Analysis: AMZN

Amazon (AMZN) reported disappointing results after the bell on Thursday, with its third quarter earnings. Revenues of $69.98 billion (+24%) outpaced the $68.83 billion consensus. But on the bottom line, earnings per share of $4.23 (-26.4% YoY) came up short vs. expectations of $4.59 per share.

Before we get into the results, let's take a look at financial guidance for the fourth quarter. Net sales are expected to be between $80 billion and $86.5 billion, representing growth of between 11% and 20% year-over-year. This guidance includes an unfavorable impact of approximately 80bps from foreign exchange. At a midpoint of $83.25 billion, management's guidance comes in very light against consensus forecasts of $87.394 billion. For a company this large, there will always be some moving parts, and in the case this quarter, it's timing related to international holidays and tax changes. But this guidance is puzzling, because as you will see in the results below, Amazon accelerated its revenue growth across several line items. Operating Income does not look much better, with management expecting the range of $1.2 billion and $2.9 billion for a midpoint of $2.05 billion, well below consensus expectations of $4.19 billion.

In reaction to earnings per share miss and the underwhelming guidance, AMZN is trading sharply lower after-hours, down roughly 6.75% to $1,660 per share.

But it appears the company is betting on its investment in one-day free shipping to drive e-commerce sales, as that was the theme of CEO Jeff Bezos in the press release, which can be found here, and the broader report and guidance as well.

"It's a big investment, and it's the right long-term decision for customers," said Bezos in the release. "And although it's counterintuitive, the fastest delivery speeds generate the least carbon emissions because these products ship from fulfillment centers very close to the customer -- it simply becomes impractical to use air or long ground routes. Huge thanks to all the teams helping deliver for customers this holiday."

For the company's 25th holiday season, it's making millions of products available for free one-day Prime delivery, added Bezos. "Customers love the transition of Prime from two days to one day -- they've already ordered billions of items with free one-day delivery this year."  

By geography, total North America sales were $42.638 billion (+24% YoY), exceeding expectations of $41.615, but operating income in the segment came in at $1.282 billion, a miss vs. expectations of $1.357 billion. Total International sales in the quarter were $18.348 billion (+18% YoY), a better-than-expected result against consensus of $17.834 billion. Additionally, operating losses were less than expected (a good thing), as the company lost $386 million in the quarter against expectations of a $907 million loss.

Additionally, unit growth accelerated for the second quarter in a row, increasing 22% YoY. Units, according to Amazon, mean "physical and digital units sold" on net of returns and cancellations by the company and sellers in its stores, as well as Amazon-owned items sold in other stores. Amazon Web Services, certain acquisitions, certain subscriptions, rental businesses or advertising businesses and Amazon gift cards are not included.

Here's the complete breakdown:

Online Stores Hot and Retail Stores Not

At Online Stores, the heart of Amazon's e-commerce business, revenues in the quarter were $35.039 billion (+21% YoY, +22% ex-FX), topping the $33.66 billion consensus. It's clear that the one-day shipping initiative has lit a fire under this business as the 22% increase represents a nice step up from the second quarter's 16% growth rate.

But clearly this is coming at a cost, as worldwide shipping costs increased 46% YoY to $9.608 billion, up from $8.134 billion a quarter ago and $7.32 billion in the first quarter of the year. Management is working to reduce the costs of one-day shopping, but looking further, its cost will have a $1.5 billion impact on Q4 shipping expense relative to the fourth quarter 2018.

At Physical Stores revenue was $4.192 billion (-YoY, -1% ex-FX) in the quarter, short of the $4.315 billion consensus. Physical Stores are Amazon's business that includes items that customers physically select in stores such as Whole Foods, but excludes online and Whole Foods delivery sales, so it's a bit skewed. 

Web Services Miss 

At Amazon Web Services, revenue of $8.995 billion was surprisingly a miss against expectations of $9.103 billion, as growth decelerated for the third quarter in a row, this time to 35% from the prior quarter's 37% rate. As we've noted in prior quarters, while the pace of sales can be lumpy at times due to differences in sales cycles -- which could explain the slowdown and we cannot discount the fact that the business grew before estimates -- we still believe it's a pretty strong growth rate considering the size of the operation. For perspective on that, AWS basically did $9 billion in business this quarter, compared to $6.679 billion one year ago.

AWS Operating Income came in at $2.261 billion (+9% YoY), short against $2.547 billion expectations. AWS' operating margin contracted too, falling to 25.1% from 25.3% a quarter ago, and 31.1% in the same quarter one year ago.

When asked about margins here, management cited how some of the strength in last year's results was during a "very efficient" time when the business cashed in on savings from forward infrastructure investments in 2017. As it relates to this year, management continues to invest in all aspects of the business, including the sales force and marketing personnel -- to manage the business and the large customer base. And that's really the driver of the margin compression.

"So the biggest impact that we saw in Q3 year-over-year in the AWS segment was tied to costs related to sales and marketing year-over-year also to the secondary extent, infrastructure," said CFO Brian Olsavsky, "so there's been a step up in infrastructure cost to support the higher usage demand."

Given that rapid growth of AWS and the cloud computing industry in general, we are not overly concerned with the margin contraction or revenue deceleration (law of large numbers). 

Not Fully Subscribed on Subscription Services

In Subscription Services, which includes annual and monthly fees associated with Prime, audiobook, e-book, digital video, digital music, and more, revenues of $4.957 billion (+34% YoY, +35% ex-FX) just missed the consensus of $5.002 billion.

Third-party Seller Services Nails It

In this segment, which includes commissions and any related fulfillment and shipping fees, and other third-party seller services, sales were $13.212 billion (+27% YoY, +28% YoY ex-FX), a tad higher vs. the $13.1581 billion the Street was looking for. One-day shipping certainly helped this business. The 28% growth rate was an improvement from the prior quarter's 25% rate.

Advertising, Other Services Beat

Other sales came in at $3.586 billion (+44% YoY, +45% YoY ex-FX), outpacing the $3.426 billion consensus and accelerating past the previous two quarters' downward trend. While the breakout of this segment is quite opaque, management acknowledged on the call that the advertising portion of this segment grew at a rate faster than the segment's reported 45% YoY growth.

Our Take: Look at the Longer Term

Overall, it was not the outcome we wanted, but consider this: When Amazon was making new high after new high throughout the majority of 2018 and in the years prior, the company's overall profitability benefited from an increased revenue shift into higher margin businesses such as AWS and Advertising.

While the growth rates of these two businesses are still outpacing the rest of the company -- and that's been core to our thesis in the stock -- the increases to shipping expenses and costs needed to support the future of AWS has pressured margins. In a stock where investors have typically favored growth, one would think the re-energized e-commerce business and the expected longevity of AWS would be favored.

But as we know from where the stock currently trades, down heavy after-hours and about 15% below our summer sale price here, the investment year has been a kiss of death to the stock and to shareholders with an incredibly short-term view.

We do not believe this multiple-quarter dynamic is worth a panic. Sure, Amazon has stepped up investments in the present -- and there will be negative analyst revisions Friday to account for this -- but the spending will be transitory in nature and operating leverage will increase in the future. Management did, however, admit it's still learning what the long-term cost structure will be.  

And in all likelihood, the company has probably under-promised with that holiday season guidance, and is primed to outperform with the benefit of one-day shipping. With shipping times reduced in general, imagine how resourceful Amazon's e-commerce platform will be to all those last-minute holiday shoppers.

It has most certainly become clear that 2019 has been, and will end, as an "investment year" that will continue to weigh on margins and the stock's near-term performance, hence the recent sluggishness trading and the sharp after-hours decline after the bell. But there will be a time in the future where Amazon reaps what they sow, and we want to make sure we are invested for that.