Here’s What You Need To Know About Amazon’s Q3 Earnings

Amazon (NASDAQ:AMZN) reported mixed third quarter earnings last week with the company’s net revenues increasing 29% year over year (y-o-y) to $32.7 billion, slightly above Reuters’ consensus estimate of $32.69 billion. The company posted earnings of $0.52 per share compared to $0.17 in the prior year period but it was still far behind market expectations of $0.78 per share. Below we discuss Amazon’s hits and misses in Q3 2016. 

Solid Top Line Growth Across Divisions, Geographies

Amazon’s sales in North America rose 26% to about $19 billion in Q3 2016, while International sales were also up 28% to $10.6 billion. Top line growth across the North America and International segments was driven by robust growth in the Electronics, Merchandise & Others category. Amazon Web Services (AWS), the company’s public cloud division, generated $3.2 billion in revenue in the third quarter, which was up 55% over the same period last year.

AWS Profitability Lifts Bottom Line

AWS contributes less than 10% of Amazon’s revenues but the majority of its profits. Amazon’s increasing focus on constantly improving and expanding its AWS business stems from the fact that it contributed over 100% of the company’s profits (offsetting loss in the international marketplace business) and has a considerably higher operating margin than Amazon’s e-commerce business. In Q3 2016, AWS had an operating margin of 26.6% compared to Amazon’s company-wide operating margin of just 1.8%.

Why Earnings Missed Estimates

In the third quarter, Amazon’s company-wide operating margin improved 20 basis points to 1.8%, driven by a significant year-over-year increase in profitability in the AWS (cloud services) business partially offset by margin decline in the marketplace business. This tepid improvement in operating margin led to earnings missing consensus estimates.

The decline in operating margin in the marketplace business was driven by: 1) rising marketing and selling expenses in international markets, especially India, 2) increased investments in acquiring and licensing digital media content for Prime customers, and 3) increasing warehousing and shipping expenses in North America. These factors were partially offset by certain gross margin improvements (due to growing third-party business) and marketplace efficiency improvements. While the company should continue to see improved profitability going forward, Amazon’s margins could witness a slight decrease in the near term owing to increased investments in AmazonFresh, Amazon Video (digital media content including movies and series), Amazon Music, Alexa (Amazon’s voice assistant), warehousing and shipping.

Free Cash Flow Growth

One of the impressive things reported by Amazon in the last 12 months has been its ability to increase free cash flows faster than its top line. Amazon’s free cash flows (ttm) increased 439% y-o-y in the 12-month period ending September 2016 due to a 49% increase in operating cash flows, partially offset by a 37% increase in cash spent in purchasing property and equipment. This should help the company continue to make investments into areas such as shipping services, drone technology, cloud services, and new products like the Echo. 

Mixed Q4 Guidance

In the fourth quarter, Amazon expects overall revenue to grow 17-27% y-o-y driven by holiday sales but increased investments in shipping, media content acquisition and warehousing could result in a decline in profits. Therefore, the company has indicated a wide range of zero to $1.25 billion as its operating income expectations for Q4 2016. 

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