No. 52, currency adjustments arising before the fourth quarter of 2003 continue to be included as a component of “Accumulated other comprehensive income” on our consolidated balance sheets. In association with the remeasurement of intercompany balances, we recorded a gain of $7 million for the three months ended September 30, 2004, and a loss of $3 million for the nine months ended September 30, 2004. Repayments among the entities made during the three months and nine months ended September 30, 2004 were $57 million and $192 million.

 

Restructuring Estimates

 

Restructuring-related liabilities include estimates for, among other things, anticipated disposition of lease obligations. Key variables in determining such estimates include anticipated timing of sublease rentals, estimates of sublease rental payment amounts and tenant improvement costs, and estimates for brokerage and other related costs. We periodically evaluate and, if necessary, adjust our estimates based on currently-available information.

 

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Additionally, we may determine that certain of the office space previously vacated as part of our 2001 restructuring, which we have been unable to sublease due to poor real estate market conditions, may be necessary for our future needs. To the extent we elect to utilize this office space, in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, we will adjust our restructuring-related liability and classify future payments to the corresponding operating expense categories on the consolidated statements of operations. See Item 1 of Part I, “Financial Statements — Note 6 — Other Operating Expense (Income).”

 

Purchase Accounting

 

Accounting for acquisitions includes estimates for the fair value and useful lives of assets acquired and fair value of liabilities assumed.

 

Liquidity and Capital Resources

 

Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities, which were $1.18 billion at fair value at September 30, 2004 and $1.39 billion at December 31, 2003. Amounts held in foreign currencies were $693 million and $764 million at September 30, 2004 and December 31, 2003. Amounts held in foreign currencies at September 30, 2004 and December 31, 2003 were primarily Euros, British Pounds, and Yen.

 

During the nine months ended September 30, 2004, we paid $154 million, which includes a redemption premium of $4 million, to redeem a portion of our 4.75% Convertible Subordinated Notes. See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”

 

Our financial focus is on long-term, sustainable growth in free cash flow. Free cash flow was $420 million for the twelve months ended September 30, 2004 compared to $239 million for the twelve months ended September 30, 2003, an increase of 76%. Operating cash flows and free cash flows can be volatile and are sensitive to many factors, including changes in working capital. Working capital at any specific point in time is subject to many variables, including world events, seasonality, the timing of expense payments, discounts offered by vendors, vendor payment terms, and fluctuations in foreign exchange rates.

 

Cash provided by operating activities was $117 million and $37 million for the three months ended September 30, 2004 and 2003, and cash provided by operating activities was $9 million for the nine months ended September 30, 2004 and cash used in operating activities was $89 million for the nine months ended September 30, 2003. Our operating cash flows result primarily from cash received from our customers and third-party sellers, offset by cash payments we make to suppliers of products and services, employee compensation, 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 the three months ended September 30, 2004, payments to product merchandise suppliers, which does not include payments to transportation suppliers, totaled $948 million, an increase of $207 million over the same period in the prior year. The increase in payments to product merchandise suppliers corresponds with cost of sales, and our efforts to add product categories, increase selection and availability in both existing and new product categories, and take advantage of additional discounts offered to us by suppliers, and is also affected by foreign exchange rates.

 

Cash provided by (used in) investing activities corresponds with purchases, sales, and maturities of marketable securities and purchases of fixed assets, including internal-use software and website development costs. Cash used in investing activities was $85 million and $252 million during the three and nine months ended September 30, 2004. This compares to cash used in investing activities of $60 million and cash provided by investing activities of $143 million during the three and nine months ended September 30, 2003. Our capital

 

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expenditures, including internal-use software and website development, were $29 million and $52 million for the three and nine months ended September 30, 2004, and $15 million and $29 million for the three and nine months ended September 30, 2003. We expect capital expenditures to be $85 million or less for 2004 and $150 million or less for 2005. We believe our expenditures for repairs and improvements are sufficient to keep our facilities and equipment in suitable operating condition.

 

On September 7, 2004, we acquired all of the outstanding shares of Joyo.com at a purchase price of $74.2 million, including a cash payment of $72.4 million, the assumption of employee stock options, and transaction-related costs. Cash paid in connection with this acquisition is classified as cash provided by (used in) investing activities on our consolidated statements of cash flows. The operating results of Joyo.com did not have a significant effect on consolidated results in the third quarter of 2004, and are not expected to have a significant effect on consolidated results in the fourth quarter of 2004. See Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies — Business Acquisition.”

 

Cash provided by financing activities was $7 million during the three months ended September 30, 2004, and cash used in financing activities was $114 million during the nine months ended September 30, 2004. This compares to cash provided by financing activities of $38 million during the three months ended September 30, 2003 and cash used in financing activities of $155 million during the nine months ended September 30, 2003. Cash inflows from financing activities primarily result from proceeds from exercises of employee stock options, which were $8 million and $43 million for the three and nine months ended September 30, 2004, and $41 million and $133 million for the three and nine months ended September 30, 2003. We expect cash proceeds from exercises of stock options to decline over time as we continue issuing restricted stock units as our primary vehicle for stock-based awards. Cash outflows from financing activities result from repayments of long-term debt and payments on capital lease obligations, which were $0.6 million and $157 million for the three and nine months ended September 30, 2004, and $3 million and $288 million for the three and nine months ended September 30, 2003.

 

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.

 

The following summarizes our principal contractual commitments as of September 30, 2004:

 

   

Three Months

Ending

December 31,
2004


  2005

  2006

  2007

  2008

  Thereafter

  Total

    (in thousands)

Operating and capital commitments:

                                         

Debt principal and other (1)

  $ 330   $ 128   $ 1,247   $ 340   $ 351   $ 1,773,483   $ 1,775,879

Debt interest (1)

    —       108,857     108,857     108,857     108,857     142,918     578,346

Capital leases

    385     1,178     420     20     —       —       2,003

Operating leases (2)

    14,857     57,040     59,876     51,596     49,307     217,483     450,159

Purchase obligations (3)

    288,238     —       —       —       —       —       288,238
   

 

 

 

 

 

 

Total operating and capital commitments

    303,810     167,203     170,400     160,813     158,515     2,133,884     3,094,625
   

 

 

 

 

 

 

Restructuring-related commitments:

                                         

Operating leases, net of estimated sublease income (4)

    863     6,993     1,999     1,961     1,614     2,952     16,382

Other

    3,902     1,201     —       —       —       —       5,103
   

 

 

 

 

 

 

Total restructuring-related commitments

    4,765     8,194     1,999     1,961     1,614     2,952     21,485
   

 

 

 

 

 

 

Total commitments

  $ 308,575   $ 175,397   $ 172,399   $ 162,774   $ 160,129   $ 2,136,836   $ 3,116,110
   

 

 

 

 

 

 

 

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(1) The principal payment due in 2010 and the annual interest payments due under our 6.875% PEACS fluctuate based on the Euro/U.S. Dollar exchange ratio. At September 30, 2004, the Euro to U.S. Dollar exchange rate was 1.2436. Due to fluctuations in the Euro/U.S. Dollar exchange ratio, which we cannot predict, our principal debt obligation under this instrument since issuance in February 2000 has increased by $178 million as of September 30, 2004.
(2) Pursuant to SFAS No. 13, Accounting for Leases, lease agreements are categorized at their inception as either operating or capital leases depending on certain defined criteria. Although operating leases represent obligations for us, pursuant to SFAS No. 13 they are not reflected on the balance sheet. As of September 30, 2004, we have remaining obligations under operating leases for equipment and real estate of $450 million. If we had applied to our operating leases the same convention used for capital leases, which, however, would not be in accordance with GAAP, we would have recorded approximately $323 million of additional assets and obligations on our balance sheet at September 30, 2004.
(3) Consists of legally-binding commitments to purchase inventory. Legally-binding commitments associated with non-inventory purchases are not significant.
(4) Net of an estimated $25 million in sublease rentals. At September 30, 2004, we had signed sublease agreements totaling $13 million.

 

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. We do not currently have a line-of-credit, and there can be no assurance that lines-of-credit or other financing instruments will be available in amounts or on terms acceptable to us, if at all.

 

Results of Operations

 

Segment Operating Income

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Segment Operating Income:

                                

North America

   $ 57,440     $ 62,515     $ 198,870     $ 168,774  

International

     37,613       11,138       113,999       39,528  
    


 


 


 


Consolidated

   $ 95,053     $ 73,653     $ 312,869     $ 208,302  
    


 


 


 


Operating Income Growth Rate:

                                

North America

     (8 )%     137 %     18 %     73 %

International

     238       872       188       N/A  

Consolidated

     29       168       50       167  

Segment Operating Margin:

                                

North America

     7.0 %     8.8 %     8.1 %     8.0 %

International

     5.8       2.6       5.9       3.3  

Consolidated

     6.5       6.5       7.1       6.3  

 

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Consolidated segment operating income increased $21 million and $105 million for the three months and nine months ended September 30, 2004 compared to the prior year periods. These increases result from revenue growth (offset partially by lower year-over-year gross margins) and year-over-year reductions in direct segment operating expenses relative to revenue.

 

North America segment operating income decreased $5 million for the three months ended September 30, 2004 in comparison to the prior year. This decline generally results from a lower gross margin on increased revenues, as well as increases in our operating expenses at a rate higher than our increases in gross profit. North America segment operating income increased $30 million for the nine months ended September 30, 2004 compared to the prior year period. This increase results primarily from growth in revenue while holding gross profit and direct segment operating expenses essentially flat relative to revenues. Increased acceptance of our free shipping offer contributed to increases of $7 million and $10 million in net shipping cost for the three months and nine months ended September 30, 2004 compared with the prior year periods.

 

International segment operating income increased $26 million and $74 million for the three months and nine months ended September 30, 2004, compared to prior year periods. For the three months ended September 30, 2004, the increase was due to an increase in gross margin and reductions in direct segment operating expenses relative to revenue. For the nine months ended September 30, 2004, the increase was primarily due to reductions in direct segment operating expenses relative to revenue, offset partially by a reduction in gross margin.

 

See our “Net Sales and Gross Profit,” and “Direct Segment Operating Expenses” sections below for further discussion of these results. See also Item 1 of Part I, “Financial Statements — Note 9 — Segment Information” for a reconciliation of consolidated segment operating income to “Net income.”

 

Net Sales and Gross Profit

 

Net sales information is as follows:

 

     Three Months Ended
September 30,


   Nine Months Ended
September 30,


     2004

   2003

   2004

   2003

     (in thousands)

Net Sales:

                           

North America

                           

Media

   $ 563,595    $ 502,271    $ 1,704,084    $ 1,518,581

Electronics and other general merchandise

     228,626      180,418      678,864      526,002

Other

     23,867      26,582      72,113      71,923
    

  

  

  

Total North America

   $ 816,088    $ 709,271    $ 2,455,061    $ 2,116,506
    

  

  

  

International

                           

Media

   $ 530,314    $ 374,989    $ 1,601,900    $ 1,096,735

Electronics and other general merchandise

     115,615      49,804      321,563      103,756

Other

     458      392      1,641      930
    

  

  

  

Total International

   $ 646,387    $ 425,185    $ 1,925,104    $ 1,201,421
    

  

  

  

Consolidated

                           

Media

   $ 1,093,909    $ 877,260    $ 3,305,984    $ 2,615,316

Electronics and other general merchandise

     344,241      230,222      1,000,427      629,758

Other

     24,325      26,974      73,754      72,853
    

  

  

  

Total consolidated

   $ 1,462,475    $ 1,134,456    $ 4,380,165    $ 3,317,927
    

  

  

  

 

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     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Net Sales Growth Rate:

                        

North America

                        

Media

   12 %   15 %   12 %   13 %

Electronics and other general merchandise

   27     35     29     34  

Other

   (10 )   49     0     26  

Total North America

   15     21     16     18  

International

                        

Media

   41 %   50 %   46 %   63 %

Electronics and other general merchandise

   132     259     210     197  

Other

   17     (31 )   76     (41 )

Total International

   52     61     60     69  

Consolidated

                        

Media

   25 %   28 %   26 %   30 %

Electronics and other general merchandise

   50     56     59     48  

Other

   (10 )   46     1     24  

Total consolidated

   29     33     32     32  

Consolidated Net Sales Mix:

                        

Media

   75 %   77 %   75 %   79 %

Electronics and other general merchandise

   24     20     23     19  

Other

   2     2     2     2  
    

 

 

 

Total consolidated

   100 %   100 %   100 %   100 %
    

 

 

 

North America

   56 %   63 %   56 %   64 %

International

   44     37     44     36  
    

 

 

 

Total consolidated

   100 %   100 %   100 %   100 %
    

 

 

 

 

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. Net sales from “Other” consists of non-retail activities, such as our Merchant.com program and miscellaneous marketing and promotional activities.

 

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Gross profit information is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Gross Profit:

                                

North America

   $ 223,341     $ 201,121     $ 668,928     $ 578,010  

International

     132,310       84,700       388,603       252,321  
    


 


 


 


Consolidated

   $ 355,651     $ 285,821     $ 1,057,531     $ 830,331  
    


 


 


 


Gross Profit Growth Rate:

                                

North America

     11 %     30 %     16 %     16 %

International

     56       38       54       59  

Consolidated

     24       32       27       26  

Gross Margin:

                                

North America

     27.4 %     28.4 %     27.2 %     27.3 %

International

     20.5       19.9       20.2       21.0  

Consolidated

     24.3       25.2       24.1       25.0  

 

The increases in gross profit in comparison with the prior year corresponds with increased revenue, offset by our year-round free shipping offers and lower prices for customers. Generally, our gross margins fluctuate based on several factors, including our product and geographic mix of sales during the year, sales volumes by third-party sellers, changes in vendor pricing and pricing to customers, including competitive pricing decisions, and the extent to which our customers accept our free shipping offers. Free shipping offers reduce shipping revenue and reduce our gross margins on retail sales. We view our shipping offers as an effective marketing tool and intend to continue offering them indefinitely.

 

North America segment gross margins decreased slightly during the three months ended September 30, 2004 and were flat for the nine months ended September 30, 2004 compared to the same periods last year. The decline in North America gross margin during the three months ended September 30, 2004 primarily results from changes in product mix and price reductions, including our year-round free shipping offers, offset partially by increased sales volume by third-party sellers.

 

International segment gross margins increased slightly during the three months ended September 30, 2004 compared to the same period last year. This was primarily the result of increased third-party sales, offset partially by changes in product mix; price reductions; and the degree to which our customers accepted our free shipping offer in the U.K., including the effect of the lower threshold introduced in September 2004.

 

International segment gross margins decreased during the nine months ended September 30, 2004 compared to the same period last year. This was primarily the result of continuing efforts to reduce prices for customers, including through our free shipping offer in the U.K., offset partially by increased sales by third parties.

 

Sales of products by third-party sellers on our websites continue to increase. Since revenues from these sales are recorded as a net amount, they generally result in lower revenues but higher gross margins per unit. If product sales by third-party sellers continue to increase, we anticipate the higher gross margin attributes of these sales will partially offset the effect on our gross margins of our strategy to lower prices for customers over time by offering additional or broader price reductions, free shipping offers, and other promotions.

 

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Supplemental Information

 

Supplemental information about shipping results is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Shipping Activity:

                                

Shipping revenue

   $ 86,538     $ 76,630     $ 264,256     $ 234,910  

Outbound shipping costs

     (127,683 )     (103,682 )     (382,879 )     (315,461 )
    


 


 


 


Net shipping cost

   $ (41,145 )   $ (27,052 )   $ (118,623 )   $ (80,551 )
    


 


 


 


 

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 alternatives that resulted in a net cost to us in delivering products. We seek to offset these costs over time through achieving higher sales volumes and better operating efficiencies and by negotiating better terms with our suppliers.

 

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Table of Contents

Direct Segment Operating Expenses

 

Selected operating expense information is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Segment Operating Expenses:

                                

North America

   $ 165,901     $ 138,606     $ 470,058     $ 409,236  

International

     94,697       73,562       274,604       212,793  
    


 


 


 


Consolidated

   $ 260,598     $ 212,168     $ 744,662     $ 622,029  
    


 


 


 


Percent of Net Sales:

                                

North America

     20.3 %     19.5 %     19.1 %     19.3 %

International

     14.7       17.3       14.3       17.7  

Consolidated

     17.8       18.7       17.0       18.7  
     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Consolidated Segment Operating Expenses:

                                

Fulfillment

   $ 135,521     $ 107,057     $ 385,943     $ 318,217  

Marketing

     34,347       28,943       99,822       82,496  

Technology and content

     64,823       53,775       178,374       155,998  

General and administrative

     25,907       22,393       80,523       65,318  
    


 


 


 


Total

   $ 260,598     $ 212,168     $ 744,662     $ 622,029  
    


 


 


 


Percent of Net Sales:

                                

Fulfillment

     9.3 %     9.4 %     8.8 %     9.6 %

Marketing

     2.3       2.6       2.3       2.5  

Technology and content

     4.4       4.7       4.1       4.7  

General and administrative

     1.8       2.0       1.8       2.0  

Total

     17.8       18.7       17.0       18.7  

Year-over-year Percentage Change:

                                

Fulfillment

     27 %     19 %     21 %     20 %

Marketing

     19       8       21       (6 )

Technology and content

     21       2       14       (6 )

General and administrative

     16       20       23       11  

Total

     23       12       20       7  

 

Fulfillment: The increase in fulfillment costs in comparison with the prior year relates to variable costs corresponding with sales volume, our mix of product sales, costs associated with credit card fees, and bad debt costs, including costs of our guarantee for certain third party seller transactions. 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 are higher as a percentage of revenue versus our retail sales, our increasing third-party sales result in increasing costs as a percent of net sales. Also, we began operations during the third quarter of 2004 of a new European fulfillment center in Scotland. The center is approximately 300,000 square feet and employs approximately 200 associates and will grow to employ approximately 300 associates over the next calendar year. Cost increases are partially offset by improvements in productivity and accuracy, the increase in units fulfilled, which leverages the fixed-cost portion of our fulfillment network, efficiencies gained through utilization of fulfillment services provided by third parties, a decline in customer service contacts per unit

 

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resulting from improvements in our operations, and enhancements to our customer self-service features. We expect absolute amounts spent in fulfillment to increase over time.

 

Marketing: We direct customers to our websites primarily through a number of targeted online marketing channels, such as our Associates program, our Syndicated Stores program, portal advertising, e-mail campaigns, sponsored search, and other initiatives. Since our marketing expenses are largely variable, we expect absolute amounts spent in marketing to increase over time. 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. While costs associated with free shipping are not included in marketing expense, we view free shipping as an effective worldwide marketing tool, and intend to continue offering it indefinitely.

 

Technology and Content: Our spending in technology and content has increased as we are adding computer scientists and software engineers to continue to enhance the customer experience on our websites and those websites powered by us, and improve our process efficiency. Additionally, we continue to invest in several areas of technology, including seller platform; A9.com, our wholly-owned subsidiary focused on search technology; web services; and additional development centers. We intend to continue investing in these and other initiatives and expect absolute dollars spent in technology and content to increase over time as we continue to add computer scientists and software engineers to our staff. A significant majority of these costs are incurred in the United States and most of them are allocated to our North America segment.

 

General and Administrative: The increase in spending in general and administrative is primarily due to increases in professional fees. We expect absolute dollars spent in general and administrative to increase over time.

 

Stock-Based Compensation

 

Stock-based compensation was $9 million and $21 million for the three months ended September 30, 2004 and 2003, and $38 million and $73 million for the nine months ended September 30, 2004 and 2003. In late 2002, we began issuing restricted stock units as our primary form of stock-based compensation. Previously, we primarily issued at-the-money stock options. In certain of our foreign jurisdictions, we continue to grant stock options.

 

Certain of our stock awards are subject to variable accounting treatment, resulting in expense or contra-expense recognition each period, using the cumulative expense method. In the third quarter of 2004, variable accounting treatment resulted in a credit to our operating results of $6 million due to a decline in the quoted price of our common stock. Comparisons to the prior year quarter and year-to-date periods show improvement in operating income of $16 million and $46 million resulting from the effect of changing stock prices on variable accounting treatment.

 

At September 30, 2004, we had 27 million stock awards outstanding, including 20 million stock options with a $12.90 weighted average exercise price; 6 million restricted stock units; and 0.5 million shares of restricted stock. Common shares outstanding (which include restricted stock), plus shares underlying stock options and restricted stock units, totaled 434 million and 433 million at September 30, 2004 and 2003. For additional information about our stock-based compensation and awards see Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies.”

 

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Other Operating Expense (Income)

 

Included in “Other operating expense (income)” are restructuring-related expenses or credits and amortization of other intangibles. Amortization of other intangibles was $0.3 million and $0.8 million for the three months ended September 30, 2004 and 2003, and $0.5 million and $2.6 million for the nine months ended September 30, 2004 and 2003.

 

During the first and second quarters of 2004, we determined that certain of the office space previously vacated as part of our 2001 restructuring, which we had been unable to sublease due to poor real estate market conditions, was necessary for our future needs. In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, we have reduced our restructuring-related liability, resulting in a gain of $8 million in the nine months ended September 30, 2004 ($1 million in the first quarter and $7 million in the second quarter). Lease-related payments for this office space, which is approximately $0.6 million per quarter, are expensed over the lease period and classified to the corresponding operating expense categories on the consolidated statements of operations. No restructuring-related amounts were recorded during the first three quarters of 2003.

 

As previously disclosed, we streamlined our organizational structure in France to reduce our operating costs. These efforts were primarily focused on eliminating French office positions in managerial, professional, clerical, and technical roles. The number of employees affected totaled 52 and severance terms were finalized in the third quarter of 2004 and will be paid in the fourth quarter of 2004. 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.

 

Cash payments resulting from our January 2001 operational restructuring were $2 million and $3 million for the three months ended September 30, 2004 and 2003, and $5 million and $23 million for the nine months ended September 30, 2004 and 2003. Based on currently available information, we estimate the remaining restructuring-related cash outflows will be as follows:

 

     Leases

   Other

   Total

     (in thousands)

Three months ending December 31, 2004

   $ 863    $ 3,902    $ 4,765

Years ended:

                    

2005

     6,993      1,201      8,194

2006

     1,999      —        1,999

2007

     1,961      —        1,961

2008

     1,614      —        1,614

Thereafter

     2,952      —        2,952
    

  

  

Total estimated cash outflows (1)

   $ 16,382    $ 5,103    $ 21,485
    

  

  


(1) Cash flows are presented net of an estimated $25 million in sublease rentals. At September 30, 2004, we had signed sublease agreements totaling $13 million.

 

For additional information about our January 2001 operational restructuring, see Item 1 of Part I, “Financial Statements — Note 6 — Other Operating Expense (Income).”

 

Income from Operations

 

Our income from operations was $81 million and $52 million for the three months ended September 30, 2004 and 2003, and $278 million and $133 million for the nine months ended September 30, 2004 and 2003. The improvement in operating results in comparison with the prior year was attributable to increasing revenues and leveraging our direct cost structure relative to sales growth. Additionally, operating income improved from year-over-year reductions of $16 million and $46 million in stock-based compensation expense associated with variable accounting.

 

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Net Interest Expense

 

We generally invest our excess cash in A-rated or higher short-to-intermediate-term fixed income securities and money market mutual funds. Our interest income corresponds with the average balance of invested funds and the prevailing rates we are earning on them. The primary components of our interest expense relate to our debt instruments. The decline in interest expense compared to the same periods a year ago resulted from principal redemptions of long-term debt. At September 30, 2004, our total long-term indebtedness was $1.78 billion compared to $2.08 billion a year ago. See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”

 

Other Income (Expense), Net

 

Other income (expense), net consisted of the following:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Gains (losses) on sales of marketable securities, net

   $ (220 )   $ 141     $ 790     $ 9,393  

Foreign-currency transaction losses, net

     (685 )     (1,021 )     (1,990 )     (1,189 )

Foreign, state, and other income taxes

     (2,692 )     1,360       (6,086 )     (1,338 )

Other miscellaneous gains, net

     665       (228 )     1,519       (70 )
    


 


 


 


Total other income (expense), net

   $ (2,932 )   $ 252     $ (5,767 )   $ 6,796  
    


 


 


 


 

Remeasurements and Other

 

Remeasurements and other consisted of the following:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands)  

Foreign-currency gains (losses) on remeasurement of 6.875% PEACS (1)

   $ (16,767 )   $ (12,213 )   $ 11,627     $ (74,993 )

Currency-related gains on sales of Euro-denominated investments, net

     4,100       —         9,469       5,827  

Loss on redemption of long-term debt

     —         —         (5,672 )     (15,176 )

Loss on termination of Euro Currency Swap (2)

     —         —         —         (5,880 )

Foreign-currency effect on intercompany balances (3)

     7,087       —         (3,328 )     —    

Other-than-temporary impairments and other (4)

     139       1,071       19,125       (3,370 )
    


 


 


 


Total remeasurements and other

   $ (5,441 )   $ (11,142 )   $ 31,221     $ (93,592 )
    


 


 


 



(1) Each period the remeasurement of our 6.875% PEACS from Euros to U.S. Dollars results in gains or losses recorded to “Remeasurements and other” on our consolidated statements of operations.
(2) During the second quarter of 2003, we terminated our Euro Currency Swap and, although neither party made cash payments to terminate, we recorded a non-cash loss of $6 million to “Remeasurements and Other” representing the remaining basis in our swap asset.
(3) Represents the gain or loss associated with the remeasurement of intercompany balances due to changes in foreign exchange rates. See “Note 1 — Accounting Policies.”
(4) Included in the nine months ended September 30, 2004 is a gain of $14 million associated with the sale of one of our equity investments and a gain of $6 million relating to the settlement of a contractual dispute. Included in the nine months ended September 30, 2003 is equity in losses of equity-method investees of less than $1 million. There were no losses from equity method investees in the nine months ended September 30, 2004.

 

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Income Taxes

 

We have provided for current and deferred U.S. federal, state, and foreign income taxes for all periods presented. Current and deferred income taxes were provided with respect to jurisdictions where certain of our subsidiaries produce taxable income. As of September 30, 2004, we have recorded a net deferred tax asset of $6 million, classified in “Other assets,” which consists of certain state jurisdiction net operating loss carryforwards. We have provided a valuation allowance for the remainder of our deferred tax asset, consisting primarily of net operating loss carryforwards, because of uncertainty regarding its realization.

 

At September 30, 2004, we have net operating loss carryforwards (“NOLs”) of $2.8 billion, primarily related to U.S. federal taxes. Utilization of NOLs, which begin to expire at various times starting in 2010, may be subject to certain limitations. Approximately $1 billion of our NOLs are attributable to continuing operations and the related tax benefits, if realized, will be credited to results of operations for both financial reporting and tax reporting purposes. The remaining portion of approximately $1.8 billion relates to tax deductible stock-based compensation in excess of amounts recognized for financial reporting purposes and the related tax benefits, if realized, will be credited to stockholders’ equity rather than to results of operations for financial reporting purposes.

 

Additionally, we have approximately $228 million of capital loss carryforwards that begin to expire in 2005.

 

Net Income (Loss)

 

Although we reported net income for the three months and nine months ended September 30, 2004, we believe that this positive net income result should not be viewed, on its own, as a material positive event and is not necessarily predictive of future results for a variety of reasons. For example, we are unable to forecast the effect on our future reported results of certain items, including the effect that fluctuations in foreign currency rates will have on the remeasurement of our 6.875% PEACS and intercompany balances. The remeasurement of our 6.875% PEACS resulted in significant gains and charges in past periods and may result in significant charges or gains in future periods. Additionally, we are unable to forecast the effect of stock-based compensation, which is based in part by the quoted price of our common stock in accordance with variable accounting treatment. In the third quarter of 2004, variable accounting treatment resulted in a credit to our operating results of $6 million due to a decline in the quoted price of our common stock. Comparisons to the prior year quarter and year-to-date periods show improvement in operating income of $16 million and $46 million resulting from the effect of changing stock prices on variable accounting treatment. Variable accounting has resulted in significant expense and contra-expense in past periods and will continue to be unpredictable going forward.

 

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:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands, except per share amounts)  

Exchange-rate effect on (1):

                                

Net sales

   $ 56,746     $ 29,140     $ 190,856     $ 134,785  

Gross profit

     11,662       5,941       38,514       29,184  

Operating expenses

     (7,309 )     (4,653 )     (23,469 )     (21,099 )

Operating income

     4,353       1,288       15,045       8,085  

Net interest expense and other

     (1,306 )     (2,314 )     (4,137 )     (5,601 )

Remeasurements and other (2)

     (5,580 )     (12,213 )     17,768       (69,166 )

Net income (loss)

     (2,533 )     (13,239 )     28,676       (66,682 )

Diluted earnings (loss) per share

   $ (0.01 )   $ (0.03 )   $ 0.07     $ (0.17 )

(1)

Represents the effect on reported results due to year-over-year changes in exchange rates. Absent year-over-year changes in exchange rates, reported amounts would have been lower (higher) by these amounts.

 

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(2) Includes foreign-currency gains (losses) on remeasurement of 6.875% PEACS and intercompany balances, and realized currency-related gains associated with sales of Euro-denominated investments held by a U.S. functional-currency subsidiary. See Item 1 of Part I, “Financial Statements — Note 8 — Remeasurements and Other.”

 

Non-GAAP Financial Measures

 

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. We believe that certain of our financial measures that meet the definition of a non-GAAP financial measure are important supplemental information to investors. We provide: “consolidated segment operating income,” “pro forma net income,” “pro forma net earnings per share,” and “free cash flow.”

 

We use these non-GAAP financial measures for internal managerial purposes, when publicly providing guidance on possible future results, and as a means to evaluate period-to-period comparisons. These non-GAAP financial measures are used in addition to and in conjunction with results presented in accordance with GAAP. These non-GAAP financial measures should not be relied upon to the exclusion of GAAP financial measures. These non-GAAP financial measures reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP results and the accompanying reconciliations to corresponding GAAP financial measures, provide a more complete understanding of factors and trends affecting our business. 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.

 

Because non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. For example, certain companies disclose a financial measure of earnings before certain charges such as interest, taxes, depreciation, and amortization, commonly referred to as EBITDA. We considered the use of EBITDA as a supplemental performance measure to GAAP, but believe consolidated segment operating income and pro forma net income are superior for our Company as certain periodic costs associated with our invested capital, such as fixed asset depreciation expense and amortization of software development costs, and certain costs associated with our capital structure, such as interest expense, are relevant and important factors affecting our management decisions. For information about our financial results as reported in accordance with GAAP, see Item 1 of Part I, “Financial Statements.” For a quantitative reconciliation of our non-GAAP financial measures to the most comparable GAAP financial measures, see “Reconciliation Tables” below.

 

Consolidated Segment Operating Income

 

We measure operating results of our segments using an internal performance measure of direct segment operating expenses that excludes:

 

  Stock-based compensation;

 

  Other operating expense (income); and

 

  Impairments of goodwill (if any)

 

These operating expense line items are not allocated to segment results, and all other centrally-incurred operating costs are fully allocated to segment results. The sum of our individual segment results is consolidated segment operating income, which we reconcile to GAAP operating income. Pursuant to SEC staff interpretations of Regulation G, when presented in our financial statement footnotes, consolidated segment operating income is a GAAP financial measure; however, since we also present this financial measure outside the context of our financial statement footnotes, we have included this financial measure in our discussion of non-GAAP financial measures.

 

Our management believes that consolidated segment operating income (loss) is useful and meaningful to investors because consolidated segment operating income (loss), together with pro forma net income (loss), and

 

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ratios based on them, are the primary measures of profitability that we use to manage and evaluate our business operations and overall financial performance. Our management evaluates consolidated segment operating income (loss) because it excludes certain cash and non-cash items that are either beyond our immediate control or that we believe are not characteristic of our underlying business operations for the period in which they are recorded, or both.

 

Items Excluded From Consolidated Segment Operating Income

 

Stock-Based Compensation

 

We exclude stock-based compensation for the following reasons:

 

  Stock-based compensation expense is excluded from our internal operating plans and measurement of financial performance, although we consider the dilutive impact to our investors when awarding stock-based compensation and value such awards accordingly;

 

  Stock-based compensation expense or contra-expense are non-cash; and

 

  The measurement of stock-based compensation is determined under a variety of methods depending on the underlying award. These methods include: (a) fixed accounting on certain stock options granted at market prices, resulting in no compensation expense, (b) variable accounting on certain stock options and restricted stock units, resulting in unpredictable charges or gains beyond our control, and (c) fixed accounting for certain restricted stock units and restricted stock awards, resulting in the estimated fair value of the award recognized over the service period.

 

We record the employer portion of payroll tax expense, a cash expense, resulting from exercises of stock-based awards in “Fulfillment,” “Marketing,” “Technology and content,” and “General and administrative” on our consolidated statements of operations and do not include such expenses in “Stock-based compensation.”

 

Other Operating Expense (Income)

 

We exclude other operating expense (income), including amortization of other intangibles and restructuring-related and other, which are cash and non-cash items for the following reasons:

 

  Amortization of other intangibles is excluded from our internal operating plans and measurement of financial performance;

 

  Amortization of other intangibles is a non-cash charge to current operations;

 

  Amortization of other intangibles has diminished and is currently immaterial; and

 

  Since we have not regularly had restructuring-related charges, the exclusion of such charges from prior periods provides better comparability of our results of operations as viewed by management.

 

Impairment of Goodwill

 

If, in the future, we incur impairment losses on our goodwill, such charges would be excluded from consolidated segment operating income since they would be non-cash, and not in the immediate control of management. We have elected to perform our annual analysis during the fourth quarter of each year. No indicators of impairment were identified during the nine months ended September 30,2004.

 

Limitations of Consolidated Segment Operating Income

 

Consolidated segment operating income has certain limitations. First, because it excludes “Stock-based compensation,” the financial measure does not include all expenses primarily related to our workforce. We

 

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compensate for this limitation by providing supplemental information about stock-based compensation on the face of our consolidated statements of operations and in the footnotes to our financial statements. We also provide supplemental information about outstanding stock-based awards, including their dilutive effect on shareholders, in the footnotes to our financial statements. See Item 1 of Part I “Financial Statements — Note 1 — Description of Business and Accounting Policies” for presentation of our stock-based compensation expense calculated on a consistent basis for all awards using the fair value method as prescribed under SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, as well as total outstanding stock-based awards and related activity.

 

Second, consolidated segment operating income excludes “Other Operating Expense (Income).” For companies that periodically undergo restructuring events, excluding restructuring-related costs from performance measures could provide an incomplete summary of ongoing costs that would affect future cash flows. However, we compensate for this limitation by disclosing cash flow measures, including operating cash flow, that incorporate all ongoing cash obligations associated with our January 2001 restructuring event and by providing disclosure of future estimated cash flows and remaining commitments associated with this event. See Item 1 of Part I, “Financial Statements — Note 6 — Other Operating Expense (Income).” Since we have initiated in the second quarter of 2004 a restructuring event in Europe, we have re-evaluated our decision to exclude such charges from our consolidated segment operating income. We have determined that it continues to be appropriate since it has been over two years since our last restructuring event, and we do not anticipate another restructuring event in the next two years. There can, however, be no assurance that we will not undertake another restructuring event in the future that would affect future cash flows.

 

Pro Forma Net Income

 

Pro forma net income, including the related pro forma net earnings per share, which we reconcile to net income (loss) and net earnings (loss) per share, excludes, in addition to the line items described above as excluded from consolidated segment operating income, the following line items on our consolidated statements of operations:

 

  Remeasurements and other; and

 

  Cumulative effect of change in accounting principle (if any).

 

We use pro forma net income, and ratios based on it, to manage and evaluate our business operations and overall financial performance. We use this financial measure as it excludes certain cash and non-cash items that are either beyond our immediate control or are not characteristic of our underlying business operations for the period in which they are recorded, or both.

 

Items Excluded From Pro Forma Net Income

 

See “Consolidated Segment Operating Income — Items Excluded from Consolidated Segment Operating Income” for an explanation of “Stock-based compensation,” “Other operating expense (income),” and “Impairment of goodwill.”

 

Remeasurements and Other

 

A portion of “Remeasurements and other” consists of gains or charges due to our quarterly remeasurement of the principal of our 6.875% PEACS from Euros to U.S. Dollars. We exclude the effect of these periodic remeasurements from our pro forma net income because the ultimate cash effect resulting from changes in exchange rates is inherently uncertain. These gains or charges would only affect near-term cash flows if we redeem or, in certain cases, restructure, our 6.875% PEACS in the next several years, rather than over a longer term or at maturity in 2010. Because these charges and gains vary based on exchange rates between the U.S. Dollar and Euro, these amounts are beyond our immediate control and are difficult to predict for future periods.

 

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Additionally, we exclude gains or charges associated with remeasurements of foreign-currency denominated intercompany balances. We exclude these amounts because they are beyond our immediate control and are difficult to predict for future periods.

 

We exclude equity in losses of equity-method investees, net, which are included in “Remeasurements and other,” because it generates potential non-cash gains or losses, based on the financial results of other companies that we do not manage or control and are difficult to predict. In addition, we believe these non-cash gains and losses are not indicative of our financial or operating performance. In recent quarters, these amounts represented insignificant charges and, absent future investments, we expect this trend to continue.

 

To the extent we incur gains or losses on the repurchase, redemption, or retirements of our debt instruments, such amounts will be recorded to “Remeasurements and other.”

 

Cumulative Effect of Change in Accounting Principle

 

We exclude cumulative effect of change in accounting principle because it generates non-cash charges, which we believe are not indicative of our financial or operating performance.

 

Limitations of Pro Forma Net Income

 

Pro forma net income has the same limitations as consolidated segment operating income. See “Consolidated Segment Operating Income — Limitations of Consolidated Segment Operating Income” above. In addition, when the 6.875% PEACS are retired, whether by early redemption or restructuring, or at maturity in 2010, the foreign currency effect of changes in the exchange ratio between the U.S. Dollar and the Euro will result in a cash effect. We compensate for this limitation by disclosing the effect of currency movements on our 6.875% PEACS on our consolidated statements of operations and presenting the fair value of our 6.875% PEACS in the notes to our financial statements. See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”

 

During certain of our reporting periods our reported net income was greater than our pro forma net income.

 

Free Cash Flow

 

Free cash flow, which we reconcile to “Net cash provided by (used in) 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 more conservative measure of cash flows since purchases of fixed assets are a necessary component of ongoing operations. In limited circumstances where 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.

 

Limitations of Free Cash Flow

 

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 such as our third quarter 2004 acquisition of Joyo.com (see Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies”). Therefore, we believe it is important to view free cash flow as a complement to our entire consolidated statements of cash flows.

 

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Reconciliation Tables

 

The following is a reconciliation of our non-GAAP financial measures to the most comparable GAAP measures for the three months ended September 30, 2004 and 2003 (in thousands, expect per share data).

 

     Three Months Ended September 30, 2004

    Three Months Ended September 30, 2003

 
     As Reported (1)

    Adjustments

    Pro Forma

    As Reported (1)

    Adjustments

    Pro Forma

 

Net sales

   $ 1,462,475     $ —       $ 1,462,475     $ 1,134,456     $ —       $ 1,134,456  

Cost of sales

     1,106,824       —         1,106,824       848,635       —         848,635  
    


 


 


 


 


 


Gross profit

     355,651       —         355,651       285,821       —         285,821  

Operating expenses:

                                                

Fulfillment

     135,521       —         135,521       107,057       —         107,057  

Marketing

     34,347       —         34,347       28,943       —         28,943  

Technology and content

     64,823       —         64,823       53,775       —         53,775  

General and administrative

     25,907       —         25,907       22,393       —         22,393  

Stock-based compensation

     9,274       (9,274 )     —         20,936       (20,936 )     —    

Other operating expense

     4,505       (4,505 )     —         786       (786 )     —    
    


 


 


 


 


 


Total operating expenses

     274,377       (13,779 )     260,598       233,890       (21,722 )     212,168  
    


 


 


 


 


 


Income from operations

     81,274       13,779       95,053 (2)     51,931       21,722       73,653 (2)

Interest income

     7,553       —         7,553       4,324       —         4,324  

Interest expense

     (26,307 )     —         (26,307 )     (29,802 )     —         (29,802 )

Other income (expense), net

     (2,932 )     —         (2,932 )     252       —         252  

Remeasurements and other

     (5,441 )     5,441       —         (11,142 )     11,142       —    
    


 


 


 


 


 


Total non-operating expense, net

     (27,127 )     5,441       (21,686 )     (36,368 )     11,142       (25,226 )
    


 


 


 


 


 


Net income

   $ 54,147     $ 19,220     $ 73,367     $ 15,563     $ 32,864     $ 48,427  
    


 


 


 


 


 


Basic earnings per share

   $ 0.13     $ 0.05     $ 0.18     $ 0.04     $ 0.08     $ 0.12  
    


 


 


 


 


 


Diluted earnings per share

   $ 0.13     $ 0.04     $ 0.17     $ 0.04     $ 0.07     $ 0.11  
    


 


 


 


 


 


Weighted average shares used in computation of earnings per share:

                                                

Basic

     406,647               406,647       397,912               397,912  
    


         


 


         


Diluted

     424,777               424,777       422,802               422,802  
    


         


 


         


Net cash provided by operating activities

                   $ 116,645                     $ 36,817  

Purchases of fixed assets, including internal-use software and website development

                     (28,722 )                     (15,192 )
                    


                 


Free cash flow

                   $ 87,923                     $ 21,625  
                    


                 


Net cash used in investing activities

                   $ (85,481 )                   $ (60,012 )
                    


                 


Net cash provided by financing activities

                   $ 7,177                     $ 37,798  
                    


                 



(1) In accordance with accounting principles generally accepted in the United States.
(2) Consolidated segment operating income.

 

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The following is a reconciliation of our non-GAAP financial measures to the most comparable GAAP measures for the nine months ended September 30, 2004 and 2003 (in thousands, expect per share data).

 

     Nine Months Ended September 30, 2004

    Nine Months Ended September 30, 2003

 
     As Reported (1)

    Adjustments

    Pro Forma

    As Reported (1)

    Adjustments

    Pro Forma

 

Net sales

   $ 4,380,165     $ —       $ 4,380,165     $ 3,317,927     $ —       $ 3,317,927  

Cost of sales

     3,322,634       —         3,322,634       2,487,596       —         2,487,596  
    


 


 


 


 


 


Gross profit

     1,057,531       —         1,057,531       830,331       —         830,331  

Operating expenses:

                                                

Fulfillment

     385,943       —         385,943       318,217       —         318,217  

Marketing

     99,822       —         99,822       82,496       —         82,496  

Technology and content

     178,374       —         178,374       155,998       —         155,998  

General and administrative

     80,523       —         80,523       65,318       —         65,318  

Stock-based compensation

     38,073       (38,073 )     —         72,712       (72,712 )     —    

Other operating expense (income)

     (3,187 )     3,187       —         2,611       (2,611 )     —    
    


 


 


 


 


 


Total operating expenses

     779,548       (34,886 )     744,662       697,352       (75,323 )     622,029  
    


 


 


 


 


 


Income from operations

     277,983       34,886       312,869 (2)     132,979       75,323       208,302 (2)

Interest income

     18,419       —         18,419       16,625       —         16,625  

Interest expense

     (80,093 )     —         (80,093 )     (100,680 )     —         (100,680 )

Other income (expense), net

     (5,767 )     —         (5,767 )     6,796       —         6,796  

Remeasurements and other

     31,221       (31,221 )     —         (93,592 )     93,592       —    
    


 


 


 


 


 


Total non-operating expense, net

     (36,220 )     (31,221 )     (67,441 )     (170,851 )     93,592       (77,259 )
    


 


 


 


 


 


Net income (loss)

   $ 241,763     $ 3,665     $ 245,428     $ (37,872 )   $ 168,915     $ 131,043  
    


 


 


 


 


 


Basic earnings (loss) per share

   $ 0.60     $ 0.01     $ 0.61     $ (0.10 )   $ 0.43     $ 0.33  
    


 


 


 


 


 


Diluted earnings (loss) per share

   $ 0.57     $ 0.01     $ 0.58     $ (0.10 )   $ 0.41     $ 0.31  
    


 


 


 


 


 


Weighted average shares used in computation of earnings (loss) per share:

                                                

Basic

     405,153               405,153       393,477               393,477  
    


         


 


         


Diluted

     423,924               423,924       393,477               418,359  
    


         


 


         


Net cash provided by (used in) operating activities

                   $ 8,993                     $ (88,941 )

Purchases of fixed assets, including internal-use software and website development

                     (52,378 )                     (28,727 )
                    


                 


Free cash flow

                   $ (43,385 )                   $ (117,668 )
                    


                 


Net cash provided by (used in) investing activities

                   $ (252,194 )                   $ 143,162  
                    


                 


Net cash used in financing activities

                   $ (114,224 )                   $ (154,744 )
                    


                 



(1) In accordance with accounting principles generally accepted in the United States.
(2) Consolidated segment operating income.

 

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The following is a reconciliation of our non-GAAP financial measure of free cash flow to the most comparable GAAP measure for the twelve months ended September 30, 2004 and 2003 (in thousands):

 

     Twelve Months Ended

 
     September 30,
2004


    September 30,
2003


 

Net cash provided by operating activities

   $ 489,956     $ 283,638  

Purchases of fixed assets, including internal-use software and website development

     (69,614 )     (44,243 )
    


 


Free cash flow

   $ 420,342     $ 239,395  
    


 


Net cash provided by (used in) investing activities

   $ (158,705 )   $ 106,883  
    


 


Net cash used in financing activities

   $ (291,466 )   $ (92,042 )
    


 


 

Guidance

 

Consistent with our October 21, 2004 earnings release furnished on Form 8-K and as of the date of this filing, our fourth quarter and full year 2004 guidance and full year 2005 expectations are as follows:

 

Fourth Quarter 2004 Guidance

 

  Net sales are expected to be between $2.295 billion and $2.545 billion, or grow between 18% and 31%, compared with fourth quarter 2003.

 

  Consolidated segment operating income is expected to be between $162 million and $222 million, or grow between 6% and 45%, compared with fourth quarter 2003.

 

  Operating income is expected to be between $137 million and $197 million, assuming, among other things, that the Company does not record any further revisions to its restructuring-related estimates and that the closing price of Amazon.com common stock on December 31, 2004, is identical to the closing price of $40.86 on September 30, 2004.

 

Full Year 2004 Guidance

 

  Net sales are expected to be between $6.675 billion and $6.925 billion, or grow between 27% and 32%, compared with 2003.

 

  Consolidated segment operating income is expected to be between $475 million and $535 million, or grow between 31% and 48%, compared with 2003.

 

  Operating income is expected to be between $415 million and $475 million, assuming, among other things, that the Company does not record any further revisions to its restructuring-related estimates and that the closing price of Amazon.com common stock on December 31, 2004, is identical to the closing price of $40.86 on September 30, 2004.

 

Full Year 2005 Expectations

 

  Net sales are expected to be between $7.40 billion and $8.15 billion.

 

  Consolidated segment operating income is expected to be between $500 million and $625 million.

 

  Operating income is expected to be between $400 million and $525 million, excluding any impact from SFAS No. 123R, and assuming, among other things, that the Company does not record any further revisions to its restructuring-related estimates and that the closing price of Amazon.com common stock on December 31, 2005, is identical to the closing price of $40.86 on September 30, 2004.

 

These projections are subject to substantial uncertainty. See “Additional Factors That May Affect Future Results.”

 

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Additional Factors That May Affect Future Results

 

The following risk factors and other information included in this Quarterly Report should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results, and cash flows could be materially adversely affected.

 

We Have an Accumulated Deficit and May Incur Additional Losses

 

We have incurred significant net losses since we began doing business. As of September 30, 2004, we had an accumulated deficit of $2.73 billion and our stockholders’ deficit was $721 million. We have incurred substantial operating losses since our inception, and although we earned net income in the three and nine months ended September 30, 2004, we may incur losses again in the future.

 

We Have Significant Indebtedness

 

As of September 30, 2004, we had long-term indebtedness of $1.78 billion. We make annual or semi-annual interest payments on the indebtedness under our two convertible notes, which are due in 2009 and 2010. Although we made debt principal reduction payments in the three months ended March 31, 2004, we may incur substantial additional debt in the future. Our indebtedness could limit our ability to obtain additional financing for working capital, capital expenditures, debt service requirements, or other purposes in the future, as needed; to plan for, or react to, changes in technology and in our business and competition; and to react in the event of an economic downturn.

 

There is no guarantee that we will be able to meet our debt service obligations. If we are unable to generate sufficient cash flow or obtain funds for required payments, or if we fail to comply with covenants in our indebtedness, we will be in default.

 

See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”

 

We Face Intense Competition

 

The market segments in which we compete are rapidly evolving and intensely competitive, and we have many competitors in different industries, including both the retail and e-commerce services industries.

 

Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition, and significantly greater financial, marketing, and other resources than we have. They may be able to secure merchandise from vendors on more favorable terms and may be able to adopt more aggressive pricing policies. Competitors in both the retail and e-commerce services industries also may be able to devote more resources to technology development and marketing than we do.

 

Competition in the e-commerce channel may intensify. Other companies in the retail and e-commerce service industries may enter into business combinations or alliances that strengthen their competitive positions. As various Internet market segments obtain large, loyal customer bases, participants in those segments may expand into the market segments in which we operate. In addition, new and expanded Web technologies may further intensify the competitive nature of online retail. The nature of the Internet as an electronic marketplace facilitates competitive entry and comparison shopping and renders it inherently more competitive than conventional retailing formats. This increased competition may reduce our sales, operating profits, or both.

 

Our Growth Will Place a Significant Strain on our Management, Operational and Financial Resources

 

We are rapidly and significantly expanding our operations both domestically and internationally and will continue to expand further to pursue growth of our product and service offerings and customer base. Such growth

 

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increases the complexity of our business and places a significant strain on our management, operations, and financial resources, and there can be no assurance that we will be able to manage it effectively. Our current and planned personnel, systems, procedures, and controls may not be adequate to support and effectively manage our future operations, especially as we employ personnel in multiple geographic locations. We may not be able to hire, train, retain, motivate, and manage required personnel, which may limit our growth.

 

In addition, we do not expect to benefit in our newer market segments, whether products, services or new geographic areas, from the first-to-market advantage that we experienced in the U.S. online book channel. Our gross profits in our newer business activities may be lower than in our older business activities. In addition, we may have limited or no experience in new product and service activities and new geographic areas, and our customers may not favorably receive our new businesses. Our newer market segments may present special technology challenges that we have not faced before. To the extent we pursue commercial agreements, acquisitions and/or strategic alliances to facilitate new product or service activities or geographic expansion, the agreements, acquisitions and/or alliances may not be successful.