Few companies have benefited from the coronavirus crisis as much as Amazon (AMZN 1.49%).
Online retail demand has surged during the pandemic as non-essential stores have been closed and consumers have been reluctant to shop in supermarkets. Meanwhile, the transition to a stay-at-home economy has led to a burst in consumption of digital services like streaming, and that shift has also benefited its cloud-computing division, Amazon Web Services (AWS), in a number of ways.
Even Amazon's advertising business seems to holding up relatively well -- shoppers come to Amazon's e-commerce portal to search for basic items, rather than things like travel and auto, which have been severely impacted by the pandemic.
Image source: Amazon
Therefore it wasn't a surprise to see Amazon's sales surge in its first-quarter earnings report. Overall revenue rose 26.4%, its fastest clip since sales spiked following the company's 2017 acquisition of Whole Foods. In its North America segment, revenue jumped 28.8%, its best performance in at least six quarters, and sales growth in physical stores -- made up almost entirely of Whole Foods -- accelerated to 8%, its fastest clip ever. Online sales growth was also the fastest in at least six quarters at 25%.
However, additional costs to handle the crush of orders in March weighed on profits. Amazon's gross margin, which accounts for expenses like products, shipping, and digital media, fell from 43.2% to 41.3%, while fulfillment costs rose 34.1% in the quarter to make up 15.3% of revenue, up from 14.4% in the year-ago quarter. Shipping costs also spiked 49% to $10.9 billion.
On the earnings call, CFO Brian Olsavsky explained the COVID-related impact to the business by saying, "While customer demand remains high, the incremental revenue we are seeing on many of the lower ASP (average selling price) essential products is basically coming at cost." In other words, the spike in demand has been for low-margin products like food, cleaning supplies, and medicine, while sales of higher-margin goods like apparel, shoes, and wireless products fell.
The company spent more than $600 million in COVID-related costs, and that, combined with the shift in demand, caused overall operating profit to fall from $4.4 billion to $4 billion. However, the impact in the e-commerce business was much more significant. In the North America segment, operating profit fell $2.3 billion to $1.3 billion, while its international operating loss expanded from $90 million to $398 million in the quarter. An increase in profits at AWS helped make up for that shortfall.
A potential for new business
Amazon stunned the market in its earnings report by saying that it would spend an incremental $4 billion on COVID-related expenses in the second quarter, essentially wiping out its profit for the period. Among those expenses were higher wages and bonuses for warehouse employees, inefficiencies related to social distancing policies in its warehouse, personal protective equipment, and $300 million to build a lab to produce tests for the coronavirus that it could use on its employees.
The testing lab, the most curious of the additional expenses, is a first-of-its-kind project for Amazon, and typical of the company's mission to invent and experiment. CEO Jeff Bezos acknowledged that it may not yield significant results, saying in his annual shareholder letter, "We're not sure how far we will get in the relevant timeframe, but we think it's worth trying, and we stand ready to share anything we learn."
In response to a question on the call about testing evolving into a new line of business, Olsavsky said, "Our main concern is getting testing in the hands of our employees and then potentially as we have excess capacity, perhaps we can help in other areas." CEO Jeff Bezos also alluded to potential new lines of business in the press release, saying, "Providing for customers and protecting employees as this crisis continues for more months is going to take skill, humility, invention, and money. If you're a shareowner in Amazon, you may want to take a seat, because we're not thinking small."
Despite the impact on its bottom line, Amazon may also be looking at the pandemic as a long-term opportunity, especially in an area like healthcare, where it has been gradually building a position in recent years with its acquisition of online pharmacy Pillpack, the launch of its pilot healthcare service Amazon Care, and its Haven joint venture with JPMorgan Chase and Berkshire Hathaway.
Why costs will remain elevated beyond Q2
Many of the COVID-related costs that Amazon is undertaking in the second quarter are for continuing needs and processes that aren't going to go away until the pandemic ends. Social distancing in its warehouses, for example, and the need to purchase and use personal protective equipment will continue as long as the virus is a threat.
Similarly, the testing lab Amazon is building now will continue to run for the duration of the crisis. Though the company intends for its higher wages and bonuses to expire later this month, it may prove difficult to end them, especially in an environment where front-line workers run a higher risk of contracting the virus. Amazon has already been the subject of protests and walkouts, and such a backlash could intensify if it removes the additional compensation. A vice president at the company just resigned to protest the terminations of several activist insiders.
For investors, the company continues to position itself well for long-term growth, and it will gain an advantage from the impact of the pandemic on its brick-and-mortar rivals as e-commerce's share of overall retail sales will accelerate during the crisis. However, it's clear that the top-line growth will not lead to bottom-line profit while the virus is a concern, and that means that the recent surge that took Amazon stock to all-time highs likely won't be repeated in the foreseeable future.
Though the tech giant will almost certainly emerge from the crisis in a stronger competitive position, the profit headwinds in the interim will keep a ceiling on the stock.
