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Amazon.com’s (AMZN) first-quarter earnings of 21 cents were well ahead of the Zacks Consensus Estimate of 10 cents. Amazon has missed estimates in three of the last four quarters, with the four-quarter negative surprise averaging at 8.7%. Therefore, the 110.0% surprise in the last quarter was commendable. Shares gained 2.2% during the day but lost momentum in after-hours trading.

Revenue

Amazon reported revenue of $16.07 billion, down 24.4% sequentially and up 21.9% from the year-ago quarter. This was in line with the guidance for the quarter of $15.0-16.6 billion (down 25.7% sequentially, or up 19.8% year over year at the mid-point), although missing our expectations by a sliver. Year-over-year revenue growth was 24% excluding unfavorable currency impact.

Over 58% of sales were generated in North America, representing a sequential decline of 22.9% and a year-over-year increase of 26.4%. The balance came from the International segment, which dropped 26.5% sequentially and increased 16.0% year over year (21% excluding unfavorable currency impact).

Active customer accounts increased by 21 million to more than 209 million. Active seller accounts stayed above 2 million. Paid (third-party) units were 30% of total units in the first quarter, compared to 39% in the Dec quarter.

Key strategies for driving revenue growth remain a vast selection, competitive pricing, free shipping, user experience on Amazon properties and the Amazon Prime program. Fulfillment centers are also important, since they are essential for providing the level of customer service that Amazon customers have come to expect of the company. Over the past year, Amazon has been investing heavily in fulfillment and technology & content.

Segment Details

Amazon’s North America Media business was down 13.4% sequentially and up 14.4% from last year to 16% of total revenue. The sequential decline is seasonal. The increase from the year-ago quarter continues to be driven by the consumption of digital content across categories. The Goodreads acquisition should help book sales going forward as it increases insight into what readers want. While selling and lending books on the Kindle platform continues, Amazon is also developing its direct publishing business. In addition to Kindle ebooks, Amazon is going great guns with its video content. Prime Instant Video has the broadest reach, across Kindles, Microsoft’s (MSFT) Xbox 360, Sony’s (SNE) Playstation 3, Apple’s (AAPL) Mac or other PCs, as well as on TV. Additionally, titles were expanded to 38,000 movies and TV episodes in the last quarter. Amazon’s reach and value proposition are making it a key player in the video distribution business. The category saw strong double-digit growth in each of the last five quarters.

The Electronics and General Merchandise (:EGM) business in North America (38% revenue share) was down 27.9% sequentially and up 28.4% from last year. EGM is a more seasonal business with holiday-driven spending having a significant impact. This seasonality has increased manifold since Amazon launched the Kindle platform. Therefore, year-over-year comparisons are more meaningful. We see very strong double-digit growth in each quarter since December 2009, which is indicative of the expansion in the market and Amazon’s growing position within it.

Amazon’s International media business (16% of total revenue) was down 29.5% sequentially and up 1.3% year over year. This is the smallest growth in the last five quarters and could indicate the need for additional content in new regions. Content aquisition remains a focus area for Amazon, but the numbers seem to indicate that it still has some work to do here. EGM, which was around 25% of total revenue, was down 24.8% from an extremely strong fourth quarter and stayed 27.6% above the year-ago level. This seems to indicate a greater preference for purchasing electronics rather than content in international locations. Once the electronics business gains momentum and Amazon has enough fulfillment centers set up, we expect further investment in content. Amazon now has Kindle stores in Brazil, Canada, China and Japan where thousands of local language books are being sold. New product categories, better selection within categories, competitive prices and free shipping remain drivers.

The Other segment, while still small (around 5% of total revenue, mostly in North America) includes Amazon Web Services (:AWS). The North America business was down sequentially but up 63.8% from the year-ago quarter. Growth in the international business was negative on a sequential basis, but not with respect to the comparable quarter of the prior year. AWS continues to launch new services and has now reduced prices 7 times this year (31 times since it launched in 2006).

Gross Margin

The gross margin expanded 243 bps sequentially and 261 bps year over year to 26.6%. Sequential variations in gross margins are usually largely mix-related, although pricing is growing into an important factor given the increase in product categories all over the world. The fact that new product launches come hand in hand with extra launch costs, is also a negative for the gross margin. Third party sites are also doing well, which has a positive impact.

Gross profit dollars dropped 16.8% sequentially and increased 35.2% from last year, due to volume changes. The consistently rising gross profit dollars from year-ago periods indicates steadily rising business volumes. It also indicates that Amazon brings a value proposition for customers that make them stick with it.

Operating Metrics

Amazon’s operating expenses of $4.09 billion were down 13.5% sequentially while increasing 37.8% from the year-ago quarter. Amazon’s heavy investing activities (headcount, fulfillment centers, content, etc) over the past few quarters have been driving up its costs. Specifically, fulfillment, marketing, technology and content, and general and administrative expenses as a percentage of sales grew 135 bps, 29 bps, 144 bps and 1 bp, respectively from a year ago. All except marketing costs also increased on a sequential basis.

As a result, the operating margin of 1.1% was dropped 78 bps and 33 bps, respectively from the previous and year-ago quarters. The operating income of $181 million was down from an income of $405 million in the previous quarter and a profit of $192 million in the year-ago quarter.

The North America segment operating margin was down 13 bps sequentially and up 17 bps from the year-ago quarter. The International segment operating margin was down 101 bps sequentially and 109 bps from the year-ago quarter (a lot of the investment over the past year was in this segment).

EBITDA was $1.11 billion, down 14.7% sequentially and up 37.2% from last year. The cash margin of 6.9% was compares favorably with the 6.1% cash margin in both the previous and year-ago quarters.

Net Income

Amazon generated third quarter net income of $99 million, or a 0.6% net income margin, compared to $97 million, or 0.5% in the previous quarter and $130 million, or 1.0% net income margin in the same quarter last year. There were no one-time items in the last quarter. Therefore, the GAAP earnings were same as the pro forma earnings of 21 cents a share compared to 21 cents in the previous quarter and 28 cents per share in the year-ago quarter.

Balance Sheet and Cash Flow

Amazon ended with a cash and investments balance of $7.89 billion, down $3.55 billion during the quarter. The company used $2.37 billion of cash from operations, spending $670 million on fixed assets (including internal-use software and website development costs), $103 million on acquisitions net of cash acquired and $182 million to pay down debt and long term obligations. The decline in the cash position was seasonality-driven, with the significant reduction in payables being partly responsible for the cash used.

Amazon saw inventories decline 10.5% sequentially, but turns went down from 10.7X to 8.7X. Receivables increased in the quarter, with DSOs steady at around 14.

Guidance

Management provided guidance for the second quarter of 2013. Accordingly, revenue is expected to come in at around $14.5-16.2 billion (down 4.5% sequentially, or up 19.6% year over year at the mid-point), below expectations of $15.9 billion. Operating income/loss (including $340 million for stock based compensation and amortization of intangible assets) is expected to come in at approximately -$340 to $10 million.

Our Take

There was little change in Amazon’s first quarter barring a decline from the strong holiday-driven fourth quarter, which led to a slight decline in the operating margin that we can only describe as seasonal. Therefore our thesis remains unchanged.

We continue to believe in Amazon’s prospects, especially its platform approach (Kindle, Prime and the still small but growing AWS). We think that Amazon is performing true to form, continuing to grow revenue and generate very strong cash flow quarter upon quarter (discounting seasonal variations).

As such Amazon remains one of the leading players in the fast-growing ecommerce market. The increase in users, units and partners overall indicates that it is outgrowing the ecommerce market. We think that this has been possible because of the broad selection, free shipping and user experience that Amazon has consistently provided. This has enabled the company to gain from the shift in offline to online consumption.

The Kindle platform will remain a major growth platform for Amazon. Despite more popular tablets from Apple, we think Amazon devices come with their own value proposition, so there will be many takers.

Amazon has the huge task of maintaining its U.S. market share and expanding globally. We expect share losses, but think that the market will expand fast enough for Amazon to maintain a solid growth rate. However, this is dependent on its own capacity to serve customers, especially in international markets, where growth rates are likely to be higher and its own facilities fewer. As a result, both fulfillment and technology & content investments will likely continue to grow. We do not consider this negative, since differentiation among online retailers is very difficult and better experience and support are the things that can drive traffic.

While the increase in operating expenses is a negative impact on the bottom line, we believe this is necessary. We expect the operating leverage to translate into accelerated growth in future quarters. However, the uncertainty regarding the timeline remains, which is the reason we remain Neutral on the shares.

Amazon shares currently carry a Zacks Rank #3 (Hold).