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Amazon - sales rise but costs dent profits

Nicholas Hyett | 25 October 2019 | A A A
Amazon - sales rise but costs dent profits

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Amazon reported net sales of $70bn in the third quarter, ahead of market expectations. However, higher costs, particularly in the North American retail business, meant operating profits fell 15% to $3.2bn.

Guidance for next quarter's sales and profits were also lower than the market had hoped, with expected operating profits of between $1.2bn and $2.9bn.

The shares fell 6.7% in after-hours trading.

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Our view

For a company with sales of $233bn last year, Amazon makes surprisingly little profit. That's because the bulk of sales come from the retail business, which generates a comparatively modest profit margin, made worse recently by the fact that massive investment in next day delivery, which cut US retail profits by almost 40% in Q3.

But then CEO Jeff Bezos has never been all that worried about the bottom line. Amazon's focus is on revenue growth, cash generation and investment opportunities.

From a revenue perspective the retail business continues to go from strength to strength. While Amazon sources and sells many of its own items, over half of the products sold on the website are actually third party sales. Almost 200,000 small businesses sold $100,000 or more of stock last year through Amazon. Investment in the 'Fulfilment by Amazon' means many of these vendors pay Amazon for warehousing and delivery - generating extra fees too.

But while we all know about Amazon's retail operation, there's a far more profitable business hidden below the surface.

Jeff Bezos wants a culture of constant innovation and improvement to flow right through the group. While there's been numerous failures along the way (billions of dollars' worth, in fact) successes like Amazon's web services business (AWS) have outweighed the failures many times over.

AWS was born from one individual's frustration with the limitations of IT infrastructure. After being given the freedom to create a solution and run with it, it's since morphed into a $25bn+ business specialising in cloud computing. This gives partners storage space or extra computing power on demand.

Combined with other high-margin innovations like the growing advertising business, cash flows look set to rise sharply from here. However, Amazon is committed to reinvesting the extra cash in the business rather than returning it to shareholders.

The growth potential means, at the time of writing, the shares trade on a lofty 56.7 times expected earnings, making the share price particularly sensitive to disappointment. But investors shouldn't dwell on short-term news.

What's more important is the big picture, which includes Amazon's enormous scale, cash resources and penchant for innovation. We believe that should stand the company in good stead in the longer-term, but it could still be a rocky ride in the meantime.

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Third Quarter Results

North American sales rose 24.1% to reach $42.6bn. However, operating costs grew at the faster rate of 28%, totalling $41.4bn, largely thanks to higher shipping costs. As a result, margins shrank and operating profit of $1.3bn was 36.9% lower than the same time last year.

Within the International business, sales rose 21% once the impact of exchange rates is stripped out, to $18.3bn. Costs also rose in this region, meaning operating profits dipped 8% on a constant currency basis.

The group continues to invest heavily in the one-day delivery service for Prime, which is said to be having a strong positive impact on sales. In the period, 20 new Fire TV products were launched, as was a new range of Echo devices.

And within Amazon Web Services (AWS), net sales rose 35% to $9bn at constant currency. Operating profits rose 6% to $2.3bn. Within that, there were several new customer signings, and AWS was launched in the Middle East.

Free cash flow over the last 12 months rose 52.6% to $23.5bn.

Looking ahead to next quarter Amazon expects net sales to grow between 11% and 20% year-on-year, putting profits between $80bn and $86.5bn.

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