Amazon: A Show Of (Margin) Force

Summary:

• Amazon.com, Inc.’s third-quarter results showed strong sales growth of 13% to $143.1 billion, exceeding the guidance.
• Operating margins were impressive at 7.8% of sales, with Amazon Web Services margins recovering and overall operating profits reaching $11.2 billion.
• Despite slower growth in AWS, the company’s overall performance and potential for margin improvement make it an attractive investment.

When Amazon.com, Inc. (AMZN) posted its second-quarter results in August, I called the results impressive across the board, but for Amazon Web Services (“AWS”) performance. Following the signs of a margin recovery and potential for future growth across the board, as well as the potential for stabilization and re-acceleration of AWS growth in the upcoming quarters, I was upbeat.

While shares were very pricey (which is nothing new), the long-term investment case remained intact, although a momentum rally over the summer did not provide a nice entry point.

Forwarding towards today: the company just delivered a strong third-quarter report, notably, margins being very strong. While the fourth quarter guidance might be underwhelming a bit, it is these margins and the recent setback in the share price that reveal long-term appeal here.

Setting The Base Picture

Pre-pandemic, Amazon was a $280 billion business in the year 2019, and after earnings were pretty much non-existent in the years before, the business posted solid operating margins in the mid-single digits. These margins were reported on a consolidated basis with AWS margins being much higher than the very low-margin retail operations.

The pandemic resulted in very strong growth as 2020 sales rose 40% to $386 billion as operating profits of $23 billion worked down to margins of 6%. Revenues rose another 21% to $469 billion in 2021, with operating profits up in a much more moderate fashion to $25 billion, as margins reverted to 5% and change.

With the pandemic on retreat in 2022, Amazon.com managed to grow full-year revenues by 9% to $514 billion as operating profits were cut in half to $12 billion, with margins coming in at 2% and change, being the lowest margins seen since quite a few years. Growth was slower than thought, as the company overbuilt its distribution footprint, faced higher shipping costs and AWS lost some momentum as well.

With the outlook for 2023 being rather uncertain, with consumers and the economy burdened by higher interest rates and inflation, first-quarter sales rose by 9% to $127 billion. The first quarter operating profit of $4.8 billion marked a big improvement, driven by the retail operations, as AWS margins fell from 35% of sales to 24% of sales.

By August, shares rose to the $140 mark (after shares traded at just $85 by year-end 2022) as second-quarter sales rose by 11% to more than $134 billion, in part aided by inflationary impacts and dollar strength in part being on the reverse. An 11% increase in North American retail sales to $82 billion and a 10% increase in International sales to $30 billion were strong, but a mere 12% increase in AWS sales was soft with sales reported at $22 billion.

The company posted a strong operating profit of $7.7 billion, driven by a $3.2 billion contribution from the North American retail business and international retail losses narrowing to $0.9 billion. A $5.4 billion operating profit number of AWS looks impressive, but besides softer growth, its margins were softer as well on a historic basis.

With overall operating margins posted at 5.5%, the annualized earnings trend came in at $2.60 per share, ahead of a seasonal stronger fourth quarter. The third quarter guidance was pretty solid as well with sales seen up to $138-$143 billion and operating profits seen at $5.5-$8.5 billion.

Trading at $140, the 10.3 billion shares valued the business at a $1.5 trillion valuation, including a flattish net debt load as valuations were of course nosebleed high. After all, an earnings number close to $3 per share translated into a multiple of around 50 times earnings. This was far from cheap, but given the obsession with long-term value creation, I found and find Amazon by definition a dangerous stock and company to bet against.

And Now?

Since August shares of Amazon have fallen back quite a bit, down from the $140 mark in August to $120, before recovering to $125 in the wake of the third quarter results. These results are actually quite good, with sales up 13% to $143.1 billion, just exceeding the higher end of the guidance.

Sales trends were similar to the second quarter with North American retail sales up 11% to nearly $88 billion, and international sales up 16% to $32 billion (although that growth came in at 11% in constant currency terms), with AWS growth flattish at 12%. The growth of AWS is among the lowest of all the major technology names (for this line of business) but remember that this is already a huge business with quarterly sales coming in at $23 billion.

The real surprise (in a positive sense) was an $11.2 billion operating profit number, for margins equal to 7.8% of sales. North American operating profits rose to $4.3 billion, international losses essentially came in around the break-even level (after they have been lossmaking for years with an exception of temporary and small profits during the pandemic) and AWS margins have recovered greatly with profits reported at $7 billion.

GAAP earnings of $9.9 billion, or $0.94 per share, included a $1.2 billion gain on the investment in Rivian Automotive (RIVN), as earnings power pegged around $3 per share in August likely comes in closer to $3.50-$4.00 per share based on the current report.

For the key holiday season, Amazon sees fourth-quarter sales up 7-12% to $160-$167 billion, as the company traditionally guides in a conservative fashion. Operating earnings are seen between $7 and $11 billion, up substantially from a $2.7 billion number in the fourth quarter, but down from the third quarter (although Amazon is, of course, guiding conservatively). Otherwise, investors have to understand that third-quarter margins were very strong, likely not sustainable here.

And Now?

Right now, the company is on track to generate about $565 billion in sales this year and about $32-$33 billion in operating profits. This means that operating margins are seen close to 6%, but arguably the growth and margin performance are stronger in the second half of the year.

With shares down to $125 and earnings power seen around $3.50-$4.00 per share, earnings multiples have come down a long way to 31-35 times. Moreover, there are some real tailwinds to margins (as was really evident in the third quarter results), notably, operating leverage seen amidst growing demand, lesser capital spending, robotization of the distribution centers, and a move from a national distribution center toward regional center resulting in operational synergies.

While the continued and flattish pace of growth of AWS lags compared to peers, it should not be forgotten that AWS is much larger than many of its peers and furthermore demonstrated huge margins in the third quarter as well. The company furthermore touts many big customer signs up (reinforcing the belief of a growth acceleration) and believing that AI opportunities are substantial.

Quite frankly, now feels like the time to be more upbeat compared to August. While earnings multiples are still high, they are very low based on historical standards, as the business is now posting real margins here. Given all this, I am quite upbeat on the network, feeling comfortable to hold onto an Amazon.com, Inc. stock position which I have initiated in the lower $120s in recent days.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AMZN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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