Quarterly Report
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, 2005

 

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  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

414,472,558 shares of common stock, par value $0.01 per share, outstanding as of October 20, 2005

 



Table of Contents

AMAZON.COM, INC.

 

FORM 10-Q

For the Quarterly Period Ended September 30, 2005

 

INDEX

 

          Page

PART I. FINANCIAL INFORMATION     

Item 1.

  

Financial Statements

   3
    

Consolidated Statements of Cash Flows

   3
    

Consolidated Statements of Operations

   4
    

Consolidated Balance Sheets

   5
    

Notes to Consolidated Financial Statements

   6

Item 2.

  

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

   21

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   50

Item 4.

  

Controls and Procedures

   52
PART II. OTHER INFORMATION     

Item 1.

  

Legal Proceedings

   53

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   53

Item 3.

  

Defaults Upon Senior Securities

   53

Item 4.

  

Submission of Matters to a Vote of Security Holders

   53

Item 5.

  

Other Information

   53

Item 6.

  

Exhibits

   53

Signatures

   54

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AMAZON.COM, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

(unaudited)

 

    Three Months Ended
September 30,


    Nine Months Ended
September 30,


    Twelve Months Ended
September 30,


 
        2005    

        2004    

        2005    

        2004    

        2005    

        2004    

 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

  $ 629     $ 701     $ 1,303     $ 1,102     $ 746     $ 666  

OPERATING ACTIVITIES:

                                               

Net income

    30       54       160       242       507       315  

Adjustments to reconcile net income to net cash provided by operating activities:

                                               

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

    30       19       85       55       106       73  

Stock-based compensation

    26       9       71       38       90       53  

Other operating expense (income)

    —         5       3       (3 )     (3 )     (3 )

Loss (gains) on sales of marketable securities, net

    —         —         —         (1 )     —         (1 )

Remeasurements and other

    (6 )     5       (38 )     (31 )     (6 )     5  

Non-cash interest expense and other

    1       1       4       3       5       4  

Deferred income taxes

    23       (4 )     116       (12 )     (128 )     (13 )

Cumulative effect of change in accounting principle

    —         —         (26 )     —         (26 )     —    

Changes in operating assets and liabilities:

                                               

Inventories

    (76 )     (70 )     10       (61 )     (98 )     (104 )

Accounts receivable, net and other current assets

    (12 )     (18 )     6       (9 )     14       (25 )

Accounts payable

    147       96       (224 )     (138 )     201       161  

Accrued expenses and other current liabilities

    (5 )     9       (30 )     (53 )     8       19  

Additions to unearned revenue

    28       34       95       84       120       108  

Amortization of previously unearned revenue

    (32 )     (27 )     (87 )     (76 )     (118 )     (102 )

Interest payable

    (1 )     4       (42 )     (29 )     (11 )     —    
   


 


 


 


 


 


Net cash provided by operating activities

    153       117       103       9       661       490  

INVESTING ACTIVITIES:

                                               

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

    (76 )     (29 )     (149 )     (52 )     (186 )     (70 )

Acquisitions, net of cash acquired

    (4 )     (71 )     (24 )     (71 )     (24 )     (71 )

Sales and maturities of marketable securities and other investments

    163       395       653       1,007       1,072       1,239  

Purchases of marketable securities

    (289 )     (380 )     (1,027 )     (1,136 )     (1,475 )     (1,257 )
   


 


 


 


 


 


Net cash used in investing activities

    (206 )     (85 )     (547 )     (252 )     (613 )     (159 )

FINANCING ACTIVITIES:

                                               

Proceeds from exercises of stock options and other

    23       8       42       43       59       73  

Proceeds from long-term debt and other

    13       —         13       —         13       —    

Repayments of long-term debt and capital lease obligations

    (6 )     (1 )     (272 )     (157 )     (272 )     (364 )
   


 


 


 


 


 


Net cash provided by (used in) financing activities

    30       7       (217 )     (114 )     (200 )     (291 )

Foreign-currency effect on cash and cash equivalents

    (6 )     6       (42 )     1       6       40  
   


 


 


 


 


 


Net increase (decrease) in cash and cash equivalents

    (29 )     45       (703 )     (356 )     (146 )     80  
   


 


 


 


 


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

  $ 600     $ 746     $ 600     $ 746     $ 600     $ 746  
   


 


 


 


 


 


SUPPLEMENTAL CASH FLOW INFORMATION:

                                               

Cash paid for interest

  $ 21     $ 21     $ 105     $ 108     $ 105     $ 111  

Cash paid for income taxes

    6       2       11       3       12       3  

 

See accompanying notes to consolidated financial statements.

 

3


Table of Contents

AMAZON.COM, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per share data)

(unaudited)

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
         2005    

        2004    

        2005    

        2004    

 

Net sales

   $ 1,858     $ 1,463     $ 5,513     $ 4,380  

Cost of sales

     1,395       1,107       4,141       3,322  
    


 


 


 


Gross profit

     463       356       1,372       1,058  

Operating expenses (1):

                                

Fulfillment

     171       138       495       392  

Marketing

     44       34       131       103  

Technology and content

     121       69       319       199  

General and administrative

     32       29       117       89  

Other operating expense (income)

     40       5       43       (3 )
    


 


 


 


Total operating expenses

     408       275       1,105       780  
    


 


 


 


Income from operations

     55       81       267       278  

Interest income

     12       7       30       19  

Interest expense

     (22 )     (26 )     (70 )     (80 )

Other income, net

     —         —         2       —    

Remeasurements and other

     6       (5 )     38       31  
    


 


 


 


Total non-operating expense

     (4 )     (24 )     —         (30 )
    


 


 


 


Income before income taxes

     51       57       267       248  

Provision for income taxes

     21       3       133       6  
    


 


 


 


Income before change in accounting principle

     30       54       134       242  

Cumulative effect of change in accounting principle

     —         —         26       —    
    


 


 


 


Net income

   $ 30     $ 54     $ 160     $ 242  
    


 


 


 


Basic earnings per share:

                                

Prior to cumulative effect of change in accounting principle

   $ 0.07     $ 0.13     $ 0.33     $ 0.60  

Cumulative effect of change in accounting principle

     —         —         0.06       —    
    


 


 


 


     $ 0.07     $ 0.13     $ 0.39     $ 0.60  
    


 


 


 


Diluted earnings per share:

                                

Prior to cumulative effect of change in accounting principle

   $ 0.07     $ 0.13     $ 0.32     $ 0.57  

Cumulative effect of change in accounting principle

     —         —         0.06       —    
    


 


 


 


     $ 0.07     $ 0.13     $ 0.38     $ 0.57  
    


 


 


 


Weighted average shares used in computation of earnings per share:

                                

Basic

     413       407       411       405  
    


 


 


 


Diluted

     428       425       426       424  
    


 


 


 



(1)    Includes stock-based compensation as follows:

                                

Fulfillment

   $ 5     $ 2     $ 13     $ 6  

Marketing

     2       —         5       3  

Technology and content

     13       4       36       21  

General and administrative

     6       3       17       8  
    


 


 


 


Total stock-based compensation expense

   $ 26     $ 9     $ 71     $ 38  
    


 


 


 


 

See accompanying notes to consolidated financial statements.

 

4


Table of Contents

AMAZON.COM, INC.

 

CONSOLIDATED BALANCE SHEETS

(in millions, except per share data)

 

     September 30,
2005


    December 31,
2004


 
     (unaudited)        
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 600     $ 1,303  

Marketable securities

     819       476  
    


 


Cash, cash equivalents, and marketable securities

     1,419       1,779  

Inventories

     456       480  

Deferred tax assets, current portion

     58       81  

Accounts receivable, net and other current assets

     188       199  
    


 


Total current assets

     2,121       2,539  

Fixed assets, net

     322       246  

Deferred tax assets, long-term portion

     190       282  

Goodwill

     159       139  

Other assets

     40       42  
    


 


Total assets

   $ 2,832     $ 3,248  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                 

Current liabilities:

                

Accounts payable

   $ 876     $ 1,142  

Accrued expenses and other current liabilities

     340       361  

Unearned revenue

     48       41  

Interest payable

     32       74  

Current portion of long-term debt and other

     17       2  
    


 


Total current liabilities

     1,313       1,620  

Long-term debt and other

     1,513       1,855  

Commitments and contingencies

                

Stockholders’ equity (deficit):

                

Preferred stock, $0.01 par value:

                

Authorized shares — 500
Issued and outstanding shares — none

     —         —    

Common stock, $0.01 par value:

                

Authorized shares — 5,000
Issued and outstanding shares — 414 and 410 shares

     4       4  

Additional paid-in capital

     2,215       2,123  

Accumulated other comprehensive income

     13       32  

Accumulated deficit

     (2,226 )     (2,386 )
    


 


Total stockholders’ equity (deficit)

     6       (227 )
    


 


Total liabilities and stockholders’ equity (deficit)

   $ 2,832     $ 3,248  
    


 


 

See accompanying notes to consolidated financial statements.

 

5


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 2005 due to seasonal and other factors. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been omitted in accordance with the rules and regulations of the SEC. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our 2004 Annual Report on Form 10-K. On January 1, 2005, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment.” Certain prior period amounts have been reclassified to conform to the current period presentation.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, and those entities relating to www.joyo.com in which we have a variable interest. Intercompany balances and transactions have been eliminated.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, internally-developed software, stock-based compensation, taxes, inventory valuation, receivables valuation, sales returns, restructuring-related liabilities, incentive discount offers, depreciable lives, valuation of investments, valuation of acquired intangibles, and contingencies. Actual results could differ materially from those estimates.

 

Earnings per Share

 

Basic earnings per share is calculated using our weighted-average outstanding common shares. Diluted earnings per share is calculated using our weighted-average outstanding common shares including the dilutive effect of stock awards. Using the treasury stock method, the weighted average effect of stock awards on diluted earnings per share was 15 million and 18 million shares for Q3 2005 and Q3 2004 and was 15 million and 19 million shares for the three quarters ended September 30, 2005 and 2004.

 

Our convertible debt instruments are excluded from the calculation of diluted earnings per share as their effect is antidilutive.

 

Business Combinations

 

We acquired certain companies during the three quarters ended September 30, 2005 for an aggregate cash purchase price of $29 million. Acquired intangibles totaled $10 million and have estimated useful lives of between one and three years. The excess of purchase price over the fair value of the net assets acquired was $19

 

6


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

million and is classified as “Goodwill” on our consolidated balance sheets. The results of operations of each of the acquired businesses have been included in our consolidated results from each transaction closing date forward. The effect of these acquisitions on consolidated net sales and operating income during Q3 2005 and the three quarters ended September 30, 2005 was not significant.

 

In the third quarter of 2004, we acquired all of the outstanding shares of Joyo.com Limited (“Joyo.com”), a British Virgin Islands company that operates an Internet retail website in the People’s Republic of China (“PRC”) in cooperation with a PRC subsidiary and PRC affiliates, at a purchase price of $75 million. Acquired intangibles were $6 million with estimated useful lives of between one and four years. The excess of purchase price over the fair value of the net assets acquired was $70 million and is classified as “Goodwill” on our consolidated balance sheets.

 

Accounts Receivable, Net and Other Current Assets

 

Included in “Accounts receivable, net and other current assets” are prepaid expenses of $20 million and $12 million at September 30, 2005 and December 31, 2004, representing advance payments for insurance, licenses, and other miscellaneous expenses.

 

Goodwill

 

We perform our annual analysis of goodwill during the fourth quarter of each year, and we update our analysis whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Based on our 2004 analysis, no impairments were present, and no indicators of impairment were identified in the three quarters ended September 30, 2005.

 

Other Assets

 

Included in “Other assets” on our consolidated balance sheets are amounts primarily related to deferred issuance charges on our long-term debt, certain equity investments, and other intangibles. At September 30, 2005 and December 31, 2004, deferred issuance charges were $13 million and $19 million; equity investments were $9 million and $15 million; and other intangibles, net were $13 million and $5 million.

 

Income Taxes

 

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested.

 

Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. See Note 9 — “Income Taxes.” SFAS No. 109, “Accounting for Income Taxes,” requires deferred tax assets be evaluated for future realization and be reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Significant judgment is required in making this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of our deferred tax assets are realizable.

 

Classification of deferred tax assets between current and long-term categories is based on the expected timing of realization, and the valuation allowance is allocated on a pro-rata basis.

 

7


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Shipping Activities

 

Outbound shipping charges to customers are included in “Net sales” and were $112 million and $87 million for Q3 2005 and Q3 2004 and $323 million and $264 million for the three quarters ended September 30, 2005 and 2004. Outbound shipping-related costs are included in “Cost of sales” and totaled $159 million and $128 million for Q3 2005 and Q3 2004 and $471 million and $383 million for the three quarters ended September 30, 2005 and 2004. The net cost to us of shipping activities was $47 million and $41 million for Q3 2005 and Q3 2004 and $148 million and $119 million for the three quarters ended September 30, 2005 and 2004.

 

Internal-use Software and Website Development

 

Costs incurred to develop software for internal use are required to be capitalized and amortized over the estimated useful life of the software in accordance with SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Costs related to design or maintenance of internal-use software are expensed as incurred. During Q3 2005 and Q3 2004, we capitalized $25 million (including $3 million of stock-based compensation) and $12 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $14 million and $8 million. For the three quarters ended September 30, 2005 and 2004, we capitalized $65 million (including $8 million of stock-based compensation) and $29 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $35 million and $22 million.

 

Depreciation of Fixed Assets

 

Fixed assets include assets such as furniture and fixtures, heavy equipment, technology infrastructure, internal-use software and website development, and our DVD rental library. Depreciation is recorded on a straight-line basis over the estimated useful lives of the assets (generally two years or less for assets such as internal-use software and our DVD rental library, three years for our technology infrastructure, five years for furniture and fixtures, and ten years for heavy equipment). Depreciation expense is generally classified within the corresponding operating expense categories on the consolidated statements of operations, and certain assets, such as our DVD rental library, are amortized as “Cost of sales.” Depreciation expense for fixed assets was $29 million and $19 million for Q3 2005 and Q3 2004 and $78 million and $54 million for the three quarters ended September 30, 2005 and 2004.

 

Stock-Based Compensation

 

Effect of Early Adoption of SFAS 123(R), Share-Based Payment

 

Prior to January 1, 2005, we accounted for stock awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The intrinsic value method of accounting resulted in compensation expense for restricted stock and restricted stock units at their estimated fair value on date of grant based on the number of shares granted and the quoted price of our common stock, and for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were subject to an exchange offer, other modifications, or performance criteria, such awards were subject to variable accounting treatment. To the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.

 

8


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

As of January 1, 2005, we adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Such value is recognized as expense over the service period, net of estimated forfeitures, using the accelerated method under SFAS 123(R). The estimation of stock awards that will ultimately vest requires significant judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. Because we implemented SFAS 123(R), we no longer have employee stock awards subject to variable accounting treatment.

 

The adoption of SFAS 123(R) resulted in a cumulative benefit from accounting change of $26 million in Q1 2005, which reflects the net cumulative impact of estimating future forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted.

 

Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based compensation was presented in operating cash flows, along with other tax cash flows, in accordance with the provisions of the Emerging Issues Task Force (“EITF”) Issue No. 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123(R) supersedes EITF 00-15, amends SFAS 95, “Statement of Cash Flows,” and requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows. Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $2 million and $4 million for Q3 2005 and the three quarters ended September 30, 2005.

 

On March 29, 2005, the SEC published Staff Accounting Bulletin (“SAB”) No. 107, which provides the Staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. We have reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense line items as cash compensation paid to employees.

 

9


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

The application of SFAS 123(R) had the following effect on reported amounts relative to amounts that would have been reported using the intrinsic value method under previous accounting (in millions, except per share amounts):

 

    Three months ended September 30, 2005

  Nine months ended September 30, 2005

 
     Using Previous 
Accounting


  SFAS 123(R)
Adjustments


    As
Reported


   Using Previous 
Accounting


    SFAS 123(R)
Adjustments


    As
Reported


 

Income from operations

  $ 51   $ 4     $ 55   $ 283     $ (16 )   $ 267  

Income before income taxes

    47     4       51     283       (16 )     267  

Income before cumulative effect of change in accounting principle

    28     2       30     142       (8 )     134  

Net income

    28     2       30     142       18       160  

Basic earnings per share:

                                           

Prior to cumulative effect of change in accounting principle

  $ 0.06   $ 0.01     $ 0.07   $ 0.34     $ (0.01 )   $ 0.33  

Cumulative effect of change in accounting principle

    —       —         —       —         0.06       0.06  
   

 


 

 


 


 


    $ 0.06   $ 0.01     $ 0.07   $ 0.34     $ 0.05     $ 0.39  
   

 


 

 


 


 


Diluted earnings per share:

                                           

Prior to cumulative effect of change in accounting principle

  $ 0.06   $ 0.01     $ 0.07   $ 0.33     $ (0.01 )   $ 0.32  

Cumulative effect of change in accounting principle

    —       —         —       —         0.06       0.06  
   

 


 

 


 


 


    $ 0.06   $ 0.01     $ 0.07   $ 0.33     $ 0.05     $ 0.38  
   

 


 

 


 


 


Cash flow from operating activities

  $ 155   $ (2 )   $ 153   $ 107     $ (4 )   $ 103  

Cash flow from financing activities

    28     2       30     (221 )     4       (217 )

 

Valuation Assumptions for Stock Options

 

Less than two thousand stock options were granted during Q3 2005. The fair value for each stock option granted was estimated at the date of grant using a Black-Scholes option-pricing model, assuming no dividends and the following assumptions.

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
         2005    

        2004    

        2005    

        2004    

 

Average risk-free interest rate

   4.0 %   2.9 %   3.7 %   2.6 %

Average expected life (in years)

   4.5     3.3     4.5     3.3  

Volatility

   37.4 %   53.3 %   38.6 %   58.0 %

 

Expected volatilities are based on historical volatilities of our common stock; the expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

 

10


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Fair Value Disclosures — Prior to SFAS 123(R) Adoption

 

Stock-based compensation for the three quarters ended September 30, 2004 was determined using the intrinsic value method. The following table provides supplemental information for Q3 2004 and the three quarters ended September 30, 2004 as if stock-based compensation had been computed under SFAS 123 (in millions, except per share data):

 

     Three Months
Ended
September 30, 2004


    Nine Months
Ended
September 30, 2004


 

Net income — as reported

   $ 54     $ 242  

Add: Stock-based compensation, as reported

     9       38  

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

     (22 )     (61 )
    


 


Net income — SFAS 123 fair value adjusted

   $ 41     $ 219  
    


 


Basic earnings per share — as reported

   $ 0.13     $ 0.60  

Diluted earnings per share — as reported

     0.13       0.57  

Basic earnings per share — SFAS 123 fair value adjusted

     0.10       0.54  

Diluted earnings per share — SFAS 123 fair value adjusted

     0.10       0.52  

 

Note 2 — Cash, Cash Equivalents, and Marketable Securities

 

As of September 30, 2005 and December 31, 2004 our cash, cash equivalents, and marketable securities of $1.4 billion and $1.8 billion, at fair value, primarily consist of cash, investment grade securities and AAA-rated money market mutual funds. At September 30, 2005 and December 31, 2004 amounts held in foreign currencies were $687 million and $970 million, primarily Euros, British Pounds, and Yen.

 

At September 30, 2005, gross unrealized gains and losses on cash equivalents and marketable securities were not significant.

 

We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. See “Note 4 — Commitments and Contingencies.”

 

Note 3 — Long-Term Debt and Other

 

Our long-term debt and other long-term liabilities are summarized as follows:

 

     September 30,
2005


    December 31,
2004


 
     (in millions)  

4.75% Convertible Subordinated Notes due February 2009 (1)

   $ 900     $ 900  

6.875% PEACS due February 2010 (2)

     589       935  

Other long-term debt and capital lease obligations

     41       22  
    


 


       1,530       1,857  

Less current portion of other long-term debt and capital lease obligations

     (17 )     (2 )
    


 


Total long-term debt and other

   $ 1,513     $ 1,855  
    


 


 

11


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 


(1) 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, which is excluded from our calculation of earnings per share as its effect is anti-dilutive. We have the right to redeem the 4.75% Convertible Subordinated Notes, in whole or in part, by paying the principal and a redemption premium, plus any accrued and unpaid interest. At September 30, 2005, the redemption premium, which decreases by 47.5 basis points on February 1 of each year until maturity, was 1.9%.
(2) In Q1 2005, we redeemed an aggregate principal amount of €200 million ($265 million based on the Euro to U.S. Dollar exchange rate on the date of redemption) of our outstanding 6.875% Premium Adjustable Convertible Securities due February 2010 (“6.875% PEACS”). Under the Indenture, no redemption premium was required. We recorded a charge in Q1 2005, classified in “Remeasurements and other,” of approximately $4 million related to the redemption, consisting of $2 million in unamortized deferred issuance charges and $2 million relating to unrealized losses on our terminated currency swap that previously hedged a portion of our 6.875% PEACS. Accrued and unpaid interest of $0.9 million was also paid at redemption and recorded to “Interest expense.” The 6.875% PEACS are convertible into our common stock at the holders’ option at a conversion price of €84.883 per share ($102.08, based on the exchange rate as of September 30, 2005). Total common stock issuable upon conversion of our outstanding 6.875% PEACS is 5.8 million shares, which is excluded from our calculation of earnings per share as its effect is anti-dilutive. The U.S. Dollar equivalent principal, interest, and conversion price fluctuate 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 $20 million and $14 million for Q3 2005 and Q3 2004, and $53 million and $41 million for the three quarters ended September 30, 2005 and 2004.

 

The following summarizes our principal contractual commitments, excluding open orders for purchases that support normal operations, as of September 30, 2005:

 

     Three Months
Ending
December 31,
2005


   Year Ended December 31,

         
        2006

   2007

   2008

   2009

   Thereafter

   Total

     (in millions)

Operating and capital commitments:

                                                

Debt principal and other (1)

   $ 1.5    $ 14.2    $ 1.4    $ 1.8    $ 901.7    $ 610.3    $ 1,530.9

Debt interest (1)

     —        83.3      83.3      83.3      61.8      40.5      352.2

Capital leases

     0.3      0.7      —        —        —        —        1.0

Operating leases (2)(3)

     34.9      113.7      102.4      77.9      65.8      194.5      589.2
    

  

  

  

  

  

  

Total commitments

   $ 36.7    $ 211.9    $ 187.1    $ 163.0    $ 1,029.3    $ 845.3    $ 2,473.3
    

  

  

  

  

  

  


(1)

Under our 6.875% PEACS, the principal payment due in 2010 and the annual interest payments fluctuate based on the Euro/U.S. Dollar exchange ratio. At September 30, 2005, the Euro to U.S. Dollar exchange rate was 1.2026. Due to changes in the Euro/U.S. Dollar exchange ratio, our remaining principal debt obligation

 

12


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

 

under this instrument since issuance in February 2000 has increased by $106 million as of September 30, 2005. The principal and interest commitments at September 30, 2005 reflect the partial redemptions of the 6.875% PEACS and 4.75% Convertible Subordinated Notes.

(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, 2005, we have remaining obligations under operating leases for equipment and real estate totaling $589 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 $521 million of additional obligations on our balance sheet at September 30, 2005.
(3) Includes $10 million related to restructuring-related leases and other commitments, consisting of $4 million due within 12 months and included in “Accrued expenses and other current liabilities,” and $5 million due after 12 months and included in “Long-term debt and other” on our balance sheets. These amounts are net of anticipated sublease income of $6 million.

 

Pledged Securities

 

We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. The amount required to be pledged for real estate lease agreements changes over the life of our leases and with fluctuations in our market capitalization, which is common shares outstanding multiplied by the closing price of our common stock, and based on our credit-rating. Information about collateral required to be pledged under these agreements is as follows:

 

     Standby
Letters of
Credit (1)


    Line of
Credit (2)


   Real Estate
Leases (3)


    Total

     (in millions)

Balance at December 31, 2004

   $ 50     $ 2    $ 22     $ 74

Net change in collateral pledged

     (2 )     12      (5 )     5
    


 

  


 

Balance at September 30, 2005 (4)

   $ 48     $ 14    $ 17     $ 79
    


 

  


 


(1) Pursuant to available standby letter-of-credit facilities totaling $130 million.
(2) Pursuant to an available line of credit totaling $13 million.
(3) At September 30, 2005, our market capitalization was $18.8 billion. The required amount of collateral to be pledged will increase by $5 million if our market capitalization is equal to or below $18 billion and by an additional $6 million if our market capitalization is equal to or below $13 billion.
(4) Includes $8 million of cash equivalents pledged as collateral.

 

Legal Proceedings

 

A number of purported class action complaints were filed by holders of our equity and debt securities against us, our directors, and certain of our senior officers during 2001, in the United States District Court for the Western District of Washington, alleging violations of the Securities Act of 1933 (the “1933 Act”) and/or the Securities Exchange Act of 1934 (the “1934 Act”). In August 2003, plaintiffs in the 1934 Act cases filed a second consolidated amended complaint alleging that we, together with certain of our officers and directors, made false or misleading statements during the period from October 29, 1998 through October 23, 2001 concerning our business, financial condition and results, inventories, future prospects, and strategic alliance transactions. The 1933 Act complaint alleges that the defendants made false or misleading statements in connection with our February 2000 offering of the 6.875% PEACS. The complaints seek damages and injunctive

 

13


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

relief against all defendants. We dispute the allegations of wrongdoing in these complaints and have been vigorously defending ourselves in these matters. In March 2005, we signed a Stipulation of Settlement with counsel representing the plaintiff class with respect to the 1934 Act claims. In July 2005, we signed a Stipulation of Settlement with counsel representing the plaintiff class with respect to the 1933 Act claims. If finalized and approved by the Court, these settlements would dispose of all claims asserted in these lawsuits in exchange for payments totaling $48 million, substantially all of which we expect to be funded by our insurers.

 

In October 2002, Gary Gerlinger, individually and on behalf of all other similarly situated consumers in the United States who, during the period from August 1, 2001 to the present, purchased books online from either Amazon.com or Borders.com, instituted an action against us and Borders in the United States District Court for the Northern District of California. The complaint alleges that the agreement pursuant to which an affiliate of Amazon.com operates Borders.com as a co-branded site violates federal anti-trust laws, California statutory law, and the common law of unjust enrichment. The complaint seeks injunctive relief, damages, including treble damages or statutory damages where applicable, attorneys’ fees, costs, and disbursements, disgorgement of all sums obtained by allegedly wrongful acts, interest, and declaratory relief. We dispute the allegations of wrongdoing in this complaint, and intend to vigorously defend ourselves in this matter.

 

Beginning in March 2003, we were served with complaints filed in several different states, including Illinois and Nevada, by a private litigant purportedly on behalf of the state governments under various state False Claims Acts. The complaints allege that we (along with other companies with which we have commercial agreements) wrongfully failed to collect and remit sales and use taxes for sales of personal property to customers in those states and knowingly created records and statements falsely stating we were not required to collect or remit such taxes. The complaints seek injunctive relief, unpaid taxes, interest, attorneys’ fees, civil penalties of up to $10,000 per violation, and treble or punitive damages under the various state False Claims Acts. It is possible that we have been or will be named in similar cases in other states as well. We do not believe that we are liable under existing laws and regulations for any failure to collect sales or other taxes relating to Internet sales and intend to vigorously defend ourselves in these matters.

 

In January 2004, Soverain Software LLC filed a complaint against us for patent infringement in the United States District Court for the Eastern District of Texas. The complaint alleged that our website technology infringed several patents obtained by Soverain purporting to cover “Internet Server Access Control and Monitoring Systems” (U.S. Patent No. 5,708,780) and “Network Sales Systems” (U.S. Patent Nos. 5,715,314 and 5,909,492) and sought injunctive relief, monetary damages in an amount no less than a reasonable royalty, treble damages for alleged willful infringement, prejudgment interest, and attorneys’ fees. In October 2004, Soverain filed an amended complaint alleging that we infringed two additional patents purporting to cover “Digital Active Advertising” (U.S. Patent No. 6,195,649) and an “Open Network Payment System for Providing Real-Time Authorization of Payment and Purchase Transactions” (U.S. Patent No. 6,205,437). In August 2005, Amazon.com announced that it entered into a settlement of the litigation that included, among other things, a one-time payment of $40 million in Q3 2005, mutual releases, and a non-exclusive license to Soverain’s patent portfolio.

 

In January 2004, IPXL Holdings, LLC brought an action against us for patent infringement in the United States District Court for the Eastern District of Virginia. The complaint alleges that aspects of our online ordering technology, including 1-Click® ordering, infringe a patent obtained by IPXL purporting to cover an “Electronic Fund Transfer or Transaction System” (U.S. Patent No. 6,149,055) and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, and attorneys’ fees. In August 2004, the Court entered a judgment in Amazon.com’s favor on the grounds that the patent claims asserted by the plaintiff were invalid and that Amazon.com’s technology did not infringe those claims in any event. The Court also awarded Amazon.com its attorneys’ fees and costs. Plaintiff is appealing that judgment.

 

14


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.

 

In May 2004, Toysrus.com LLC filed a complaint against us for breach of contract in the Superior Court of New Jersey. The complaint alleges that we breached our commercial agreement with Toysrus.com LLC by selling, and by permitting other third parties to sell, products that Toysrus.com LLC alleges it has an exclusive right to sell on our website. The complaint seeks injunctive relief, declaratory judgment, termination of the agreement, and monetary damages in excess of $65 million. We dispute the allegations of wrongdoing in this complaint and have brought counterclaims alleging breach of contract and seeking damages and declaratory relief. We are vigorously defending ourselves in this matter.

 

In September 2004, BTG International Inc. filed a complaint against us for patent infringement in the United States District Court for the District of Delaware. The complaint alleges that our website technology, including our Associates program, infringes two patents obtained by BTG purporting to cover methods and apparatuses for “Attaching Navigational History Information to Universal Resource Locator Links on a World Wide Web Page” (U.S. Patent No. 5,712,979) and for “Tracking the Navigation Path of a User on the World Wide Web” (U.S. Patent No. 5,717,860) and seeks injunctive relief, monetary damages in an amount no less than a reasonable royalty, treble damages for alleged willful infringement, prejudgment interest, costs, and attorneys’ fees. We dispute the allegations of wrongdoing in this complaint and intend to vigorously defend ourselves in this matter.

 

In October 2004 Cendant Publishing, Inc. filed a complaint against us for patent infringement in the United States District Court for the District of Delaware. The complaint alleged that our website technology, including our recommendations features, infringes a patent obtained by Cendant purporting to cover a “System and Method for Providing Recommendation of Goods or Services Based on Recorded Purchasing History” (U.S. Patent No. 6,782,370) and sought injunctive relief, monetary damages in an amount no less than a reasonable royalty, prejudgment interest, costs, and attorneys’ fees. In February 2005, Cendant voluntarily withdrew the complaint without prejudice. In June 2005, however, Cendant re-filed a new complaint containing substantially the same claims. In response, we filed a countersuit in the United States District Court for the Western District of Washington alleging that Cendant’s parent, Cendant Corporation, and its affiliates Orbitz, Inc., Budget Rent A Car System, Inc., Avis Rent A Car System, Inc., and Trilegiant Corporation infringe certain patents owned by us and our subsidiary, A9.com. We dispute Cendant’s allegations of wrongdoing in its complaint and intend to vigorously defend ourselves in these matters.

 

Depending on the amount and the timing, an unfavorable resolution of some or all of these matters could materially affect our business, results of operations, financial position, or cash flows in a particular period.

 

Note 5 — Stockholders’ Equity (Deficit)

 

Stock Award Plans and Shares Reserved for Future Issuance

 

Common stock reserved for future issuance was as follows (in millions):

 

     September 30,
2005


   December 31,
2004


Stock awards

   111    114

Shares issuable upon conversion of 4.75% Convertible Subordinated Notes

   11    11

Shares issuable upon conversion of 6.875% PEACS

   6    8
    
  

Total common stock reserved for future issuance

   128    133
    
  

 

15


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Stock Award Activity

 

Employees vest in restricted stock unit awards and stock options ratably over the service term, generally between two and five years. Outstanding stock options generally have a term of 10 years from the date of grant.

 

We granted stock awards, which since October 2002 have consisted primarily of restricted stock units, representing 1.0 million and 0.7 million shares of common stock during Q3 2005 and Q3 2004 with a per share weighted average fair value of $40.11 and $40.12. For the three quarters ended September 30, 2005 and comparable period in 2004 we granted stock awards representing 5.5 million and 2.7 million shares of common stock with per share weighted average fair values of $35.90 and $44.59.

 

Common shares underlying outstanding stock awards were as follows:

 

     September 30,
2005


   December 31,
2004


     (in millions)

Stock options

   14    18

Restricted stock units

   10    6
    
  

Outstanding stock awards, excluded from common stock outstanding

   24    24

Restricted stock, included in outstanding common stock

   —      1
    
  

Total outstanding stock awards

   24    25
    
  

 

Common shares outstanding (which includes restricted stock), plus shares underlying outstanding stock options and restricted stock units totaled 438 million and 434 million at September 30, 2005 and December 31, 2004. These totals include all stock-based awards outstanding, without regard for estimated forfeitures, consisting of vested and unvested awards, and in-the-money and out-of-the-money stock options. Common shares outstanding increased by 2.3 million shares and 0.8 million shares during Q3 2005 and Q3 2004 and by 4.3 million and 4.1 million shares during the three quarters ended September 30, 2005 and 2004, due to exercises of stock options, vesting of restricted stock units, and matching contributions under our 401(k) savings plan.

 

The following table summarizes our restricted stock unit activity for the three quarters ended September 30, 2005 (in millions):

 

     Number of
Units


 

Outstanding at December 31, 2004

   6.4  

Units granted

   5.4  

Units vested

   (0.5 )

Units cancelled

   (0.9 )
    

Outstanding at September 30, 2005

   10.4  
    

 

The aggregate intrinsic value of restricted stock units as of September 30, 2005 was $439 million. Intrinsic value for restricted stock units is calculated based on the number of awards outstanding and the quoted price of our common stock as of the reporting date.

 

16


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Scheduled vesting for outstanding restricted stock units at September 30, 2005 is as follows (in millions):

 

     Three Months
Ending
December 31,
2005


   Year Ended December 31,

         
        2006

   2007

   2008

   2009

   Thereafter

   Total

Scheduled vesting — restricted stock units

   0.6    2.1    3.3    2.6    1.3    0.5    10.4
    
  
  
  
  
  
  

 

The following table summarizes our stock option activity for the three quarters ended September 30, 2005:

 

     Number of
Options


    Weighted Avg
Exercise Price


Outstanding at December 31, 2004

   18.4     $ 12.98

Options granted

   0.1       35.82

Options exercised

   (3.8 )     10.51

Options terminated

   (1.0 )     11.58
    

     

Outstanding at September 30, 2005

   13.7     $ 13.90
    

     

 

The following table summarizes information about stock options outstanding at September 30, 2005:

 

     Stock Options Outstanding

   Stock Options Vested

Range of Exercise Prices


   Number of
Awards


   Remaining
Life (yrs)


   Weighted Avg
Exercise Price


   Number of
Awards


   Weighted Avg
Exercise Price


     (in millions)              (in millions)     

$  0.08 – $  10.00

   10.2    5.5    $ 7.55    4.5    $ 7.01

  10.01 –     30.00

   2.3    5.3      17.23    1.4      17.58

  30.01 –     50.00

   0.5    6.2      38.30    0.4      38.16

  50.01 –     70.00

   0.1    3.6      59.73    0.1      59.81

  70.01 –   104.97

   0.6    3.2      73.37    0.3      75.36
    
              
      

$  0.08 – $104.97

   13.7    5.4    $ 13.90    6.7    $ 15.24
    
              
      

 

The aggregate intrinsic value of stock options outstanding at September 30, 2005 was $451 million, of which $236 million relates to vested awards. Intrinsic value for stock options is calculated based on the difference between the exercise price of the underlying awards and the quoted price of our common stock as of the reporting date.

 

As matching contributions under our 401(k) savings plan, we granted 0.07 million shares of common stock for the three quarters ended September 30, 2005. Shares granted as matching contributions under our 401(k) plan and shares of restricted stock are included in outstanding common stock when issued.

 

As of September 30, 2005, there was $198 million of total unrecognized compensation cost, net of estimated forfeitures of $98 million, related to unvested stock-based compensation arrangements. This compensation is recognized on an accelerated basis resulting in approximately half of the compensation expected to be expensed in the next twelve months, and a weighted average recognition period of 1.3 years.

 

During Q3 2005 and Q3 2004, the fair value of restricted stock units and restricted stock awards vested was $8 million and $1 million, and the intrinsic value of options exercised was $71 million and $22 million. The fair value of restricted stock units and restricted stock awards vested in the three quarters ended September 30, 2005 and 2004 was $22 million and $19 million, and the intrinsic value of options exercised was $111 million and $162 million.

 

17


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

Note 6 — Other Comprehensive Income (Loss)

 

Comprehensive income was $16 million and $53 million for Q3 2005 and Q3 2004, and $141 million and $232 million for the three quarters ended September 30, 2005 and 2004. The primary differences between net income as reported and comprehensive income are foreign currency translation adjustments and changes in unrealized gains and losses on available-for-sale securities.

 

Note 7 — Other Operating Expense (Income)

 

In Q3 2005 we settled a patent lawsuit on terms that include, among other things, a one-time payment of $40 million in Q3 2005 that was recorded to “Other operating expense (income)” on the consolidated statements of operations.

 

In Q3 2004 severance terms were finalized to eliminate certain managerial, professional, clerical and technical positions in France. The corresponding costs of $4 million were recorded in the third quarter of 2004 and classified in “Other operating expense (income)” on the consolidated statements of operations.

 

“Other operating expense (income)” for the three quarters ended September 30, 2004 includes a gain of $8 million related to the reduction of our restructuring-related liability due to our occupation of certain office space previously vacated as part of our 2001 restructuring.

 

Note 8 — Remeasurements and Other

 

Remeasurements and other consisted of the following:

 

    Three months ended
September 30,


    Nine months ended
September 30,


 
        2005    

        2004    

        2005    

        2004    

 
    (in millions)     (in millions)  

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

  $ 4     $ (16 )   $ 81     $ 12  

Gain (loss) on sales of Euro-denominated investments, net

    —         4       (2 )     9  

Loss on redemption of long-term debt

    —         —         (4 )     (6 )

Foreign-currency effect on intercompany balances (2)

    (2 )     7       (41 )     (3 )

Other (3)

    4       —         4       19  
   


 


 


 


Total remeasurements and other

  $ 6     $ (5 )   $ 38     $ 31  
   


 


 


 



(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) Represents the loss associated with the remeasurement of intercompany balances due to changes in foreign exchange rates.
(3) Primarily includes gains associated with the sale of certain equity investments.

 

Note 9 — Income Taxes

 

Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, with the cumulative effect of a change to the estimated annual rate being recorded in the interim period such a change is made. The Q3 2005 tax provision includes a cumulative adjustment benefit of $4 million, with a corresponding benefit to diluted earnings per share of $0.01, to reflect our current estimate of our annual effective tax rate of

 

18


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

50%. Our effective tax rate for Q3 2005 and for the three quarters ended September 30, 2005 remains higher than the 35% statutory rate associated with taxable income resulting from the Q1 2005 transfer of certain operating assets from the U.S. to international locations. We expect these asset transfers to result in tax expense for financial reporting purposes above the statutory rate throughout 2005. Since we have Net Operating Losses (“NOLs”) these asset transfers will not have a significant effect on cash taxes paid in 2005. Cash paid for income taxes was $6 million and $2 million in Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 was $11 million and $3 million.

 

At September 30, 2005, approximately $720 million of our gross deferred tax assets were related to approximately $2.3 billion of NOLs. Our NOL deferred tax assets are reduced by a valuation allowance of approximately $510 million due to uncertainty about their future realization. The remainder of our deferred tax assets relate to temporary timing differences between tax and financial reporting. The majority of our NOLs expire after 2016, and utilization of NOLs may be subject to certain limitations under Sections 382 and 1502 of the Internal Revenue Code of 1986 (“Internal Revenue Code”), and other limitations under state and foreign tax laws.

 

Note 10 — Segment Information

 

We have organized our operations into two principal segments: North America and International. We present our segment information along the same lines that our chief executive reviews our operating results in assessing performance and allocating resources.

 

We allocate to segment results the operating expenses “Fulfillment,” “Marketing,” “Technology and content,” and “General and administrative,” but exclude from our allocations the portions of these expense lines attributable to stock-based compensation. Additionally, we do not allocate the line item “Other operating income (expense)” to our segment operating results. A significant majority of our costs for “Technology and content” are incurred in the United States and most of these costs are allocated to our North America segment. There are no internal revenue transactions between our reporting segments.

 

North America

 

The North America segment consists of amounts earned from retail sales of consumer products (including from third-party sellers) and subscriptions through North America-focused websites, such as www.amazon.com and www.amazon.ca, from North America-focused Syndicated Stores and mail-order catalogs, and from non-retail activities such as North America-focused Amazon Services’ Merchant.com program, marketing, and promotional agreements.

 

International

 

The International segment consists of amounts earned from retail sales of consumer products (including from third-party sellers) and subscriptions through internationally-focused websites, such as www.amazon.co.uk, www.amazon.de, www.amazon.fr, www.amazon.co.jp, and www.joyo.com, from internationally-focused Syndicated Stores and from non-retail activities such as internationally-focused marketing and promotional agreements. This segment includes export sales from www.amazon.co.uk, www.amazon.de, www.amazon.fr, www.amazon.co.jp, and www.joyo.com (including export sales from these sites to customers in the U.S. and Canada), but excludes export sales from www.amazon.com and www.amazon.ca.

 

19


Table of Contents

AMAZON.COM, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(unaudited)

 

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

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
         2005    

        2004    

        2005    

        2004    

 

North America

                                

Net sales

   $ 1,041     $ 816     $ 3,028     $ 2,455  

Cost of sales

     749       593       2,179       1,786  
    


 


 


 


Gross profit

     292       223       849       669  

Direct segment operating expenses

     226       166       645       470  
    


 


 


 


Segment operating income

     66       57       204       199  

International

                                

Net sales

     817       647       2,485       1,925  

Cost of sales

     646       514       1,962       1,536  
    


 


 


 


Gross profit

     171       133       523       389  

Direct segment operating expenses

     116       95       346       275  
    


 


 


 


Segment operating income

     55       38       177       114  

Consolidated

                                

Net sales

     1,858       1,463       5,513       4,380  

Cost of sales

     1,395       1,107       4,141       3,322  
    


 


 


 


Gross profit

     463       356       1,372       1,058  

Direct segment operating expenses

     342       261       991       745  
    


 


 


 


Segment operating income

     121       95       381       313  

Stock-based compensation

     (26 )     (9 )     (71 )     (38 )

Other operating income (expense)

     (40 )     (5 )     (43 )     3  
    


 


 


 


Income from operations

     55       81       267       278  

Total non-operating income (expense), net

     (4 )     (24 )     —         (30 )

Provision for income taxes

     (21 )     (3 )     (133 )     (6 )

Cumulative effect of change in accounting principle

     —         —         26       —    
    


 


 


 


Net income

   $ 30     $ 54     $ 160     $ 242  
    


 


 


 


 

20


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, international growth and expansion, outcomes of legal proceedings and claims, fulfillment center optimization, risks of inventory management, seasonality, the degree to which the Company enters into, maintains, and develops commercial agreements, acquisitions, and strategic transactions, and risks of fulfillment throughput and productivity. These risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in “Additional Factors That May Affect Future Results,” which, along with the previous discussion, describes some, but not all, of the factors that could cause actual results to differ significantly from management’s expectations.

 

Overview

 

Our primary source of revenue is the sale of a wide range of products and services to customers of our global websites. The products offered on our websites include products we have purchased from distributors, publishers, and manufacturers and products offered by third parties. Generally, we recognize gross revenue from items we sell from our inventory and recognize our net share of revenue of items sold by third parties.

 

Our financial focus is on long-term, sustainable growth in free cash flow1. Free cash flow is driven primarily by increasing operating income and efficiently managing working capital and capital expenditures. Increases in operating income result from increases in sales through our websites and a focus on keeping our operating costs low, offset by investments we make in longer-term strategic initiatives including hiring additional software engineers and computer scientists. To increase sales, we focus on improving all aspects of the customer experience, including lowering prices, improving availability, offering faster delivery times, increasing selection, expanding product information, improving ease of use, and earning customer trust. We generally focus on gross profit and operating profit dollars rather than margin percentages. Because we have net operating loss carryforwards, the free cash flow impact from income taxes paid is less than our income tax provision.

 

We also seek to efficiently manage shareholder dilution while maintaining the flexibility to issue shares for strategic purposes, such as financings and aligning employee interests with shareholders. We moved to restricted stock units as our primary vehicle for equity compensation in late 2002 because we believe they better align the interests of our shareholders and employees. Restricted stock units result in charges to our income statement based on the fair value of the awards at the grant date recorded over the underlying service periods, net of estimated cancellations. Total shares outstanding plus outstanding stock awards were 438 million and 434 million at September 30, 2005 and December 31, 2004. These totals include all stock awards outstanding, without regard for estimated forfeitures, consisting of vested and unvested awards, and in-the-money and out-of-the-money stock options.

 


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.

 

21


Table of Contents

We seek to leverage our fixed customer experience costs and work to reduce our variable costs per unit. Our customer experience costs, specifically the costs necessary to build, enhance, and add features to our websites and build and optimize our fulfillment centers, are largely fixed in that they do not vary directly with sales. The customer experience costs that remain largely variable as a percentage of sales include product costs; credit-card processing fees; bad debt; picking, packaging, and preparing orders for shipment; transportation; customer service support; and most aspects of our marketing costs. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct to publisher and manufacturer sourcing; seek to maximize volume discounts available to us from suppliers; and focus on maintaining a lean culture, including by reducing defects in our processes.

 

Because of our model we are able to turn our inventory quickly and have a negative operating cycle2. On average, our high inventory velocity means we generally collect from our customers before our payments to suppliers come due. Inventory turnover3 was 15 and 17 for Q3 2005 and Q3 2004. We expect some variability in inventory turnover over time since it is affected by several factors, including our product mix, our mix of third-party sales, our continuing focus on in-stock inventory availability, our future investment in new geographies and product lines, and the extent we choose to utilize outsource fulfillment providers. Accounts payable days4 were 58 and 57 for Q3 2005 and Q3 2004. We expect some variability in accounts payable days over time since it is affected by several factors, including the mix of product sales, the mix of third-party sales, the mix of suppliers, seasonality, and changes in payment terms over time, including the effect of negotiating better pricing from our suppliers in exchange for shorter payment terms.

 

Our spending in technology and content will increase as we add computer scientists and software engineers to continue to improve our process efficiency and enhance the customer experience on our websites. We believe that advances in technology, specifically the speed and reduced cost of processing power, the improved consumer experience of the Internet outside of the workplace through lower-cost broadband service to the home, and the advances of wireless connectivity, will continue to improve the consumer experience on the Internet and increase its ubiquity in people’s lives. Our challenge will be to continue to build and deploy innovative and efficient software that will best take advantage of continued advances in technology.

 

Our financial reporting currency is the U.S. Dollar and changes in exchange rates significantly affect our reported results and consolidated trends. For example, if the U.S. Dollar weakens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit, and operating expenses will be higher than if currencies had remained constant. Likewise, if the U.S. Dollar strengthens year-over-year relative to currencies in our international locations, our consolidated net sales, gross profit, and operating expenses will be lower than if currencies had remained constant. We believe that our increasing diversification beyond the U.S. economy through our growing international businesses benefits our shareholders over the long term. We also believe it is important to evaluate our operating results and growth rates before and after the effect of currency changes.

 

In addition, the remeasurement of our 6.875% PEACS and intercompany balances can result in significant gains and charges associated with the effect of movements in currency exchange rates. Currency volatilities will likely continue, which may significantly impact (either positively or negatively) our reported results and consolidated trends and comparisons. Assuming exchange rates remain at recent levels, we expect an over $100 million year-over-year negative impact to consolidated net sales in the fourth quarter from foreign exchange.

 


2 The operating cycle is the number of days of sales in inventory plus the 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 over five quarter ends.
4 Accounts payable days is the quotient of accounts payable to cost of sales, multiplied by the number of days in the period.

 

22


Table of Contents

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 it to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business and Accounting Policies,” of our 2004 Annual Report on Form 10-K. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.

 

Revenue Recognition

 

We recognize revenue from product sales or services rendered when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured. Additionally, revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: the delivered item has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of undelivered items; and delivery of any undelivered item is probable.

 

We evaluate the criteria of EITF 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not primarily obligated and amounts earned are determined using a percentage, a fixed-payment schedule, or a combination of the two, we generally record the net amounts as commissions earned. Under our Syndicated Stores arrangements, we record gross product sales and costs since we own the inventory, set prices, and are responsible for fulfillment and customer service, and the other business earns a sales commission.

 

Product sales and shipping revenues, net of promotional discounts, rebates, and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to sales contracts that generally provide for transfer of both title and risk of loss upon our delivery to the carrier. Return allowances, which reduce product revenue by our best estimate of expected product returns, are estimated using historical experience. Amounts paid in advance for subscription services, including amounts received for online DVD rentals, Amazon Prime, and other membership programs, are deferred and classified in “Unearned revenue” on our consolidated balance sheets and recognized as revenue over the subscription term.

 

We periodically provide incentive offers to our customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases, inducement offers, such as offers for future discounts subject to a minimum current purchase, and other similar offers. Current discount offers, when accepted by our customers, are treated as a reduction to the purchase price of the related transaction, while inducement offers, when accepted by our customers, are treated as a reduction to purchase price based on estimated future redemption rates. Redemption rates are estimated using our historical experience for similar inducement offers. Current discount offers and inducement offers are classified as an offsetting amount in “Net sales.”

 

23


Table of Contents

Commissions and per-unit fees received from third-party sellers and similar amounts earned through our Amazon Services’ Merchant.com program are recognized when the item is sold by the third-party seller and our collectibility is reasonably assured. When we are responsible for fulfillment-related services, commissions are recognized when risk of loss and title transfer to the customer. We record an allowance for estimated refunds on such commissions using historical experience.

 

Inventories

 

Inventories, consisting of products available for sale, are accounted for using the first-in first-out (“FIFO”) method, and are valued at the lower of cost or market value. This valuation requires us to make judgments, based on currently-available information, about the likely method of disposition, such as through sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each disposition category. Based on this evaluation, we adjust the carrying amount of our inventories to lower of cost or market value.

 

We provide fulfillment-related services in connection with certain of our Amazon Services’ Merchants@ and Merchant.com programs. In those arrangements, as well as other product sales by third parties, the third-party maintains ownership of the related products.

 

Internal-Use Software and Website Development

 

Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our websites and processes supporting our business. As required by Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” we capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of two years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.

 

During Q3 2005 and Q3 2004, we capitalized $25 million (including $3 million of stock-based compensation) and $12 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $14 million and $8 million. For the three quarters ended September 30, 2005 and 2004, we capitalized $65 million (including $8 million of stock-based compensation) and $29 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $35 million and $22 million.

 

Valuation of Deferred Tax Assets

 

SFAS 109, “Accounting for Income Taxes,” requires that deferred tax assets be evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Significant judgment is required in making this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of our deferred tax assets are realizable.

 

Stock-Based Compensation

 

As of January 1, 2005, we adopted SFAS 123(R), which requires us to measure compensation cost for stock awards at fair value and recognize compensation over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.

 

24


Table of Contents

When the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), they encouraged early adoption of the standard. After we early-adopted SFAS 123(R), the FASB deferred the required implementation date. Additionally, the FASB continues to discuss implementation issues with industry leaders and the large accounting firms, and this may result in clarifications or modifications of rules affecting the application of the standard. If additional clarifications or conclusions affecting implementation are reached that differ from our application of the standard, this may have an impact, either positive or negative, on our reported results.

 

Liquidity and Capital Resources

 

Our financial focus is on long-term, sustainable growth in free cash flow. Free cash flow was $475 million for the trailing twelve months ended September 30, 2005, which includes the effect of a $40 million patent litigation settlement in Q3 2005, compared to $420 million for the trailing twelve months ended September 30, 2004, an increase of 13%. Operating cash flows and free cash flows can be volatile and are sensitive to many factors, including changes in working capital and timing of capital expenditures. Working capital at any specific point in time is subject to many variables, including seasonality, the timing of expense payments, discounts offered by vendors, vendor payment terms, and fluctuations in foreign exchange rates.

 

Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, which, at fair value, were $1.4 billion and $1.8 billion at September 30, 2005 and December 31, 2004. Amounts held in foreign currencies were $687 million and $970 million at September 30, 2005 and December 31, 2004, and were primarily Euros, British Pounds, and Yen.

 

Cash provided by operating activities was $153 million and $117 million for Q3 2005 and Q3 2004 and was $103 million and $9 million for the three quarters ended September 30, 2005 and 2004. Our operating cash flows result primarily from cash received from our customers, third-party sellers, and from non-retail activities such as our Amazon Services’ Merchant.com program, and miscellaneous marketing and promotional agreements, offset by cash payments we make to suppliers of products and services, employee compensation, credit card transaction fees, operating leases, bad debt, and interest payments on our long-term debt obligations. Cash received from customers and third-party sellers generally corresponds to our net sales. Because our customers primarily use credit cards to buy from us, our receivables from customers settle quickly. Cash paid to inventory and transportation suppliers generally corresponds with cost of sales, adjusted for increases or decreases in inventory and payable levels. During Q3 2005, payments to product merchandise suppliers, which do not include payments to transportation suppliers, totaled $1.2 billion, a 24% increase over Q3 2004. Payments to product merchandise suppliers correspond with cost of sales, and are also affected by our efforts to add product categories, increase selection of products we offer for sale, improve availability in both existing and new product categories, and take advantage of additional discounts offered to us by suppliers, and by foreign exchange rates. Cash provided by operating activities in Q3 2005 and the three quarters ended September 30, 2005 were negatively affected by the $40 million patent litigation settlement in Q3 2005. See “Note 7 — Other Operating Expense (Income).”

 

Cash used in investing activities corresponds with purchases, sales, and maturities of marketable securities, net cash flows from acquisitions, and purchases of fixed assets, including internal-use software and website development costs. Cash used in investing activities was $206 million and $85 million during Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 cash used in investing activities was $547 million and $252 million. Capital expenditures were $76 million and $29 million during Q3 2005 and Q3 2004 and were $149 million and $52 million during the three quarters ended September 30, 2005 and 2004, with the increases reflecting additional investment in development of new features and product offerings on our websites, as well as investments in fulfillment-related assets and technology infrastructure. Capital expenditures included $21 million and $12 million for internal-use software and website development during Q3 2005 and Q3 2004, and $57 million and $29 million for the three quarters ended September 30, 2005 and 2004. Stock-based compensation capitalized for internal-use software and website development costs does not affect cash flows. We purchased certain companies in the three quarters ended September 30, 2005 and 2004 resulting in cash payments, net of acquired cash, of $24 million and $71 million. We believe our expenditures for repairs and improvements are sufficient to keep our facilities and equipment in suitable operating condition.

 

25


Table of Contents

Cash provided by financing activities was $30 million and $7 million during Q3 2005 and Q3 2004, and cash used in financing activities was $217 million and $114 million for the three quarters ended September 30, 2005 and 2004. In Q1 2005, we repaid €200 million of our 6.875% PEACS for $265 million. In Q1 2004, we repaid $150 million of our 4.75% Convertible Subordinated Notes for $154 million. Cash inflows from financing activities primarily result from proceeds from exercises of employee stock options, which were $23 million and $8 million for Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 were $42 million and $43 million. We expect cash proceeds from exercises of stock options will decline over time as we continue issuing restricted stock units as our primary vehicle for stock-based awards.

 

Since our 6.875% PEACS, which are due in 2010, are denominated in Euros, our U.S. Dollar equivalent interest payments and principal obligations fluctuate with the Euro to U.S. Dollar exchange rate. We currently do not hedge our exposure to foreign currency effects on our interest or principal obligations relating to the 6.875% PEACS, and, as a result, any fluctuations in the exchange rate will have an effect on our interest expense and, to the extent we make principal payments, the amount of U.S. Dollar equivalents necessary for principal settlement. Additionally, since our interest payable on our 6.875% PEACS is due in Euros, the balance of interest payable is subject to gains or losses on currency movements until the date of the interest payment. Gains or losses on the remeasurement of our Euro-denominated interest payable are classified as “Other income, net” on our consolidated statements of operations.

 

The following summarizes our principal contractual commitments as of September 30, 2005:

 

    Three Months
Ending
December 31,
2005


  Year Ended December 31,

 

Thereafter


 

Total


    2006

  2007

  2008

  2009

   
    (in millions)

Operating and capital commitments:

                                         

Debt principal and other (1)

  $ 1.5   $ 14.2   $ 1.4   $ 1.8   $ 901.7   $ 610.3   $ 1,530.9

Debt interest (1)

    —       83.3     83.3     83.3     61.8     40.5     352.2

Capital leases

    0.3     0.7     —       —       —       —       1.0

Operating leases (2)(3)

    34.9     113.7     102.4     77.9     65.8     194.5     589.2

Purchase obligations (4)

    466.3     11.2     11.8     8.4     8.4     16.7     522.8
   

 

 

 

 

 

 

Total commitments

    503.0     223.1     198.9     171.4     1,037.7     862.0     2,996.1
   

 

 

 

 

 

 


(1) At September 30, 2005, the Euro to U.S. Dollar exchange rate was 1.2026. Due to changes in the Euro/U.S. Dollar exchange ratio, our remaining principal debt obligation under this instrument since issuance in February 2000 has increased by $106 million as of September 30, 2005. The principal and interest commitments reflect the partial redemptions of the 6.875% PEACS and 4.75% Convertible Subordinated Notes.
(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, 2005, we have remaining obligations under operating leases for equipment and real estate totaling $589 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 $521 million of additional obligations on our balance sheet at September 30, 2005.
(3) Includes $10 million related to restructuring-related leases and other commitments, consisting of $4 million due within 12 months and included in “Accrued expenses and other current liabilities,” and $5 million due after 12 months and included in “Long-term debt and other” on our balance sheets. These amounts are net of anticipated sublease income of $6 million.
(4) Consists of legally-binding commitments to purchase inventory and significant non-inventory commitments.

 

26


Table of Contents

Pledged Securities

 

We are required to pledge a portion of our cash equivalents or marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a line of credit, and real estate lease agreements. The amount required to be pledged for real estate lease agreements changes over the life of our leases and with fluctuations in our market capitalization, which is common shares outstanding multiplied by the closing price of our common stock, and based on our credit rating. Information about collateral required to be pledged under these agreements is as follows:

 

     Standby
Letters of
Credit (1)


    Line of
Credit (2)


   Real Estate
Leases (3)


    Total

     (in millions)

Balance at December 31, 2004

   $ 50     $ 2    $ 22     $ 74

Net change in collateral pledged

     (2 )     12      (5 )     5
    


 

  


 

Balance at September 30, 2005 (4)

   $ 48     $ 14    $ 17     $ 79
    


 

  


 


(1) Pursuant to available standby letter-of-credit facilities totaling $130 million.
(2) Pursuant to an available line of credit totaling $13 million.
(3) At September 30, 2005, our market capitalization was $18.8 billion. The required amount of collateral to be pledged will increase by $5 million if our market capitalization is equal to or below $18 billion and by an additional $6 million if our market capitalization is equal to or below $13 billion.
(4) Includes $8 million of cash equivalents pledged as collateral.

 

We believe that current cash, cash equivalents, and marketable securities balances will be sufficient to meet our anticipated operating cash needs for at least the next 12 months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See “Additional Factors That May Affect Future Results.” We continually evaluate opportunities to sell additional equity or debt securities, obtain credit facilities from lenders, repurchase common stock, pay dividends, or repurchase, refinance, or otherwise restructure our long-term debt for strategic reasons or to further strengthen our financial position. The sale of additional equity or convertible debt securities would likely be dilutive to our shareholders. In addition, we will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services, and technologies, which might affect our liquidity requirements or cause us to issue additional equity or debt securities. There can be no assurance that additional lines-of-credit or financing instruments will be available in amounts or on terms acceptable to us, if at all.

 

Results of Operations

 

We have organized our operations into two principal segments: North America and International. We present our segment information along the same lines that our chief executive reviews our operating results in assessing performance and allocating resources.

 

27


Table of Contents

Net Sales and Gross Profit

 

Net sales information is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 
     (in millions)  

Net Sales:

                                

North America

   $ 1,041     $ 816     $ 3,028     $ 2,455  

International

     817       647       2,485       1,925  
    


 


 


 


Consolidated

   $ 1,858     $ 1,463     $ 5,513     $ 4,380  
    


 


 


 


Year-over-year Percentage Growth:

                                

North America

     28 %     15 %     23 %     16 %

International

     26       52       29       60  

Consolidated

     27       29       26       32  

Year-over-year Percentage Growth, excluding effect of exchange rates:

                                

North America

     27 %     15 %     23 %     16 %

International

     28       39       27       45  

Consolidated

     28       24       25       26  

Net Sales Mix:

                                

North America

     56 %     56 %     55 %     56 %

International

     44       44       45       44  
    


 


 


 


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. Revenue growth is also affected by general economic conditions and by changes in exchange rates — see “Effect of Exchange Rates” below. The Q3 2005 and three quarters ended September 30, 2005 growth rates include the effects of the Q3 2005 release of Harry Potter and the Half-Blood Prince, for which we sold over 1.6 million copies during Q3 2005. Additionally, the year-over-year growth rates for the three quarters ended September 30, 2004 were affected by the previous year release of Harry Potter and the Order of the Phoenix, for which we sold over 1.4 million copies in Q2 2003.

 

North America revenue growth rates for Q3 2005 and the three quarters ended September 30, 2005 were higher than the comparable periods in 2004, which reflects several current-year factors such as our continued efforts to reduce prices for our customers, including from our free shipping offers, additions to our product categories and selection available on our websites, and increases in our Amazon Services’ Merchant.com program and marketing and promotional-related revenues including from our co-branded credit card agreement.

 

International revenue growth rates for Q3 2005 and the three quarters ended September 30, 2005 were lower than the comparable periods in 2004. This primarily reflects the increasing size of our International business, which creates a larger revenue base against which future growth is measured, offset partially by our customer experience initiatives including new category introductions; increased selection; third-party offerings; and our efforts to reduce prices for our customers, including from our free shipping offers. Additionally, changes in currency exchange rates negatively affected Q3 2005 revenue growth rates, and positively affected growth rates for Q3 2004 and the three quarters ended September 30, 2005 and 2004.

 

We expect that, over time, our International segment will represent 50% or more of our consolidated total. Additionally, as we continue to offer increased selection, lower prices, and additional product lines in our Electronics and other general merchandise category, we expect to see the relative mix of sales from this category increase. See “Supplemental Information” below.

 

28


Table of Contents

Gross profit information is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
       2005  

      2004  

      2005  

      2004  

 
     (in millions)  

Gross Profit:

                                

North America

   $ 292     $ 223     $ 849     $ 669  

International

     171       133       523       389  
    


 


 


 


Consolidated

   $ 463     $ 356     $ 1,372     $ 1,058  
    


 


 


 


Year-over-year Percentage Growth:

                                

North America

     31 %     11 %     27 %     16 %

International

     29       56       35       54  

Consolidated

     30       24       30       27  

Gross Margin:

                                

North America

     28.1 %     27.4 %     28.1 %     27.2 %

International

     20.9       20.5       21.0       20.2  

Consolidated

     24.9       24.3       24.9       24.1  

 

The increase in gross profit in absolute terms during Q3 2005 and the three quarters ended September 30, 2005 compared to 2004 corresponds with increases in sales, including increases in sales by third-party sellers, increases in amounts earned from our co-branded credit card agreement, and increases in amounts earned from our Amazon Services’ Merchant.com program, offset by our free shipping offers and lower prices for customers. Generally, our gross margins fluctuate based on several factors, including our product, service, and geographic mix of sales; sales volumes by third-party sellers; changes in vendor pricing, including the extent to which we receive discounts and allowances; lowering prices for customers, including from competitive pricing decisions; improvements in product sourcing and inventory management; and the extent to which our customers accept our free shipping and membership offers. Free shipping and membership offers reduce shipping revenue and reduce our gross margins on retail sales. We view our shipping offers as an effective worldwide marketing tool and intend to continue offering them indefinitely. Amazon Prime, introduced in Q1 2005, is a new shipping membership program in which members receive free two-day shipping and discounted overnight shipping.

 

Sales of products by third-party sellers on our websites continue to increase, representing 30% and 28% of unit sales in Q3 2005 and Q3 2004, and 29% and 25% in the three quarters ended September 30, 2005 and 2004. Since revenues from these sales are recorded as a net amount, they generally result in lower revenues but higher gross margin per unit. If product sales by third-party sellers continue to increase, the higher gross margin attributes of these sales will offset decreases in our gross margins due to lowering prices for customers over time by offering price reductions, free shipping offers, and promotions.

 

Gross profit growth is also affected by changes in exchange rates — see “Effect of Exchange Rates” below.

 

North America segment gross margins in Q3 2005 and the three quarters ended September 30, 2005 improved by 71 basis points and 81 basis points over the comparable periods in 2004 resulting primarily from increases in sales by third-party sellers, increases in amounts earned from our co-branded credit card agreement, and increases in amounts earned from our Amazon Services’ Merchant.com program.

 

International segment gross margins in Q3 2005 and the three quarters ended September 30, 2005 improved by 47 basis points and 85 basis points over the comparable periods in 2004 resulting from several factors including increasing sales by third-party sellers and increases in discounts we receive from our product suppliers, offset partially by changes in mix of product sales and our efforts to continue reducing prices for customers, including from our year-round free shipping offers.

 

29


Table of Contents

Supplemental Information

 

Supplemental information about shipping results is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
       2005  

      2004  

      2005  

      2004  

 
     (in millions)  

Shipping Activity:

                                

Shipping revenue (1)(2)

   $ 112     $ 87     $ 323     $ 264  

Outbound shipping costs

     (159 )   $ (128 )     (471 )     (383 )
    


 


 


 


Net shipping cost

   $ (47 )   $ (41 )   $ (148 )   $ (119 )
    


 


 


 


Year-over-year Percentage Growth:

                                

Shipping revenue

     30 %     13 %     22 %     12 %

Outbound shipping costs

     25       23       23       21  

Net shipping cost

     15       52       25       47  

Percent of Net Sales:

                                

Shipping revenue

     6.0 %     5.9 %     5.9 %     6.0 %

Outbound shipping costs

     (8.5 )     (8.7 )     (8.6 )     (8.7 )
    


 


 


 


Net shipping cost

     (2.5 )     (2.8 )     (2.7 )     (2.7 )
    


 


 


 



(1) Outbound shipping charges to customers do not include amounts earned on shipping by third-party sellers where we do not provide the fulfillment service.
(2) Includes amounts earned from Amazon Prime membership program.

 

We believe that offering low prices to our customers is fundamental to our future success. One way we offer lower prices is through free-shipping offers that result in a net cost to us in delivering products, as well as through membership in Amazon Prime. We seek to partially mitigate the costs of lowering prices over time through achieving higher sales volumes, negotiating better terms with our suppliers, and achieving better operating efficiencies, including by reducing split-shipments. In addition, we anticipate that the costs of lowering prices over time will be partially mitigated to the extent product sales by third-party sellers continue to increase.

 

30


Table of Contents

Supplemental information about our net sales is as follows:

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
         2005    

        2004    

        2005    

        2004    

 
     (in millions)  

Net Sales:

                                

North America

                                

Media

   $ 684     $ 564     $ 2,015     $ 1,704  

Electronics and other general merchandise

     304       228       863       679  

Other (1)

     53       24       150       72  
    


 


 


 


Total North America

   $ 1,041     $ 816     $ 3,028     $ 2,455  
    


 


 


 


International

                                

Media

   $ 629     $ 530     $ 1,917     $ 1,601  

Electronics and other general merchandise

     187       116       565       322  

Other (1)

     1       1       3       2  
    


 


 


 


Total International

   $ 817     $ 647     $ 2,485     $ 1,925  
    


 


 


 


Consolidated

                                

Media

   $ 1,313     $ 1,094     $ 3,932     $ 3,305  

Electronics and other general merchandise

     491       344       1,428       1,001  

Other (1)

     54       25       153       74  
    


 


 


 


Total consolidated

   $ 1,858     $ 1,463     $ 5,513     $ 4,380  
    


 


 


 


Year-over-year Percentage Growth:

                                

North America

                                

Media (2)

     21 %     12 %     18 %     12 %

Electronics and other general merchandise

     33       27       27       29  

Other

     122       (10 )     108       —    

Total North America

     28       15       23       16  

International

                                

Media (2)

     19 %     41 %     20 %     46 %

Electronics and other general merchandise

     62       132       76       210  

Other

     177       17       85       76  

Total International

     26       52       29       60  

Consolidated

                                

Media (2)

     20 %     25 %     19 %     26 %

Electronics and other general merchandise

     43       50       43       59  

Other

     123       (10 )     107       1  

Total consolidated

     27       29       26       32  

Consolidated Net Sales Mix:

                                

Media

     71 %     75 %     71 %     75 %

Electronics and other general merchandise

     26       24       26       23  

Other

     3       2       3       2  
    


 


 


 


Total consolidated

     100 %     100 %     100 %     100 %
    


 


 


 



(1) Includes non-retail activities, such as our Amazon Services’ Merchant.com program, and miscellaneous marketing and promotional activities, such as our co-branded credit card program.
(2) Year-over-year percentage growth comparisons are affected by the Q3 2005 release of Harry Potter and the Half-Blood Prince, and the Q2 2003 release of Harry Potter and the Order of the Phoenix.

 

31


Table of Contents

Operating Expenses

 

Supplemental Information about Stock-Based Compensation

 

Prior to January 1, 2005, we accounted for stock-based awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The intrinsic value method of accounting resulted in compensation expense for restricted stock and restricted stock units at fair value on date of grant based on the number of shares granted and the quoted price of our common stock, and for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were subject to an exchange offer, other modifications, or performance criteria, such awards were subject to variable accounting treatment. To the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.

 

As of January 1, 2005, we adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of restricted stock and restricted stock units is determined based on the number of shares granted and the quoted price of our common stock, and the fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Such value is recognized as expense over the service period, net of estimated forfeitures, using the accelerated method under SFAS 123(R). The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. Because we implemented SFAS 123(R), we no longer have employee stock awards subject to variable accounting treatment.

 

The adoption of SFAS 123(R) resulted in a cumulative benefit from accounting change of $26 million in Q1 2005, which reflects the net cumulative impact of estimating forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted.

 

Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $2 million and $4 million for Q3 2005 and the three quarters ended September 30, 2005. Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based compensation was presented in operating cash flows, along with other tax cash flows, in accordance with the provisions of EITF 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123(R) supersedes EITF 00-15, amends SFAS 95, “Statement of Cash Flows,” and requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows.

 

On March 29, 2005, the SEC published SAB 107, which provides the SEC staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. We have reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense categories as cash compensation paid to employees.

 

32


Table of Contents

Information about operating expenses with and without stock-based compensation was as follows:

 

        Three months ended September 30, 2005    

    Three months ended September 30, 2004

 
    As
Reported


    Stock-Based
Compensation


    Net

   

As

Reported


    Stock-Based
Compensation


    Net

 

Operating Expenses:

                                               

Fulfillment

  $ 171     $ (5 )   $ 166     $ 138     $ (2 )   $ 136  

Marketing

    44       (2 )     42       34       —         34  

Technology and content

    121       (13 )     108       69       (4 )     65  

General and administrative

    32       (6 )     26       29       (3 )     26  

Other operating expense (income)

    40       —         40       5       —         5  
   


 


 


 


 


 


Total operating expenses

  $ 408     $ (26 )   $ 382     $ 275     $ (9 )   $ 266  
   


 


 


 


 


 


Year-over-year Percentage Growth:

                                               

Fulfillment

    24 %             23 %     23 %             27 %

Marketing

    28               23       13               19  

Technology and content

    74               66       5               21  

General and administrative

    12               1       13               16  

Percent of Net Sales:

                                               

Fulfillment

    9.2 %             8.9 %     9.4 %             9.3 %

Marketing

    2.4               2.3       2.4               2.3  

Technology and content

    6.5               5.8       4.7               4.4  

General and administrative

    1.7               1.4       2.0               1.8  
    Nine months ended September 30, 2005

    Nine months ended September 30, 2004

 
    As
Reported


    Stock-Based
Compensation


    Net

   

As

Reported


    Stock-Based
Compensation


    Net

 

Operating Expenses:

                                               

Fulfillment

  $ 495     $ (13 )   $ 482     $ 392     $ (6 )   $ 386  

Marketing

    131       (5 )     126       103       (3 )     100  

Technology and content

    319       (36 )     283       199       (21 )     178  

General and administrative

    117       (17 )     100       89       (8 )     81  

Other operating expense (income)

    43       —         43       (3 )     —         (3 )
   


 


 


 


 


 


Total operating expenses

  $ 1,105     $ (71 )   $ 1,034     $ 780     $ (38 )   $ 742  
   


 


 


 


 


 


Year-over-year Percentage Growth:

                                               

Fulfillment

    26 %             25 %     17 %             21 %

Marketing

    27               25       18               21  

Technology and content

    60               59       2               14  

General and administrative

    31               25       14               23  

Percent of Net Sales:

                                               

Fulfillment

    9.0 %             8.7 %     9.0 %             8.8 %

Marketing

    2.4               2.3       2.3               2.3  

Technology and content

    5.8               5.1       4.5               4.1  

General and administrative

    2.1               1.8       2.0               1.8  

 

See Item 1 of Part I, “Financial Statements — Note 1 — Accounting Policies — Stock-Based Compensation.”

 

33


Table of Contents

Fulfillment

 

The increase in fulfillment costs in absolute dollars during Q3 2005 and for the three quarters ended September 30, 2005 in comparison with the prior year relates primarily to variable costs corresponding with sales and inventory volumes; our mix of product sales; costs associated with credit card fees; bad debt costs, including costs of our guarantee for certain third-party seller transactions; expanding fulfillment capacity; and stock-based compensation. Fulfillment includes stock-based compensation of $5 million and $2 million for Q3 2005 and Q3 2004, and $13 million and $6 million for the three quarters ended September 30, 2005 and 2004.

 

Fulfillment costs as a percentage of net sales may vary due to several factors, such as costs associated with bad debt, including costs of our guarantee for certain third-party seller transactions, our level of productivity and accuracy, changes in volume of units received and fulfilled, the extent we utilize fulfillment services provided by third parties, and our ability to reduce customer service contacts per unit by implementing improvements in our operations and enhancements to our customer self-service features. The mix of product sales affects fulfillment costs per shipment based on variations in shape and weight of products we sell. Additionally, since credit card fees associated with third-party seller transactions are based on the gross purchase price of underlying transactions, and bad debt costs associated with these transactions are higher as a percentage of revenue versus our retail sales, our increasing third-party sales have higher fulfillment costs as a percent of net sales.

 

We expanded our fulfillment capacity in 2004 and the three quarters ended September 30, 2005 through gains in efficiencies as well as increases in leased warehouse space. We plan to continue expanding our world-wide fulfillment capacity in order to meet anticipated shipment volumes from sales of our own products as well as sales by third parties where we provide the fulfillment. We expect absolute amounts spent in fulfillment and fulfillment-related cost of sales to increase over time.

 

Marketing

 

We direct customers to our websites primarily through a number of targeted online marketing channels, such as our Associates and Syndicated Stores programs, sponsored search, portal advertising, e-mail campaigns, and other initiatives. Our marketing expenses are largely variable, based on growth in sales and changes in rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing expense. Marketing includes stock-based compensation of $2 million for Q3 2005, and $5 million and $3 million for the three quarters ended September 30, 2005 and 2004. Stock-based compensation included in Marketing in Q3 2004 was not significant.

 

Marketing costs increased in absolute terms in Q3 2005 and the three quarters ended September 30, 2005 compared to comparable prior year periods. These increases correspond with revenue growth as we utilized variable online marketing channels, such as our Associates program, sponsored search, and other variable marketing initiatives.

 

While costs associated with free shipping are not included in marketing expense, we view free shipping offers as an effective worldwide marketing tool, and intend to continue offering them indefinitely. We expect absolute amounts spent in marketing to increase over time.

 

Technology and Content

 

Our spending in technology and content has primarily increased because we are adding computer scientists and software engineers to continue to enhance the customer experience on our websites and those websites powered by us, to improve our process efficiency, and to continue to invest in several areas of technology including seller platforms, search, web services, and digital initiatives. As we have done throughout the year, we intend to continue investing in areas of technology and content, and expect absolute amounts spent in technology

 

34


Table of Contents

and content to increase over time as we continue to add computer scientists and software engineers to our staff. Technology and content includes stock-based compensation of $13 million and $4 million for Q3 2005 and Q3 2004, and $36 million and $21 million for the three quarters ended September 30, 2005 and 2004.

 

A significant majority of our technology costs are incurred in the U.S. and most of them are allocated to our North America segment.

 

General and Administrative

 

The increase in spending in general and administrative in Q3 2005 and for the three quarters ended September 30, 2005 versus comparable prior year periods is primarily due to increases in payroll and related expenses, professional fees, and legal costs, offset by a $12 million credit in Q3 2005 for actual and expected reimbursement by an insurer of certain legal costs previously incurred by us. General and administrative includes stock-based compensation of $6 million and $3 million for Q3 2005 and Q3 2004, and $17 million and $8 million in the three quarters ended September 30, 2005 and 2004. We expect absolute amounts spent in general and administrative to increase over time.

 

Other Operating Expense (Income)

 

In Q3 2005 we settled a patent lawsuit on terms that include, among other things, a one-time payment of $40 million in Q3 2005 that was recorded to “Other operating expense (income)” on the consolidated statements of operations.

 

In Q3 2004 severance terms were finalized to eliminate certain managerial, professional, clerical and technical positions in France. The corresponding costs of $4 million were recorded in the third quarter of 2004 and classified in “Other operating expense (income)” on the consolidated statements of operations.

 

“Other operating expense (income)” for the three quarters ended September 30, 2004 includes a gain of $8 million related to the reduction of our restructure-related liability due to our occupation of certain office space previously vacated as part of our 2001 restructuring.

 

Net Interest Expense

 

The primary component of our net interest expense is the interest we incur on our long-term debt instruments, including $900 million principal balance of our 4.75% Convertible Subordinated Notes and €490 million ($589 million based on the exchange rate at September 30, 2005) of our 6.875% PEACS at September 30, 2005. Interest expense was $22 million and $26 million in Q3 2005 and Q3 2004, and $70 million and $80 million for the three quarters ended September 30, 2005 and 2004, with declines primarily relating to principal repayments of our long-term debt.

 

At September 30, 2005, our total long-term debt was $1.5 billion compared to $1.8 billion at September 30, 2004. See Item 1 of Part I, “Financial Statements — Note 3 — Long-Term Debt and Other.”

 

We generally invest our excess cash in investment grade short- to intermediate-term fixed income securities and AAA-rated money market mutual funds. Our interest income corresponds with the average balance of invested funds and the prevailing rates we are earning on them, which vary depending on the geographies in which they are invested.

 

35


Table of Contents

Remeasurements and Other

 

Remeasurements and other consisted of the following:

 

     Three months ended
September 30,


    Nine months ended
September 30,


 
         2005    

        2004    

        2005    

        2004    

 
     (in millions)     (in millions)  

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

   $ 4     $ (16 )   $ 81     $ 12  

Gain (loss) on sales of Euro-denominated investments, net

     —         4       (2 )     9  

Loss on redemption of long-term debt

     —         —         (4 )     (6 )

Foreign-currency effect on intercompany balances (2)

     (2 )     7       (41 )     (3 )

Other (3)

     4       —         4       19  
    


 


 


 


Total remeasurements and other

   $ 6     $ (5 )   $ 38     $ 31  
    


 


 


 



(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) Represents the loss associated with the remeasurement of intercompany balances due to changes in foreign exchange rates.
(3) Primarily includes gains associated with the sale of certain equity investments.

 

Income Taxes

 

Our tax provision for interim periods is determined using an estimate of the annual effective tax rate, with the cumulative effect of a change to the estimated annual rate being recorded in the interim period such a change is made. The Q3 2005 tax provision includes a cumulative adjustment benefit of $4 million, with a corresponding benefit to diluted earnings per share of $0.01, to reflect our current estimate of our annual effective tax rate of 50%. Our effective tax rate for Q3 2005 and for the three quarters ended September 30, 2005 remains higher than the 35% statutory rate associated with taxable income resulting from the Q1 2005 transfer of certain operating assets from the U.S. to international locations. We expect these asset transfers to result in tax expense for financial reporting purposes above the statutory rate throughout 2005 and to beneficially impact our effective tax rate over time. Since we have NOLs, these asset transfers will not have a significant effect on cash taxes paid, which we expect to be approximately $25 million in 2005, compared with $4 million in 2004. Cash paid for income taxes was $6 million and $2 million in Q3 2005 and Q3 2004, and for the three quarters ended September 30, 2005 and 2004 was $11 million and $3 million.

 

At September 30, 2005, approximately $720 million of our gross deferred tax assets were related to approximately $2.3 billion of NOLs. Our NOL deferred tax assets are reduced by a valuation allowance of approximately $510 million due to uncertainty about their future realization. The remainder of our deferred tax assets relate to temporary timing differences between tax and financial reporting. The majority of our NOLs expire after 2016, and utilization of NOLs may be subject to certain limitations under Sections 382 and 1502 of the Internal Revenue Code, and other limitations under state and foreign tax laws.

 

Net Income

 

Income before income taxes was $51 million and $57 million for Q3 2005 and Q3 2004, and was $267 million and $ 248 million for the three quarters ended September 30, 2005 and 2004. The year-over-year changes include the effect of the patent lawsuit settlement, which resulted in a one-time payment of $40 million. Net income was $30 million and $54 million for Q3 2005 and Q3 2004, and was $160 million and $242 million for the three quarters ended September 30, 2005 and 2004. The year-over-year declines in net income are primarily

 

36


Table of Contents

related to the Q3 2005 patent lawsuit settlement, $20 million net of tax, and the increase in our effective tax rate and corresponding provision for income taxes, which increased $18 million and $128 million for Q3 2005 and the three quarters ended September 30, 2005 in comparison with the prior year periods. See “Income Taxes” above for a discussion of our tax provision.

 

Effect of Exchange Rates

 

The effect on our consolidated statements of operations from changes in exchange rates versus the U.S. Dollar is as follows:

 

     For the three months ended September 30,

 
     2005

    2004

 
     At Prior
Year
Rates (1)


    Exchange
Rate
Effect (2)


    As
Reported


    At Prior
Year
Rates (1)


    Exchange
Rate
Effect (2)


    As
Reported


 
     (in millions, except per share amounts)  

Net sales

   $ 1,865     $ (7 )   $ 1,858     $ 1,406     $ 57     $ 1,463  

Gross profit

     464       (1 )     463       344       12       356  

Operating expenses

     408       —         408       282       (7 )     275  

Income from operations

     56       (1 )     55       77       4       81  

Net interest expense and other

     (10 )     —         (10 )     (18 )     (1 )     (19 )

Remeasurements and other (3)

     4       2       6       1       (6 )     (5 )

Net income

     29       1       30       57       (3 )     54  

Diluted earnings per share

   $ 0.07     $ —       $ 0.07     $ 0.13     $ —       $ 0.13  
     For the nine months ended September 30,

 
     2005

    2004

 
     At Prior
Year
Rates (1)


    Exchange
Rate
Effect (2)


    As
Reported


    At Prior
Year
Rates (1)


    Exchange
Rate
Effect (2)


    As
Reported


 
     (in millions, except per share amounts)  

Net sales

   $ 5,465     $ 48     $ 5,513     $ 4,189     $ 191     $ 4,380  

Gross profit

     1,362       10       1,372       1,019       39       1,058  

Operating expenses

     1,112       (7 )     1,105       803       (23 )     780  

Income from operations

     263       4       267       263       15       278  

Net interest expense and other

     (41 )     3       (38 )     (57 )     (4 )     (61 )

Remeasurements and other (3)

     (1 )     39       38       13       18       31  

Net income

     137       23       160       213       29       242  

Diluted earnings per share

   $ 0.32     $ 0.06     $ 0.38     $ 0.50     $ 0.07     $ 0.57  

(1) Represents the outcome that would have resulted had exchange rates in the current period been the same as those in effect in the comparable prior year period for operating results, and if we did not incur the variability associated with remeasurements for our 6.875% PEACS and intercompany balances.
(2) Represents the increase (decrease) in reported amounts resulting from changes in exchange rates from those in effect in the comparable prior year period for operating results, and if we did not incur the variability associated with remeasurements for our 6.875% PEACS and intercompany balances.
(3) 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. subsidiary. See Item 1 of Part I, “Financial Statements — Note 8 — Remeasurements and Other.”

 

Non-GAAP Financial Measure: Free Cash Flow

 

Regulation G, Conditions for Use of Non-GAAP Financial Measures, and other provisions of the 1934 Act define and prescribe the conditions for use of certain non-GAAP financial information. Our measure of “Free

 

37


Table of Contents

cash flow” meets the definition of a non-GAAP financial measure. Free cash flow is used in addition to and in conjunction with results presented in accordance with GAAP and free cash flow should not be relied upon to the exclusion of GAAP financial measures. Free cash flow reflects an additional way of viewing our liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our cash flows. Management strongly encourages investors to review our financial statements and publicly-filed reports in their entirety and to not rely on any single financial measure.

 

Free cash flow, which we reconcile to “Net cash provided by operating activities,” is cash flow from operations reduced by “Purchases of fixed assets, including internal-use software and website development.” We use free cash flow, and ratios based on it, to conduct and evaluate our business because, although it is similar to cash flow from operations, we believe it is a useful measure of cash flows since purchases of fixed assets are a necessary component of ongoing operations. In limited circumstances in which proceeds from sales of fixed assets exceed purchases, free cash flow would exceed cash flow from operations. However, since we do not anticipate being a net seller of fixed assets, we expect free cash flow to be less than operating cash flows.

 

Free cash flow has limitations due to the fact that it does not represent the residual cash flow available for discretionary expenditures. For example, free cash flow does not incorporate payments made on capital lease obligations or cash payments for business acquisitions. Therefore, we believe it is important to view free cash flow as a complement to our entire consolidated statements of cash flows.

 

The following is a reconciliation of free cash flow to the most comparable GAAP measure, “Net cash provided by operating activities” for the trailing twelve months ended September 30, 2005 and 2004 (in millions):

 

     Twelve Months Ended
September 30,


 
         2005    

        2004    

 

Net cash provided by operating activities

   $ 661     $ 490  

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

     (186 )     (70 )
    


 


Free cash flow

   $ 475     $ 420  
    


 


Net cash used in investing activities

   $ (613 )   $ (159 )
    


 


Net cash provided by (used in) financing activities

   $ (200 )   $ (291 )
    


 


 

Guidance

 

The Company provided guidance on October 25, 2005 in its earnings release furnished on Form 8-K as follows:

 

Fourth Quarter 2005 Guidance

 

    Net sales are expected to be between $2.86 billion and $3.16 billion, or grow between 13% and 24%, compared with fourth quarter 2004.

 

    Operating income is expected to be between $135 million and $210 million, or between (17%) decline and 29% growth, compared with fourth quarter 2004. This guidance includes $30 million for stock-based compensation and amortization of intangible assets, and assumes, among other things, that no additional intangible assets are recorded, and that there are no further revisions to stock-based compensation or restructuring-related estimates.

 

Full Year 2005 Guidance

 

    Net sales are expected to be between $8.373 billion and $8.673 billion, or grow between 21% and 25%, compared with 2004.

 

38


Table of Contents
    Operating income is expected to be between $403 million and $478 million, or between (9%) decline and 8% growth, compared with 2004. This guidance includes $144 million for stock-based compensation, amortization of intangible assets and the $40 million legal settlement, and assumes, among other things, that no additional intangible assets are recorded and that there are no changes to stock-based compensation or restructuring-related estimates.

 

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

 

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, 2005, we had an accumulated deficit of $2.2 billion and our stockholders’ equity was $6 million. We have incurred substantial operating losses since our inception, and although we earned net income for Q3 2005, we may incur losses again in the future.

 

We Have Significant Indebtedness

 

As of September 30, 2005, we had long-term indebtedness of $1.5 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, we may incur substantial additional debt in the future, and in any event a significant portion of our future cash flow from operating activities is likely to remain dedicated to the payment of interest and the repayment of principal on our indebtedness. Our indebtedness could limit our ability to obtain additional financing for working capital, capital expenditures, debt service requirements, acquisitions 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. In addition, we may not be able to refinance our indebtedness on terms acceptable to us, or at all.

 

See Item 1 of Part I, “Financial Statements and Supplementary Data — 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, fulfillment, and marketing than we do.

 

39


Table of Contents

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 Expansion Places 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 expansion increases the complexity of our business and places a significant strain on our management, operations, technical performance, financial resources, and internal financial control and reporting functions, 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. If any of this were to occur, it could damage our reputation, limit our growth, negatively affect our operating results and harm our business.

 

Our Expansion into New Product Areas and Geographic Regions Subjects Us to Business and Competitive Risks

 

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. If any of this were to occur, it could damage our reputation, limit our growth, negatively affect our operating results and harm our business.

 

We May Experience Significant Fluctuations in Our Operating Results and Rate of Growth

 

Due to our limited operating history, our evolving business model, and the unpredictability of our industry, we may not be able to accurately forecast our rate of growth. We base our current and future expense levels and our investment plans on estimates of future net sales and rate of growth. Our expenses and investments are to a large extent fixed, and we may not be able to adjust our spending quickly enough if our net sales fall short of our expectations.

 

Our revenue and operating profit growth depends on the continued growth of demand for the products offered by us or our sellers, and our business is affected by general economic and business conditions throughout the world. A softening of demand, whether caused by changes in consumer preferences or a weakening of the U.S. or global economies, may result in decreased revenue or growth. Terrorist attacks and armed hostilities create economic and consumer uncertainty that could adversely affect our revenue or growth. Such events could create delays in, and increase the cost of, product shipments, which may decrease demand. Revenue growth may not be sustainable and our company-wide percentage growth rate may decrease in the future.

 

Our net sales and operating results will also fluctuate for many other reasons, including:

 

    our ability to retain and increase sales to existing customers, attract new customers, and satisfy our customers’ demands;

 

40


Table of Contents
    our ability to expand our network of sellers, and to enter into, maintain, renew, and amend on favorable terms our commercial agreements and strategic alliances;

 

    foreign exchange rate fluctuations, particularly as international sales become an increasingly larger contributor to our revenues;

 

    our ability to acquire merchandise, manage inventory, and fulfill orders;

 

    the introduction by our current or future competitors of websites, products, services, price decreases, or improvements;

 

    changes in usage of the Internet and e-commerce, including in non-U.S. markets;

 

    timing, effectiveness, and costs of upgrades and developments in our systems and infrastructure;

 

    the effects of commercial agreements and strategic alliances and our ability to successfully implement the underlying relationships and integrate them into our business;

 

    the effects of acquisitions, and other business combinations and our ability to successfully integrate them into our business;

 

    the success of our geographic and product line expansions;

 

    the outcomes of legal proceedings and claims;

 

    technical difficulties, system downtime, or interruptions;

 

    variations in the mix of products and services we sell;

 

    variations in our level of merchandise and vendor returns;

 

    disruptions in service by shipping carriers;

 

    the extent to which we offer free shipping, continue to reduce product prices worldwide, and provide additional benefits to our customers which reduce our gross or operating profits;

 

    the extent to which we invest in technology and content, fulfillment, marketing and other expense categories;

 

    the extent to which we provide for and pay taxes; and

 

    increases in the prices of fuel and gasoline, which are used in the transportation of packages, as well as increases in the prices of other energy products, primarily natural gas and electricity, and commodities like paper and packing supplies, all of which are used in our operating facilities.

 

Finally, both seasonal fluctuations in Internet usage and traditional retail seasonality are likely to affect our business. Internet usage generally slows during the summer months, and sales in almost all of our product groups, particularly toys and electronics, usually increase significantly in the fourth calendar quarter of each year.

 

We May Not Be Successful in Our Efforts to Expand into International Market Segments

 

Our international activities have become increasingly significant to our revenues and profits and we plan, over time, to continue to expand our reach in international market segments. We have relatively little experience in purchasing, marketing, and distributing products or services for these market segments and may not benefit from any first-to-market advantages. It is costly to establish international facilities and operations, promote our brand internationally and develop localized websites, stores, and other systems. We may not succeed in these efforts. Our net sales from international market segments may not offset the expense of establishing and maintaining the related operations and, therefore, these operations may not be profitable on a sustained basis.

 

Our international sales and related operations are subject to a number of risks inherent in selling abroad, including, but not limited to, risks with respect to:

 

    foreign exchange rate fluctuations;

 

41


Table of Contents
    local economic and political conditions;

 

    restrictive governmental actions (such as trade protection measures, including export duties and quotas and custom duties and tariffs) and restrictions on the level of foreign ownership;

 

    restrictions on sales of certain products or services and uncertainty regarding our liability for the products or services we offer and content provided by us or our users, including uncertainty as a result of less Internet-friendly legal systems, local laws, lack of legal precedent, and varying rules, regulations, and practices regarding the distribution of media products and enforcement of intellectual property rights;

 

    import, export, or other business licensing requirements;

 

    limitations on the repatriation of funds and foreign currency exchange restrictions;

 

    difficulty in obtaining distribution and support;

 

    nationalization or restrictions on foreign ownership;

 

    shorter payable and longer receivable cycles and the resultant negative impact on cash flow;

 

    consumer and data protection laws and restrictions on pricing or discounts;

 

    lower levels of adoption or use of the Internet and other technologies vital to our business and the lack of appropriate infrastructure to support widespread Internet usage;

 

    lower levels of consumer spending on a per capita basis and fewer opportunities for growth in certain foreign market segments compared to the U.S.;

 

    lower levels of credit card usage and increased payment risk;

 

    difficulty in staffing, developing and managing a number of unique foreign operations as a result of distance, language and cultural differences;

 

    different employee/employer relationships and the existence of workers’ councils and labor unions;

 

    laws and policies of the U.S. and other jurisdictions affecting trade, foreign investment, and loans;

 

    tax and other laws of the U.S. and other jurisdictions; and

 

    geopolitical events, including war and terrorism.

 

As the international e-commerce channel continues to grow, competition will likely intensify. Local companies may have a substantial competitive advantage because of their greater understanding of, and focus on, the local customer, as well as their more established local brand name recognition. In addition, governments in foreign jurisdictions may regulate e-commerce or other online services in such areas as licenses, content, privacy, network security, copyright, encryption, taxation, or distribution. We may not be able to hire, train, retain, motivate, and manage required personnel, which may limit our growth in international market segments.

 

If We Do Not Successfully Optimize and Operate Our Fulfillment Centers, Our Business Could Be Harmed

 

If we do not successfully operate our fulfillment centers, it could significantly limit our ability to meet customer demand. Because it is difficult to predict demand, we may not manage our facilities in an optimal way, which may result in excess or insufficient inventory or warehousing, fulfillment, and distribution capacity. A failure to optimize inventory in our fulfillment network will increase our net shipping cost by requiring us to make long-zone shipments or partial shipments from one or more locations. Orders from several of our internationally-focused websites are fulfilled primarily from a single fulfillment center, and we have only a limited ability to reroute orders to third parties for drop-shipping. We and our co-sourcers may be unable to adequately staff our fulfillment and customer service centers. As we continue to add fulfillment and warehouse capability or add new businesses with different fulfillment requirements, operating our fulfillment network becomes more challenging and there can be no assurance that we will be able to operate our network effectively.

 

42


Table of Contents

We rely on a limited number of shipping companies to deliver inventory to our fulfillment centers and completed orders to our customers. If we are not able to negotiate acceptable terms with these companies or they experience performance problems or other difficulties, it could negatively impact our operating results and customer experience. In addition, our ability to receive inbound inventory efficiently and ship completed orders to customers also may be negatively affected by inclement weather, fire, flood, power loss, earthquakes, labor disputes, acts of war or terrorism, acts of God and similar factors.

 

Third parties either drop-ship or otherwise fulfill an increasing portion of our customers’ orders, and we are increasingly reliant on the reliability, quality, and future procurement of their services. Under some of our commercial agreements, we maintain the inventory of other companies in our fulfillment centers, thereby increasing the complexity of tracking inventory in and operating our fulfillment centers. Our failure to properly handle such inventory or the inability or failure of these other companies to accurately forecast product demand would result in unexpected costs and other harm to our business and reputation.

 

The Seasonality of Our Business Places Increased Strain on Our Operations

 

We expect a disproportionate amount of our net sales to be realized during the fourth quarter of our fiscal year. If we do not stock popular products in sufficient amounts or fail to have sources to timely restock popular products, such that we fail to meet customer demand, it could significantly affect our revenue and our future growth. If we overstock products, we may be required to take significant inventory markdowns or write-offs, which could reduce gross profits. A failure to optimize inventory in our fulfillment network will harm our shipping margins by requiring us to make long-zone shipments or partial shipments from one or more locations. Orders from several of our internationally-focused websites are fulfilled primarily from a single fulfillment center, and we have only a limited ability to reroute orders to third parties for drop-shipping. We may experience an increase in our net shipping cost due to complimentary upgrades, split-shipments, and additional long-zone shipments necessary to ensure timely delivery, especially for the holiday season. If the other businesses on whose behalf we perform inventory fulfillment services deliver product to our fulfillment centers in excess of forecasts, we may be unable to secure sufficient storage space and may be unable to optimize our fulfillment centers. If too many customers access our websites within a short period of time due to increased holiday or other demand, we may experience system interruptions that make our websites unavailable or prevent us from efficiently fulfilling orders, which may reduce the volume of goods we sell and the attractiveness of our products and services. In addition, we may be unable to adequately staff our fulfillment centers during these peak periods and third parties that provide fulfillment services to our customers may be unable to meet the seasonal demand. Finally, we, along with our customer service co-sourcers, may be unable to adequately staff customer service centers.

 

We generally have payment terms with our vendors that extend beyond the amount of time necessary to collect proceeds from our customers. As a result of holiday sales, at December 31 of each year, our cash, cash equivalents, and marketable securities balances typically reach their highest level (other than as a result of cash flows provided by or used in investing and financing activities). This operating cycle results in a corresponding increase in accounts payable. Our accounts payable balance should decline during the first three months following year-end, which will result in a decline in the amount of cash, cash equivalents, and marketable securities on hand.

 

Our Business Could Suffer if We Are Unsuccessful in Making, Integrating, and Maintaining Commercial Agreements, Strategic Alliances, and Other Business Relationships

 

We may enter into commercial agreements, strategic alliances, and other business relationships with other companies. We have entered into agreements to provide e-commerce services to other businesses and we plan to enter into similar agreements in the future, including as part of our Merchants@, Syndicated Stores, and Amazon Services’ Merchant.com program initiatives. Under such agreements, we may perform services such as: providing our technology services such as search, browse, and personalization; permitting other businesses and individuals to offer products or services through our websites; and powering third-party websites, either with or without providing

 

43


Table of Contents

accompanying fulfillment services. These arrangements are complex and require substantial personnel and resource commitments by us, which may constrain the number of such agreements we are able to enter into and may affect our ability to integrate and deliver services under the relevant agreements. If we fail to implement, maintain, and develop successfully the various components of such commercial relationships, which may include fulfillment, customer service, inventory management, tax collection, payment processing, licensing of third party software, hardware, and content, and engaging third parties to perform hosting and other services, these initiatives may not be viable. The amount of compensation we receive under certain of these agreements is partially dependent on the volume of sales that the other company makes. Therefore, if the other business’s website or product or services offering is not successful, we may not receive all of the compensation we are otherwise due under the agreement or may not be able to maintain the agreement. Moreover, we may not be able to succeed in our plans to enter into additional commercial relationships and strategic alliances on favorable terms.

 

As our commercial agreements expire or otherwise terminate, we may be unable to renew or replace these agreements on comparable terms, or at all. In the past, we amended several of our commercial agreements to reduce future cash proceeds to be received by us, shorten the term of the agreements, or both. Some of our agreements involve high margin services, such as marketing and promotional agreements, and as such agreements expire they may be replaced, if at all, by agreements involving lower margin services. In addition, several past commercial agreements were with companies that experienced business failures and were unable to meet their obligations to us. We may in the future enter into further amendments of our commercial agreements or encounter other parties that have difficulty meeting their contractual obligations to us, which could adversely affect our operating results. As an example, we are currently in litigation with Toysrus.com over our commercial agreement, and Toysrus.com’s parent, Toysrus, Inc., recently was acquired by a private investment group. In the event of the early termination of our commercial agreement with Toysrus.com, we would attempt to replace the product selection currently provided by Toysrus.com with owned inventory and offerings from other parties, but our operating results could be negatively impacted.

 

Our present and future third-party services agreements, other commercial agreements, and strategic alliances create additional risks such as:

 

    disruption of our ongoing business, including loss of management focus on existing businesses;

 

    impairment of other relationships;

 

    variability in revenue and income from entering into, amending, or terminating such agreements or relationships; and

 

    difficulty integrating under the commercial agreements.

 

Our Business Could Suffer if We Are Unsuccessful in Making, Integrating, and Maintaining Acquisitions and Investments

 

We have acquired and invested in a number of companies, including our acquisition of Joyo.com in September 2004, and we may acquire or invest in (such as through joint ventures or other business combinations) additional companies. Acquisitions and investments create risks such as:

 

    disruption of our ongoing business, including loss of management focus on existing businesses;

 

    problems retaining key technical and managerial personnel, resulting from, among other factors, changes in compensation, responsibilities, reporting relationships, future prospects, and the direction of the business;

 

    additional operating losses and expenses of the businesses we acquired or in which we invested;

 

    the potential impairment of amounts capitalized as intangible assets as part of the acquisition;

 

    the potential impairment of customer and other relationships of the company we acquired or in which we invested or our own customers as a result of any integration of operations;

 

44


Table of Contents
    the difficulty of incorporating acquired technology and rights into our offerings and unanticipated expenses related to such integration;

 

    the difficulty of integrating a new company’s accounting, financial reporting, management, information, human resource and other administrative systems to permit effective management, and the lack of control if such integration is delayed or not implemented;

 

    the difficulty of implementing controls, procedures and policies appropriate for a larger public company at companies that prior to acquisition or investment had lacked such controls, procedures and policies;

 

    potential unknown liabilities associated with a company we acquire or in which we invest; and

 

    for foreign acquisitions and investments, additional risks related to the integration of operations across different cultures and languages, currency risks, and the particular economic, political, and regulatory risks associated with specific countries.

 

Finally, as a result of future acquisitions or mergers, we might need to issue additional equity securities, spend our cash, or incur debt, contingent liabilities, or amortization expenses related to intangible assets, any of which could reduce our profitability and harm our business.

 

Our Recent Acquisition of Joyo.com Creates Risks and Uncertainties Relating to the Laws of the People’s Republic of China

 

In September, 2004, we acquired Joyo.com, a company organized under the laws of the British Virgin Islands. Joyo.com operates www.joyo.com and www.joyo.com.cn in the People’s Republic of China (“PRC”) in cooperation with a PRC subsidiary and PRC affiliates and is subject to many of the risks described in “Our Business Could Suffer if We are Unsuccessful in Making, Integrating, and Maintaining Acquisitions and Investments” and “We May Not Be Successful in Our Efforts to Expand into International Market Segments.” In addition, the PRC regulates Joyo.com’s business through regulations and license requirements restricting (i) the scope of foreign investment in the Internet, retail and delivery sectors, (ii) Internet content and (iii) the sale of certain media products. In order to meet the PRC local ownership and regulatory licensing requirements, Joyo.com’s business is operated through a PRC subsidiary which acts in cooperation with PRC companies owned by nominee shareholders who are PRC nationals. Although we believe Joyo.com’s structure complies with existing PRC laws, it involves unique risks. There are substantial uncertainties regarding the interpretation of PRC laws and regulations, and it is possible that the PRC government will ultimately take a view contrary to ours. If Joyo.com or its subsidiary or affiliates were found to be in violation of any existing or future PRC laws or regulations or if interpretations of those laws and regulations were to change, the business could be subject to fines and other financial penalties, have its licenses revoked or be forced to shut down entirely. In addition, if Joyo.com were unable to enforce its contractual relationships with respect to management and control of its business, it might be unable to continue to operate the business.

 

We Have Foreign Exchange Risk

 

The results of operations of, and certain of our intercompany balances associated with, our internationally-focused websites are exposed to foreign exchange rate fluctuations. Upon translation, net sales and other operating results may differ materially from expectations, and we may record significant gains or losses on the remeasurement of intercompany balances. As we have expanded our international operations, our exposure to exchange rates fluctuations has become more pronounced. See Item 2 of Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Effect of Exchange Rates” for a table demonstrating the effect on our consolidated statements of operations from changes in exchange rates versus the U.S. Dollar.

 

In addition, our 6.875% PEACS are denominated in Euros, not U.S. Dollars. We remeasure the principal of the 6.875% PEACS quarterly based on fluctuations in the Euro/U.S. Dollar exchange ratio and record gains or losses in “Remeasurements and other” on our consolidated statements of operations. As a result, increases in the

 

45


Table of Contents

Euro relative to the U.S. Dollar increase the U.S. dollar amount we owe as interest and principal. Furthermore, we hold cash equivalents and/or marketable securities in Euros, British Pounds, Yen, Canadian Dollars, and Chinese Yuan. Accordingly, if the U.S. Dollar strengthens compared to these currencies, cash equivalents and marketable securities balances, when translated, may be materially less than expected and vice versa.

 

Our Investments and the Consideration We Receive under Certain Commercial Agreements May Subject Us to a Number of Risks

 

In the past, we have entered into commercial agreements with other companies, including strategic alliances whereby we perform certain e-commerce services, and in exchange for our services we received cash, equity securities of these companies, and/or additional benefits, such as website traffic. The amount of compensation we receive under certain of these agreements is dependent on the volume of sales made by the other company. In some cases, we have also made separate investments in the other company by making a cash payment in exchange for equity securities of that company. We may make similar investments in the future. To the extent we have received equity securities as compensation, fluctuations in the value of such securities will affect our ultimate realization of amounts we have received as compensation for services.

 

In the past, we amended several of our commercial agreements to reduce future cash proceeds to be received by us, shorten the term of our commercial agreements, or both. We may in the future enter into further amendments of our commercial agreements. Although these amendments did not affect the amount of unearned revenue previously recorded by us (if any), the timing of revenue recognition of these recorded unearned amounts was changed to correspond with the terms of the amended agreements. To the extent we believe any such amendments cause or may cause the compensation to be received under an agreement to no longer be fixed or determinable, we limit our revenue recognition to amounts received, excluding any future amounts not deemed fixed or determinable. As future amounts are subsequently received, such amounts are incorporated into our revenue recognition over the remaining term of the agreement.

 

Our investments in equity securities are included in “Marketable securities” and “Other assets” on our consolidated balance sheets. We regularly review all of our investments in public and private companies for other-than-temporary declines in fair value. When we determine that the decline in fair value of an investment below our accounting basis is other-than-temporary, we reduce the carrying value of the securities we hold and record a loss in the amount of any such decline. In recent years, securities of companies in the Internet and e-commerce industries have experienced significant difficulties. We may conclude in future quarters that the fair values of our investments have experienced additional other-than-temporary declines. As of September 30, 2005, our recorded basis in equity securities was $14 million, including $5 million classified as “Marketable securities” and $9 million classified as “Other assets.”

 

The Loss of Key Senior Management Personnel Could Negatively Affect Our Business

 

We depend on the continued services and performance of our senior management and other key personnel, particularly Jeffrey P. Bezos, our President, Chief Executive Officer, and Chairman of the Board. We do not have “key person” life insurance policies. The loss of any of our executive officers or other key employees could harm our business.

 

System Interruption and the Lack of Integration and Redundancy in Our Systems May Affect Our Sales

 

Customer access to our websites directly affects the volume of goods we sell and the services we offer and thus affects our net sales. We experience occasional system interruptions that make our websites unavailable or prevent us from efficiently fulfilling orders or providing services to third parties, which may reduce our net sales and the attractiveness of our products and services. If we are unable to continually add additional software and hardware and upgrade in an effective manner our systems and network infrastructure, it could cause system interruption and adversely affect our operating results.

 

46


Table of Contents

Our computer and communications systems and operations could be damaged or interrupted by fire, flood, power loss, telecommunications failure, earthquakes, acts of war or terrorism, acts of God, computer viruses, physical or electronic break-ins, and similar events or disruptions. Any of these events could cause system interruption, delays, and loss of critical data, and could prevent us from accepting and fulfilling customer orders. Should this occur, it would make our product offerings less attractive to our customers and our service offerings less attractive to third parties. While we do have backup systems for certain aspects of our operations, our systems are not fully redundant and our disaster recovery planning may not be sufficient for all eventualities. In addition, we may have inadequate insurance coverage or insurance limits to compensate us for losses from a major interruption. If any of this were to occur, it could damage our reputation and be expensive to remedy.

 

We Face Significant Inventory Risk

 

We are exposed to significant inventory risks as a result of seasonality, new product launches, rapid changes in product cycles and changes in consumer tastes with respect to our products. In order to be successful, we must accurately predict these trends and avoid overstocking or under-stocking products. Demand for products, however, can change significantly between the time inventory is ordered and the date of sale. In addition, when we begin selling a new product, it may be difficult to establish vendor relationships, determine appropriate product selection, and accurately forecast product demand. A failure to optimize inventory within our fulfillment network will increase our net shipping cost by requiring us to make split shipments from one or more locations, complimentary upgrades, and additional long-zone shipments necessary to ensure timely delivery.

 

As a result of our third-party services relationships with Toysrus.com, Babiesrus.com, Target, and other companies, these parties identify, buy, and bear the financial risk of inventory obsolescence for their corresponding stores and merchandise. As a result, if any of these parties fail to forecast product demand or optimize or maintain access to inventory, we would receive reduced service fees under the agreements and our business and reputation could be harmed.

 

The acquisition of certain types of inventory, or inventory from certain sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection and significant inventory levels of certain products, such as consumer electronics, and we may be unable to sell products in sufficient quantities or during the relevant selling seasons.

 

Any one of the inventory risk factors set forth above may adversely affect our operating results.

 

We May Not Be Able to Adequately Protect Our Intellectual Property Rights or May Be Accused of Infringing Intellectual Property Rights of Third Parties

 

We regard our trademarks, service marks, copyrights, patents, trade dress, trade secrets, proprietary technology, and similar intellectual property as critical to our success, and we rely on trademark, copyright, and patent law, trade secret protection, and confidentiality and/or license agreements with our employees, customers, partners, and others to protect our proprietary rights. Effective trademark, service mark, copyright, patent, and trade secret protection may not be available in every country in which our products and services are made available online.

 

We also may not be able to acquire or maintain appropriate domain names in all countries in which we do business. Furthermore, regulations governing domain names may not protect our trademarks and similar proprietary rights. We may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon, or diminish the value of our trademarks and other proprietary rights.

 

Policing unauthorized use of our proprietary rights is inherently difficult, and we may not be able to determine the existence or extent of any such unauthorized use. The protection of our intellectual property may require the expenditure of significant financial and managerial resources. Moreover, we cannot be certain that the

 

47


Table of Contents

steps we take to protect our intellectual property will adequately protect our rights or that others will not independently develop or otherwise acquire equivalent or superior technology or other intellectual property rights.

 

Third parties that license our proprietary rights may take actions that diminish the value of our proprietary rights or reputation. In addition, the steps we take to protect our proprietary rights may not be adequate and third parties may infringe or misappropriate our copyrights, trademarks, trade dress, patents, and similar proprietary rights. Other parties may claim that we infringed their proprietary rights. We have been subject to, and expect to continue to be subject to, claims and legal proceedings regarding alleged infringement by us of the patents, trademarks, and other intellectual property rights of third parties. Such claims, whether or not meritorious, may result in the expenditure of significant financial and managerial resources, injunctions against us or the imposition of damages that we must pay. We may need to obtain licenses from third parties who allege that we have infringed their rights, but such licenses may not be available on terms acceptable to us or at all. In addition, we may not be able to obtain or utilize on terms that are favorable to us, or at all, licenses or other rights with respect to intellectual property we do not own in providing e-commerce services to other businesses and individuals under commercial agreements.

 

We Have a Limited Operating History and Our Stock Price Is Highly Volatile

 

We have a relatively short operating history and, as an e-commerce company, we have a rapidly evolving and unpredictable business model. The trading price of our common stock fluctuates significantly. Trading prices of our common stock may fluctuate in response to a number of events and factors, such as:

 

    general economic conditions;

 

    changes in interest rates;

 

    conditions or trends in the Internet and the e-commerce industry;

 

    fluctuations in the stock market in general and market prices for Internet-related companies in particular;

 

    quarterly variations in operating results;

 

    new products, services, innovations, and strategic developments by our competitors or us, or business combinations and investments by our competitors or us;

 

    changes in financial estimates by us or securities analysts and recommendations by securities analysts;

 

    changes in Internet regulation;

 

    changes in our capital structure, including issuance of additional debt or equity to the public;

 

    additions or departures of key personnel;

 

    corporate restructurings, including layoffs or closures of facilities;

 

    changes in the valuation methodology of, or performance by, other e-commerce companies; and

 

    transactions in our common stock by major investors and certain analyst reports, news, and speculation.

 

Any of these events may cause our stock price to rise or fall and may adversely affect our business and financing opportunities.

 

Future volatility in our stock price could force us to increase our cash compensation to employees or grant larger stock awards than we have historically, which could hurt our operating results or reduce the percentage ownership of our existing stockholders, or both.

 

48


Table of Contents

Government Regulation of the Internet and E-commerce Is Evolving and Unfavorable Changes Could Harm Our Business

 

We are subject to general business regulations and laws, as well as regulations and laws specifically governing the Internet and e-commerce. Such existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access, and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property ownership, sales and other taxes, libel, and personal privacy apply to the Internet and e-commerce. Unfavorable resolution of these issues may harm our business. In addition, many jurisdictions currently regulate “auctions” and “auctioneers” and may regulate online auction services. Jurisdictions may also regulate other consumer-to-consumer online markets, including certain aspects of Amazon Marketplace. This could, in turn, diminish the demand for our products and services and increase our cost of doing business.

 

Taxation Risks Could Subject Us to Liability for Past Sales and Cause Our Future Sales to Decrease

 

We do not collect sales taxes or other taxes with respect to shipments of most of our goods into most states in the U.S. Under some of our commercial agreements, the other company is the seller of record of the applicable merchandise and we are obligated to collect sales tax in most states in accordance with that company’s instructions. We may enter into additional strategic alliances requiring similar tax collection obligations. Our fulfillment center and customer service center networks, and any future expansion of those networks, along with other aspects of our evolving business, may result in additional sales and other tax obligations. We collect consumption tax (including value added tax, goods and services tax, and provincial sales tax) as applicable on goods and services sold by us that are ordered on our international sites. One or more states or foreign countries may seek to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in e-commerce. A successful assertion by one or more states or foreign countries that we should collect sales or other taxes on the sale of merchandise or services could result in substantial tax liabilities for past sales, decrease our ability to compete with traditional retailers, and otherwise harm our business.

 

Currently, decisions of the U.S. Supreme Court restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made over the Internet. However, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s position regarding sales and use taxes on Internet sales. If any of these initiatives addressed the Supreme Court’s constitutional concerns and resulted in a reversal of its current position, we could be required to collect sales and use taxes in additional states. The imposition by state and local governments of various taxes upon Internet commerce could create administrative burdens for us and could decrease our future sales.

 

Our Vendor Relationships Subject Us to a Number of Risks

 

Although we continue to increase the number of vendors that supply products to us and no vendor accounts for 10% or more of our inventory purchases, we have significant vendors that are important to our sourcing. We do not have long-term contracts or arrangements with most of our vendors to guarantee the availability of merchandise, particular payment terms, or the extension of credit limits. If our current vendors were to stop selling merchandise to us on acceptable terms, we may not be able to acquire merchandise from other suppliers in a timely and efficient manner and on acceptable terms.

 

We May Be Subject to Product Liability Claims if People or Property Are Harmed by the Products We Sell

 

Some of the products we sell may expose us to product liability claims relating to personal injury, death, or property damage caused by such products, and may require us to take actions such as product recalls. Certain businesses and individuals also sell products using our e-commerce platform that may increase our exposure to product liability claims, such as if these sellers do not have sufficient resources to protect themselves from such

 

49


Table of Contents

claims. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. In addition, some of our vendor agreements with our distributors, manufacturers, and third party sellers do not indemnify us from product liability.

 

We Could Be Liable for Breaches of Security on Our Website

 

A fundamental requirement for e-commerce is the secure storage and transmission of confidential information. Although we have developed systems and processes that are designed to protect consumer information and prevent fraudulent credit card transactions and other security breaches, failure to mitigate such fraud or breaches may adversely affect our operating results.

 

We Could Be Liable for Fraudulent or Unlawful Activities of Sellers

 

The law relating to the liability of providers of online payment services is currently unsettled. In addition, we are aware that governmental agencies have investigated the provision of online payment services and could require changes in the way this business is conducted. Under Merchants@, Marketplace and certain other of our programs, we may be unable to prevent sellers from collecting payments, fraudulently or otherwise, when buyers never receive the products they ordered or when the products received are materially different from the sellers’ descriptions. Under our A2Z Guarantee, we reimburse buyers for payments up to certain limits in these situations and as our third party sales grow, the cost of this program will increase and could negatively affect our operating results. Any costs we incur as a result of liability because of our A2Z Guarantee or otherwise could harm our business. In addition, the functionality of our payments program depends on certain third-party vendors delivering services. If these vendors are unable or unwilling to provide services, our payments program and our businesses that use it may not be viable. Finally, we may be unable to prevent sellers in our Merchants@, Marketplace, Amazon Services’ Merchant.com, and certain other programs from selling unlawful goods, from selling goods in an unlawful manner, or violating the proprietary rights of others, and could face civil or criminal liability for unlawful activities by our sellers.

 

We May Not Be Able to Adapt Quickly Enough to Changing Customer Requirements and Industry Standards

 

Technology in the e-commerce industry changes rapidly. We may not be able to adapt quickly enough to changing customer requirements and preferences and industry standards. Competitors often introduce new products and services with new technologies. These changes and the emergence of new industry standards and practices could render our existing websites and proprietary technology obsolete.

 

The Internet as a Medium for Commerce Is Subject to Uncertainty

 

Consumer use of the Internet as a medium for commerce is subject to uncertainty. While the number of Internet users has been rising, the Internet infrastructure may not expand fast enough to meet the increased levels of demand. In addition, activity that diminishes the experience for Internet users, such as spyware, spoof emails, viruses and spam directed at Internet users, as well as viruses and “denial of service” attacks directed at Internet companies and service providers, may discourage people from using the Internet, including for commerce. Furthermore, newer users of the Internet could be less active e-commerce customers compared to our earlier customers. If use of the Internet as a medium for commerce grows at a slower rate than we anticipate, our sales would be lower than expected and our business could be harmed.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

We are exposed to market risk for the effect of interest rate changes, foreign currency fluctuations, and changes in the market values of our investments.

 

50


Table of Contents

Information relating to quantitative and qualitative market risks is set forth below and in Item 2 of Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

 

Interest Rate Risk

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt. All of our cash equivalent and marketable fixed income securities are designated as available-for-sale and, accordingly, are presented at fair value on our balance sheets. We generally invest our excess cash in investment grade short- to intermediate-term fixed income securities and AAA-rated money market mutual funds. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates.

 

At September 30, 2005, we had long-term debt of $1.5 billion primarily associated with our 4.75% Convertible Subordinated Notes and 6.875% PEACS, which are due in 2009 and 2010. The market value of our long-term debt will fluctuate with movements of interest rates, increasing in periods of declining rates of interest and declining in periods of increasing rates of interest. Based upon quoted market prices, the fair value of the 4.75% Convertible Subordinated Notes (outstanding principal of $900 million) was $880 million and $907 million at September 30, 2005 and December 31, 2004, and the fair value of the 6.875% PEACS (outstanding principal of €490 million and €690 million) was $598 million and $936 million at September 30, 2005 and December 31, 2004.

 

Foreign Exchange Risk

 

During Q3 2005, net sales from our International segment (consisting of www.amazon.co.uk, www.amazon.de, www.amazon.fr, www.amazon.co.jp, and www.joyo.com) accounted for 44 % of our consolidated revenues. Net sales and related expenses generated from these websites, as well as those relating to www.amazon.ca (which is included in our North America segment), are denominated in the functional currencies of the corresponding websites and include British Pounds, Euros, Yen, Chinese Yuan, and Canadian Dollars. The functional currency of our subsidiaries that either operate or support these websites is the same as the corresponding local currency. The results of operations of, and certain of our intercompany balances associated with, our internationally-focused websites are exposed to foreign exchange rate fluctuations. Upon consolidation, as exchange rates vary, net sales and other operating results may differ materially from expectations, and we may record significant gains or losses on the remeasurement of intercompany balances. For example, as a result of fluctuations in foreign exchange rates throughout the period compared to rates in effect the prior year, International segment revenues in Q3 2005 was reduced by $9 million and our consolidated operating income was reduced by $1 million.

 

We have foreign exchange risk related to foreign-denominated cash, cash equivalents, and marketable securities (“foreign funds”). Based on the balance of foreign funds at September 30, 2005 of $687 million, an assumed 5%, 10%, and 20% negative currency movement would result in fair value declines of $34 million, $69 million, or $137 million. The balance of foreign funds at September 30, 2004 was $693 million. All investments are classified as “available for sale,” as defined by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

 

We have foreign exchange risk related to our 6.875% PEACS, which have an outstanding principal balance at September 30, 2005 of €490 million ($589 million, based on the exchange rate as of September 30, 2005). Due to fluctuations in the Euro/U.S. Dollar exchange ratio, which we cannot predict, our remaining principal debt obligation under the 6.875% PEACS since issuance in February 2000 has increased by $106 million as of September 30, 2005. Based on the outstanding 6.875% PEACS’ principal balance, an assumed 5%, 10%, and 20% weakening of the U.S. Dollar in relation to the Euro would result in additional losses of approximately $29

 

51


Table of Contents

million, $59 million, or $118 million, recorded to “Remeasurements and other.” Additionally, we have not hedged our interest payments under our 6.875% PEACS to protect against exchange rate fluctuations. Assuming the U.S. Dollar weakens against the Euro by 5%, 10%, and 20%, we would incur $2 million, $4 million, or $8 million additional annual interest expense due solely to fluctuations in foreign exchange.

 

See Item 2 of Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Effect of Exchange Rates” for additional information on the effect on reported results of changes in exchange rates.

 

Investment Risk

 

As of September 30, 2005, our recorded basis in equity securities (including both publicly-traded and private companies) was $14 million, including $5 million classified as “Marketable securities,” and $9 million classified as “Other assets.” We regularly review the carrying value of our investments and identify and record losses when events and circumstances indicate that declines in the fair value of such assets below our accounting basis are other-than-temporary. The fair values of our investments are subject to significant fluctuations due to volatility of the stock market in general, company-specific circumstances, and changes in general economic conditions. Based on the fair value of the publicly-traded equity securities we held at September 30, 2005 of $55 million (recorded basis of $7 million), an assumed 15%, 30%, and 50% adverse change to market prices of these securities would result in a corresponding decline in total fair value of approximately $8 million, $17 million, or $28 million.

 

Item 4. Controls and Procedures

 

We carried out an evaluation required by the 1934 Act, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the 1934 Act, as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective in providing reasonable assurance that material information required to be included in our periodic SEC reports is made known to them in a timely manner. Management does not expect that our disclosure controls and procedures will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected.

 

During the most recent fiscal quarter, there has not occurred any change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

52


Table of Contents

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

See Item 1 of Part I, “Financial Statements — Note 4 — Commitments and Contingencies.”

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

None.

 

Item 5. Other Information

 

None.

 

Item 6. Exhibits

 

Exhibits

 

Exhibit
Number


  

Description


  3.1    Restated Certificate of Incorporation of the Company (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2000).
  3.2    Restated Bylaws of the Company (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2002).
12.1    Computation of Ratio of Earnings to Fixed Charges.
31.1    Certification of Jeffrey P. Bezos, Chairman and Chief Executive Officer of Amazon.com, Inc., pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
31.2    Certification of Thomas J. Szkutak, Senior Vice President and Chief Financial Officer of Amazon.com, Inc., pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
32.1    Certification of Jeffrey P. Bezos, Chairman and Chief Executive Officer of Amazon.com, Inc., pursuant to 18 U.S.C. Section 1350.
32.2    Certification of Thomas J. Szkutak, Senior Vice President and Chief Financial Officer of Amazon.com, Inc., pursuant to 18 U.S.C. Section 1350.

 

53


Table of Contents

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

AMAZON.COM, INC. (REGISTRANT)

By:

  /S/    MARK S. PEEK        
    Mark S. Peek
    Vice President and
    Chief Accounting Officer

 

Dated: October 26, 2005

 

54


Table of Contents

EXHIBIT INDEX

 

Exhibit
Number


  

Description


  3.1    Restated Certificate of Incorporation of the Company (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the Quarter ended March 31, 2000).
  3.2    Restated Bylaws of the Company (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2002).
12.1    Computation of Ratio of Earnings to Fixed Charges.
31.1    Certification of Jeffrey P. Bezos, Chairman and Chief Executive Officer of Amazon.com, Inc., pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
31.2    Certification of Thomas J. Szkutak, Senior Vice President and Chief Financial Officer of Amazon.com, Inc., pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
32.1    Certification of Jeffrey P. Bezos, Chairman and Chief Executive Officer of Amazon.com, Inc., pursuant to 18 U.S.C. Section 1350.
32.2    Certification of Thomas J. Szkutak, Senior Vice President and Chief Financial Officer of Amazon.com, Inc., pursuant to 18 U.S.C. Section 1350.

 

55