Wall Street is starting to get excited about a technology idea that's tantalized the business world for more than a decade now — Amazon, but profitable. After all, in the most recent two quarters, Amazon has earned meaningful profits — profits driven by the success of Amazon Web Services, an enormously popular technology infrastructure company that enjoys tech-like economics rather than retail-like ones. That means 25 percent profit margins on a business that does $2 billion in revenue a quarter and is growing at a 70 percent rate.
That's led Citigroup's Mark May to issue a bullish forecast, calling for Amazon to demonstrate rapidly growing profits over the next few years with stock price growth that matches. May's note sees that breakout as driven by two factors. One is a shift within the retail business toward higher-margin items. The other is a shift away from the retail business and toward Amazon's fast-growing and high-margin Amazon Web Services business.
May thinks these two factors will lead to steady profit growth, which will drive the price up of Amazon stock. It's an intriguing theory, but it reflects a fundamental misunderstanding of Amazon's nature. Amazon may become consistently profitable someday, but if it happens it's likely to be the result of a financial, legal, or political battle that reshapes its nature. The company as we know it today will never be a profit engine, because it doesn't want to be.
May's case for Amazon profits
May's note is packed with jargon but worth reading. The key points are that "GAAP Net Income" and "EPS" — earnings per share — are both measures of profitability:
The profit potential of Amazon's business has dominated dialogue around the stock nearly since its inception. Concerns over margins were far from ill-founded, with Amazon converting a 1,200% increase in revenue from 2004 to 2014 into a 141% decline in GAAP Net Income. The primary symptom of this penchant for long-term investing has been confusion around how to value the company, with many investors opting for an EV/Revenue approach — not dissimilar to our current EV/GMP SOTP model. The dramatic transformation of Amazon's business should change this, and potentially sooner than expected. An ongoing mix-shift in the Retail business and stellar growth in its high-margin [Amazon Web Services] segment are expected to drive adjusted EPS growth of 50% annually over the next three years, bringing [Calendar Year 2018] EPS to as much as $20. Considering Amazon's projected earnings growth, the S&P 500's historical PEG ratio of 1.2-1.5, and a 10% discount rate, AMZN is currently trading at a discount to fair value on an EPS (not revenue) basis. We believe there is an opportunity to attract a new class of investors as the company proves the sustainability of its recent margin expansion and produces more meaningful EPS.
The basic model here is that even though Amazon is an old company, we should think of it as a startup like Uber or Snapchat: a company that has a lot of customers and a successful product but that has struggled to demonstrate profitability, and whose share price will take off like a rocket if it can convert its user base into earnings. Investors can reap a fortune if they can buy in right before this happens.
Does Amazon want to be profitable?
There is considerable evidence that this model of Amazon's decision-making is mistaken. Amazon has not, historically, been a profitable company because Amazon's leaders don't want it to be a profitable company. In the future it will continue to not be profitable for the exact same reason. In the past, Amazon has managed to turn a profit when it's forced to by skepticism from Wall Street, which suggests that non-profitability is a choice.
Indeed, it's a choice that CEO Jeff Bezos has explained to the public in response to a joke I once made about the company's unprofitability:
Our heavy investments in Prime, AWS, Kindle, digital media, and customer experience in general strike some as too generous, shareholder indifferent, or even at odds with being a for-profit company. "Amazon, as far as I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers," writes one outside observer. But I don’t think so. To me, trying to dole out improvements in a just-in-time fashion would be too clever by half. It would be risky in a world as fast-moving as the one we all live in. More fundamentally, I think long-term thinking squares the circle. Proactively delighting customers earns trust, which earns more business from those customers, even in new business arenas. Take a long-term view, and the interests of customers and shareholders align.
As I write this, our recent stock performance has been positive, but we constantly remind ourselves of an important point – as I frequently quote famed investor Benjamin Graham in our employee all-hands meetings – "In the short run, the market is a voting machine but in the long run, it is a weighing machine." We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed, and we’re always working to build a heavier company.
Bezos is interesting in weighing, not voting, as a plan for long-term stock price appreciation. And the way the company builds mass is by investing revenue in new endeavors, not by increasing profit margin.
Amazon's profits have surprised the company
Recent talk of a new, profitable Amazon is driven by several successive quarters in which the company — driven by Amazon Web Services' growth — has reported earnings that, while modest, were ahead of the company's own forecasts.
"I think you could absolutely argue that AWS is simply spinning off more cash than Amazon knows what to do with," writes technology industry analyst Ben Thompson. "To be sure, Amazon is projecting a likely loss next quarter (-$480 million~$70 million), but then again, their prediction for this quarter was even more negative (-$500 million~$50 million). It will be fascinating to see if they unexpectedly beat their projections again."
One could interpret this as a sign of a covert plan to grow AWS into a financial engine that finally turns Amazon into a consistently profitable company.
But one could also take it at face value. AWS has simply grown faster than Amazon planned for, meaning the company invested less money than it realized it was going to have available, thus creating surprise profits. But if AWS's success continues, Amazon will likely respond by ramping up its level of investment, not by booking profits.
Profits would attract the wrong kind of investor
One reason May thinks profits will boost Amazon's share price is that he believes consistent profitability would "attract a new class of investors."
This is likely not something that Amazon management would welcome. What profits do is attract the kind of investors who try to mount activist campaigns to force companies to push their profits out to shareholders in the form of dividends and share buybacks.
Whether those kinds of campaigns are good for individual companies or the economy as a whole is controversial. But they're clearly not good for engaged, megalomaniacal founders who are still running the companies they created. Bezos obviously is not hard up for cash, personally, at this point in his life. If he wanted money, he would sell shares and retire. The reason he bothers to show up for work every day is that he wants Amazon to be the biggest and most important company in the world — the Everything Store where everyone buys everything all the time.
You don't build the Everything Store by paying dividends, and if you don't have profits, there are no dividends to pay. Far better to keep building and investing, disappointing as it may be to Wall Street analysts.
Amazon has plenty of room to invest
Fundamentally, Amazon will only start booking large consistent profits when the company's leaders run out of new ideas to invest in. Right now they are not out of ideas, as you can easily tell from the wide range of businesses they are halfway into.
A few examples:
- AmazonFresh grocery delivery is currently available only in five cities, and not even in all neighborhoods in all of those cities.
- Some items are now available for free one-day Prime shipping, but most still require two-day shipping.
- Amazon produces some well-regarded original video content likeThe Man in the High Castle, but doesn't yet have enough to be a true must-subscribe for TV fans.
- Under the brand name Amazon Elements, Amazon makes and sells a line of baby wipes, but Elements hasn't yet expanded into other adjacent product areas like diapers and diaper cream, to say nothing of the larger universe of pacifiers, infant formula, and other everyday baby essentials.
- Amazon is assembling a fleet of delivery drones.
- Amazon has a couple of successful hardware products (Fire TV, Echo, Kindle) but has struggled somewhat with tablets, struggled more with smartphones, and not even tried at laptops — there's plenty of room to do more.
- Amazon currently operates one physical store. It could open more.
Those are just areas where Amazon could ramp up spending on things it's already spending money on. Amazon also employs a lot of bright and hard-working people, some of whom can no doubt think up some brand new ideas all on their own. And of course there are always super-boring ways for a profit-averse company to reduce profits. Amazon could make AWS or Prime membership cheaper. It could start paying its warehouse workers more. A company can accidentally turn a profit for a quarter or three, but fundamentally this is not that difficult a problem to solve.