Sometime this week, Amazon will post its fiscal third-quarter earnings. The results will be crucial, not only for the company but for the economy.
For the past several years, Amazon has surprised everyone — including itself — by regularly blowing away analysts’ expectations. The company also faces plenty of hurdles as its sales and margins slow. The earnings reports will reveal how well the company is navigating these hard issues.
For the investors who have bet a tremendous amount of money on Amazon, the reports have also coincided with greater volatility in the stock market. Overall, those investors have been exceedingly rewarded, whether or not they anticipated the run-up in price.
This makes the July quarter the most important one since the second quarter of 2018. The fourth quarter of 2018 was Amazon’s most profitable ever. The third quarter of last year, though, was its least profitable, by an order of magnitude. That’s because the company was in the midst of a major restructuring.
The fourth quarter of 2018 was already the most successful quarter in Amazon’s history. The decision to add new services like Prime Video to Amazon’s marketing mix was particularly profitable — and also, perhaps, risky, because the content it was purchasing was of lower quality than it had been in the past. This did not change over the year.
In short, Amazon did precisely what it should have done. Over time, Amazon’s cost structure will adjust for the increased value being obtained from Prime subscribers and the availability of high-quality content.
This made the fourth quarter of 2018 one of the best of Amazon’s life. But the company’s expense base is still significantly higher than it was a year ago, even if Amazon spends more on advertising. At the same time, the company has been scaling back sales commissions and price discounts. This has meant more profits to get by.
In the most recent quarterly filing, Amazon says, “We believe that reduced sales commissions as a percentage of net sales will be sustainable.” But of course we’ll have to wait for this quarter’s report to know for sure.
The most important risks to Amazon’s growth are external. Overall spending on new services and products comes at a time when Amazon is becoming a major target for criticism. There are plenty of reasons to be concerned about that, and also plenty of reasons to hope for it.
The good news is that the company is responding in many ways to the criticisms of its labor force and its distribution network. It has also rolled out Prime Video, much to the delight of its customers, and much to the annoyance of its competitors. At the same time, the company also appears to be growing ever more confident in its ability to reach its global ambitions.
One argument for believing Amazon’s growth has peaked is the excesses of the stock market. There is a persistent belief that the days of 50 times earnings are over, but that is not obvious from reading the annual reports for the past decade. It might be worth taking Amazon’s most recent report — out on Thursday — as a first step.
There are dozens of different metrics to measure Amazon’s profits. For this exercise, we’ll consider three figures — gross margin, revenue and net revenue.
Gross margin measures Amazon’s revenue relative to its cost of goods sold. It’s the difference between the amount Amazon pays its suppliers for the goods that it sells, including the materials Amazon needs to build its ships and its infrastructure, as well as the value of things Amazon buys from its vendors. Gross margin is high because Amazon enjoys higher prices on some goods (think high-margin mobile phones) than it does on other things (think low-margin electronics and household goods).
Net revenue will help illustrate how Amazon is using its operating leverage.
Net revenue measures Amazon’s sales, minus all the costs related to them, including commissions. Amazon’s revenue is therefore split up into much smaller components. What net revenue tells us is how effective Amazon’s buying power is at creating value for its customers.
In short, net revenue will help demonstrate how well Amazon is exploiting its assets, and a good profit and loss report will help show whether it has begun turning them into opportunities.
Finally, investors will want to see whether or not Amazon did as well as the market expects. Again, there are a lot of proxies available to estimate Amazon’s profits. When the company posted its most recent report, for example, analysts assumed it would report about $3.33 billion in profit for the quarter. The actual number turned out to be more than twice that much — $6.79 billion.