Amazon.com Inc. (AMZN) is the most successful consistently profitless company in the history of Wall Street. With a surprising and large profit in Q2 2015, Amazon’s stock price soared in the past four months to over $650 and the company’s P/E hovers near an astonishing 900.
Shareholders obviously believe that a new era of Amazon has begun—one of posted profits and dividends. This is unfortunately untrue given Amazon’s business plan is to grow revenue, reinvest it all into new revenue generating endeavors, rinse and repeat.
Instead of assuming that Amazon has abandoned its policy of continual reinvestment, it’s best to assume that these past two quarters saw unintentional profits.
Amazon has been increasing its profits exponentially for the past five years. In that time, the company has sought to find new places to invest the money and has diversified itself into a laundry list of industries. Not all of these ventures have been successful – the Fire phone and Amazon Destinations being two recent examples – but the ones that are successful are spinning off revenue faster than Amazon can spend it. (For related reading, see: Is Amazon Prime Actually Profitable?)
Amazon breaks its revenue down into four categories: Media, Electronics and General Merchandise, Amazon Web Services (AWS) and other. The AWS net sales category has recently been implemented as previously its revenue was reported segmentally, alongside North America and International sales.
AWS is widely heralded as the cause of Amazon’s profitability. In Q1 2015 AWS made $265 million, in Q2 2015 $391 million and in Q3 2015 $521 million. Profit is growing, in part because expenses in this sector are not. Since AWS’s revenue and expense figures began to be released in Q1, revenue has increased by $519 million while expenses have only gone up $263 million. In short, Amazon has this profit machine that’s bringing in revenue twice as fast as it costs to provide service.
Why Is This a Problem?
Rather than getting excited about the profit machine that is AWS, investors should look at the problem behind the profit, namely that Amazon has nowhere to spend this money.
The core to Amazon’s business has always been reinvesting into new industries. With the failure of a very expensive project, the Fire Phone, now behind them, executives at Amazon might not be so willing to give into everything CEO Jeff Bezos demands. If that’s the case, Amazon’s profits are here to stay but it’s a worrying thought for a company that’s synonymous with Bezos. If not, this might be the end of Amazon as a growth company, which is another worrying thought that could send the stock price down to a P/E closer to a stable, mature company.
Biggest Threats to Profitability
Amazon faces other threats to its newfound profitability. First, there’s its mandate to increase revenue infinitely. In its attempts to grow in every direction and as quickly as it has, Amazon has over-diversified itself. Over-diversification in a business can be catastrophic in every which way, including employees getting overworked and burnt-out, as well as companies becoming unable to scale back or adapt to changing economic conditions. (For more, see: The Dangers of Over-Diversifying Your Portfolio.)
By over-diversifying, Amazon runs the risk of jumping too quickly into new products and services. Without solid market research and knowledge that the product or service in development is something that the consumer actually wants or needs, Amazon could find itself making costly mistake after costly mistake. Instead, Amazon should focus on scaling down its product and service line before the company gets too large to effectively control.
Moving on to the expense side of things, Amazon’s cost of business will rise in the coming years and eat into potential profits. As the retail sector of the business grows, Amazon might also need to raise its margins to continue providing the same services to more people.
Currently Amazon has a huge competitive advantage wherein it isn’t required to collect sales tax in about half of the states it operates in. Expanding physical locations into new states to provide faster shipping or to expand service means the company will have to begin collecting sales tax in that state. It’s a catch-22 that means consumers will have better or more service options but no longer save money by shopping on Amazon vs. shopping at a brick-and-mortar.
As sales increase, more distribution centers will need to be built and more shipping services will need to be provided. In Q3 2015, shipping cost Amazon over $2 billion—double what it charged consumers for shipping and a whopping 10.4% of its net sales.
The Bottom Line
The new and huge Amazon profits should be worrying to investors. Instead of wondering what’s in store for these profits—dividends? share repurchases?—investors should wonder why Amazon is straying from its core strategy of continual reinvestment of 100% of the profits. The profits aren’t here to stay and investors should be glad for that.