Amazon released their quarterly results Friday, to a 13% pop in stock price.  Their market cap increased by $62B in a single day as a result, more than many huge enterprises are worth.

This is a paradox.   If profits are what matters (and in the long run, they are), Amazon turned in a paltry $347M in operating income, vs. $575M last year – so they’re actually shrinking!   Their P/E ratio is now a terrifying 279 (vs. Apple at 19, Google at 50).   Most of Amazon’s stock price has been driven by PE expansion, not by earnings.   Amazon’s price growth is about investor sentiment, not financial performance.

A Deeper Dive into the Financials

What’s going on at Amazon to drive so much enthusiasm?   To find out, I’ve combed through Amazon’s 10-Q, read the conference call transcript, and will do some deeper math.

First, Let’s summarize what’s going on down at South Lake Union:

• Revenue growth continues apace.   Profits are paltry, but revenues grew from $33B to $44B vs. last year, a stellar 34% rate. Amazon is growing fastest in North America, slightly slower overseas.
•  AWS is growing rapidly (42% YoY) but this is slower growth than last year.  Amazon says the 2nd derivative revenue slowdown is driven not by customer growth but rather by price cuts (your margin is their opportunity!).
• Under the covers, profitability tells a different story.   Amazon’s operating income now comes primarily from AWS ($1.2B), not retailing (where they actually lost money, driven by international sales (-$926B) not North American sales ($112).   Assuming I believe their numbers (which are suspect as costs can be shifted around between the businesses arbitrarily), AWS is now their primary business!
•  Lack of profitability is about spending choices, not revenues.   Retail revenue growth is amazing, but it’s being offset by equally amazing expense growth.   Cost of sales are keeping pace with revenues growing at 30%.   Retail fulfillment, Marketing, and R&D are all vastly outpacing revenue.

To illustrate the power of these choices, let’s take a look at a contrafactual.   Imagine Amazon had just kept spending in line with revenue growth where they could.  The table below shows some napkin math:

In the “choose not to spend” column we see what 3Q17 would have looked like had Bezos just chosen to increase marketing, fulfillment, R&D, and G&A in line with revenues.   Faster-than-revenue growth in these categories is largely a choice they made.   The result is a 10x increase in profits, to $3B in the quarter.  Of course, less marketing might have meant fewer sales, so this is simplistic.   But it gives an idea the leverage of the choices Bezos is making, and the profit opportunity that exists hidden inside of Amazon.   The secret is that their retail businesses are in fact highly profitable at the GM level, and GM is growing very rapidly.   Bezos is simply choosing to invest profits into more distribution centers, data centers, and R&D towards new businesses.    This is enormously powerful and shows the options Amazon has once growth slows.

I’m of course not recommending change strategy; Amazon is buying share and using retail profits to drive R&D in future businesses like AWS, Echo, etc.   As long as Wall Street allows this, it’s the right thing to do vs. pile up vast cash as Apple, Microsoft, and Google are doing (and must do given their relatively limited investment opportunities).

Headcount Explosion

When I first joined Microsoft in 1996, we had 17k employees.   5 years later we were approaching 100k.  During those 5 years, it felt like my primary job was interviewing candidates for new headcount openings!    It must feel like that at Amazon right now, as they’ve nearly doubled their workforce in a year.   Many must be out in fulfillment centers, but the traffic at South Lake Union, construction around Puget Sound, and number of my LinkedIn Contacts changing jobs from MSFT to AMZN attest to the rapid growth in high priced headcount.

This is a way to grasp at opportunity and feels great on the way up, but if things ever turn it’s painful and expensive to unwind this kind of investment.   The financials above attest to the likelihood they won’t have to.

Investing in Deep Moats

Amazon is working to be sticky with its customers and impossible to compete with.   They are building moats that will be tough for anyone to beat.   Some specific examples:

• Clever, capital-intensive ideas that benefit from scale.   Amazon Lockers, their own delivery drivers, unique deals with the post office for Sunday delivery, fulfillment centers everywhere, systems that make delivery faster and cheaper.   Can a smaller e-commerce business build these?   Can Walmart?
• AWS.   Nobody else is close to this right now and it’s largely a game of scale/cost and efficiency.   Amazon culture gives them a huge thrift advantage, and their free cash flow unleashes a lot of investment capital to build out infrastructure.
• Amazon Prime.   Amazon is coy, but estimates are this service has 80M-90M US members.   What a triumph!   These members are sockets for increasing loyalty, sales, and gross margins, and potential users of Amazon technologies like Echo and Alexa.

Amazon Web Services

This is a deep topic, but I did want to lightly call out a milestone; AWS grew operating income to $1.1B on $4.6B of revenue.   These margins are impressive and powerful, and represent a huge opportunity to make money and/or to use decreased prices as a weapon against Microsoft and Google.   Were I competing with AWS, I’d expect price competition to intensify.

Whole Foods Acquisition

Wow, this was a big bet.   This really hit home in their filings,; Amazon didn’t have enough cash to simply write a check they had to borrow a lot of money.   As a result, their long-term debt exploded from $7.7B to $24.7B.  The 10-Q is preliminary given the short timeframe, but there can be no doubt this is a huge bet that really does need to pay off.   Bezos must really believe in the long-term value of this, as he’ll have some uncomfortable discussions if they must write off $13B in value – 13 years of earnings at the current rate – due to bad execution.   Fortunately, it’s an acquisition that comes with a lot of assets and free cash flow, so a full write-off is unlikely.

But this wasn’t a lark; expect Amazon to go all in to drive synergies and make it successful.

Amazing Customer Innovation

Amazon’s list of accomplishments for the quarter is amazing.   A full accounting can be found here.  I see a number of themes:

• Sticky customer innovations designed to get more customers, keep more customers, and get more of their business.    I suspect they metric “% of total retail spending per customer” which must be below 10% now.   Lots of upside there!   Of course there’s lots of activity around Echo and Alexa as well as Fire TV and Video services.
• AWS features, adding new workloads that can be moved into the cloud.   Most involve geographic expansion and new, basic workloads but some of the partnerships (VMWare and Microsoft) are interesting.   I see less enterprise features than I’d have expected as this is where Azure is investing and it’d be good to move aggressively there, but perhaps that’s fighting where the enemy is strong.
• An unusual number of “feel good” employee and charitable efforts.   Perhaps the (somewhat unfair) New York Times article is having an impact.

Opportunities Abound

Their connection to consumers and scale give them an array of things to pursue.   Some have been rumored, some exist only in my head.   But to illustrate:

• Pharmacy.   This is rumored with some evidence and would make a huge amount of sense.   Pharmaceuticals are a perfect product for mail order and have a lot of margin to attack.
• More delivery logistics.   Amazon spent $5.4B on shipping last quarter; this scale means they can cherry pick lots of delivery scenarios and take them first party and save a lot of costs.
• More first party products.   Amazon 1st party brands are expanding rapidly; electronics, accessories, clothing.   Someone at Amazon is having a great time shopping in China for good, low priced products and rebranding them.   This enables lower prices, better customer loyalty, AND higher margins.
• AWS.   This is a good service platform leading a rapidly growing category with high margins.   Simply execute well and grow.   Google is way behind, Microsoft will gain traction in their areas of strength, but momentum here is clear.
• New Retail Categories.  I have no idea which they’re working on, but Amazon’s history started with Books, then CDs.   I now buy a stunning variety of products from Amazon, many of which I’d have predicted you couldn’t possibly sell this way.   I recently ordered a mattress online, for goodness’ sake – and not from Amazon.   Next?

The World’s Most Impressive Nonprofit?

During the dot-com boom, an industry wag suggested Amazon should rename themselves to Amazon.org given their eternal lack of profits.    This is to some extent still true given a profit margin of 0.5% ($256M on $44B revenue!).   But I hope I’ve convinced you this is a very superficial criticism.   Amazon has vast market power and is simply scaling investment with gross margin to keep profits at zero – and Wall Street is rewarding them.   This makes Amazon hard to value exactly, but they are incredibly valuable.