There’s a saying in golf: “Drive for show, putt for dough.”

It’s a great phrase, as anyone who has ever hacked around a golf course will attest to.

A perfect drive down the middle of the fairway might make you feel good as you stroll away from the tee box, but four putts on the green will quickly ruin your score.

When you’re a professional golfer, your career earnings will be made and broken on the greens.

Revenue for show, profit for dough

The relationship between revenue and profit is remarkably similar.

Driving sales isn’t necessarily as difficult as it sounds. You can drop your prices and chase volumes at any cost. You can spend an absolute fortune on marketing. There are many ways to make it happen.

The real test is whether your profit is growing along with revenue.

The best outcome is an expanding profit margin, which means your profit is growing at a faster rate than your revenue. That’s possible when a business has fixed costs that don’t increase as revenue increases.

In contrast, a decreasing profit margin is not happy news for shareholders. It means that each sale is becoming progressively more expensive to achieve, which obviously isn’t sustainable. Profits ultimately pay dividends and put money in the bank, so that’s what really counts.

Amazon – high on show, low on dough

A significant drop in profit margin can cause profits to shrink even when revenue has grown. That’s exactly what happened at Amazon in the first quarter of 2020.

This Q1 earnings season in the U.S. is making for fascinating reading as the effects of lockdown start to play out in the numbers. Remember, only the March portion of lockdown is being reflected in these results.

Amazon generated an enormous $75.5bn in sales, up 26% year on year, but could only manage $2.5bn in profit. That’s 29% less profit than the prior year.

The result suffered from a consumer shift to lower margin products (essentials like toilet paper) rather than higher margin products (like clothing), which does no favours for margin even when sales are growing.

There were also $600m in Covid-related expenses in Q1.

What does Q2 look like?

The great thing about U.S. earnings announcements is that companies need to provide earnings guidance for the following quarter. We can only dream of such a requirement in the South African market, where companies only have to report earnings every 6 months and are under no obligation to provide financial forecasts.

For Amazon, profits are going to get worse before they get better.

Amazon’s management team have guided Q2 sales growth of between 18% and 28%, which would be another strong result on the revenue line. As the Covid costs come in though, operating income guidance ranges from a loss of -$1.5bn to a profit of $1.5bn.

They are expecting to spend around $4bn in Covid-related costs in Q2, which would include measures like:

  • Additional 175,000 employees hired to keep up with sales demand
  • $700m in increased hourly pay rates to incentivise hourly workers
  • $300m on staff testing costs for the virus

e-Commerce isn’t easy and isn’t cheap to execute. Amazon is the best in the business and we are once again seeing them struggle to trade with attractive profitability.

Amazon Web Services (AWS): the joy of diversification

With a vast range of IT services and partners across the globe, AWS now has 76 “Availability Zones” within 24 geographic regions, including close to home in Cape Town.

It’s an incredibly attractive business within the Amazon stable that benefitted greatly from an overall move to cloud computing during this unprecedented lockdown.

Microsoft’s management team noted on their earnings call that they have seen two years’ worth of digital transformation in the cloud take place in just two months. With a 33% growth in net sales for AWS, Amazon clearly got a meaty piece of that pie.

AWS managed another operating margin of 30% despite the big jump in sales, so the growth has not come at the expense of profit. In fact, AWS contributed $3bn of Amazon’s $3.9bn operating profit in Q2, which is extraordinary. They basically carried the business.

In 2019, AWS only contributed 50% of Amazon’s group operating profit, so it will be interesting to see what the steady-state profit mix looks like after lockdown.

Looking ahead

The market didn’t love Amazon’s results, sending the share price down 6%. Still, Amazon is up over 25% year to date, so it’s a sell-down against the backdrop of overall share price growth this year. If you’re a South African investor in Amazon, your ZAR return looks amazing because of Rand depreciation coupled with a 25% USD return.

Long term investors in Amazon will take a lot of heart from the high-margin growth in AWS and the trend of consumers becoming more comfortable with online shopping globally. They will feel good about customers becoming sticky and continuing to buy on Amazon, particularly as higher margin product categories become popular again.

However, as with so many tech stocks, Amazon is trading at a demanding valuation. Investors must weigh this up against the clear underlying growth in the business to determine if there is still good value in the share. Notably, many international stock commentators believe that Amazon is expensive at current levels.

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