Pando

Amazon still delights in confounding its investors

By Kevin Kelleher , written on January 29, 2016

From The Earnings Desk

Amazon has long been a company as intent on delighting its customers as confounding its investors.

Every year, for example, CEO Jeff Bezos writes a Dear John letter to shareholders explaining all the reasons why he will never love them as much as he loves his customers. For further evidence, just take a look at Amazon's earnings report last night and the volatile response it inspired in the trading of its shares.

Amazon offered a strong argument that its long march toward the total dominance of the retail industry remains on track. Its net sales rose 22 percent to $35.7 billion in the fourth quarter of 2015, a remarkable growth rate for a retail company celebrating its 22nd birthday this year. In Internet time, 22 years represents a lifespan many companies, defunct or struggling, would envy. But a 22-year-old company growing 22 percent a year? It's not often done.

The company is famous for living with razor-thin profit margins so that it can plow the bulk of its income back into future revenue growth. Bezos steers shareholders to examine not the bottom-line of Investing 101 but rather free cash flow, a measure of Amazon's ability to extract cash from its core operations. Free cash flow over the trailing 12 months surged 276 percent to $7.3 billion last quarter.

But even for traditionalists who prefer to look at profit margins, Amazon had some encouraging news last quarter. Operating income rose 80% year-over-year to $1.1 billion. That's equal to 3.1% of its revenue, well above the year-ago operating margin of 2% and the highest operating margin the company has reported in a while.

And yet investors responded to this bill of health by driving shares down as much is 15% in after-hours trading, back to levels Amazon last saw in October. Amazon's revenue in the quarter was nothing to sneeze at, but it came in a bit shy of analyst forecasts. More disconcerting, Wall Street had been looking for $1.56 a share in profit, but Amazon came up with only $1.00 a share, a huge miss after four straight quarters of beating forecasts.

What happened? Two things, basically. Amazon does a terrible job of telegraphing to analysts where its financials are headed. And so they are left scrambling to forecast a company that is nearly impossible to read. It's almost like watching an awkward tango, where one partner doesn't bother with the steps, and the other keeps getting tripped up trying to keep the dance going.

To understand this, it helps to look back on the past several quarters of Amazon's earnings reports. For a while, Amazon slumped after increasing spending in the face of tepid revenue growth. In time, Amazon showed it could dial back on capital spending in order to return to profitability, inflating investor confidence in the company's ability to manage growth.

In the meantime, Amazon Web Services began to surprise in its ability to not only generate strong revenue growth but to do it in a way that built up a welcome buffer to Amazon's anemic profits. After a string of positive news, Amazon investors began to ratchet up their expectations for future growth, even daring to dream that its ridiculously high price-to-earnings ratio - currently standing at 910 - would begin to be validated by real and amazing growth in its net income. Someday.

No such luck. In a conference call to discuss earnings yesterday, Amazon executives offered anodyne words about how spending and growth would “ebb and flow,” as if Amazon’s bottom line were subject to lunar tides. Only these tides aren't so regular you can print them on a calendar. These tides are subject to the inscrutable whims of Jeff Bezos.

"The investments will ebb and flow over time, but our focus on cost reductions and improvement on customer experience will be constant," CFO Brian Olsavsky said on the call. “There are quarter-to-quarter and even year-to-year fluctuations in some accounts and some investment areas.”

Got that? Never mind that a company named after a rainforest is now pleading to be understood as if it were an ocean. The "ebb and flow" comment is a nice way of saying that Amazon's spending, and therefore its profits, will remain unpredictable. What will remain predictable is the long-term plan for global retail domination the company is hellbent on chasing, along with the steady increase of its free cash flow.

In a weird way, Amazon's profit disappointment came because of how strong its business grew – or rather, where that growth came from. Third-party sellers on Amazon opted to use Amazon's shipping and delivery services more aggressively than before, which added to overall sales but also ate into its fulfillment costs. As Olsavsky explained it,

“Sellers using our FBA [Fulfillment by Amazon] services put a lot of demands on our warehouses and we were full. It was a very busy quarter and it did increase some of our variable costs as a result... the demand for space and services was very large by our seller base, which was great from a lot of standpoints, but did exceed our expectations.”

Another area of supposed disappointment was Amazon Web Services, perhaps the biggest driver behind Amazon's 119 percent rally in 2015. Revenue from cloud services rose 69 percent to $2.4 billion. Last quarter, when AWS surprised everyone with its growth, revenue rose 78 percent to $2.1 billion.

In other words, three months ago, investors adjusted their AWS expectations to astound them, whereas Amazon delivered results that were merely excellent. Operating margins from cloud services, for example, rose to 29 percent last quarter from 25 percent a quarter ago, but apparently that wasn't enough helium to keep Amazon investors on their giddy high.

If Amazon investors have tossed out their compasses and lost sight of Amazon's overall direction, Amazon isn't trying hard to help them. One person on the call asked, reasonably, about declining gross margins. Olsavsky pointed to a familiar hobby horse: “On gross margins, I would – first I'll caution you and say, we would encourage you to look at free cash flow.”

Free cash flow! Of course. It's an important measure of growth, especially important for Amazon. But it's not so important it washes away the sins of other, less salutary measures, and yet Amazon has been peddling this form of financial denial as long as it's been a public company. There is nothing wrong with answering a simple question with a simple answer, especially when it involves simple math. This notion has yet to sink in at Seattle's Terry Avenue.

The disconnect between Amazon's performance and investor expectations is significant because it leaves Amazon's stock dropping during a month when markets are sifting out the financial wheat from the chaff. The tech sector, as we have been arguing in recent months, is dividing into winners and also-rans. The also-rans are legion, while the winners can be counted on one's fingers.

Facebook and Netflix have shown themselves to be in the winner's camp this month. Apple is too, but is having a harder time. Amazon's post-earnings decline makes it appear it's tipping over into the also-ran contingent, whereas the message from last quarter is that growth is as unpredictable in the short term as it is certain in the long term.

Looking at Amazon's stock, this message simply failed to be received. Part of the failure is Amazon's fault, for being as stingy with its metrics as it is liberal with its discounts. But just as much is the fault of investors who speculate on what is, by fundamental analysis, an inherently risky stock. Ebbs and flows aside, Amazon remains a company that eases into middle age while moving like a hyperactive adolescent.

Investors – or anyone, really – would be foolish to stand in the way of this middle-aged adolescent.