Amazon's (NASDAQ:AMZN) profitability is on the rise. The company's second quarter showed significant profit margin improvements despite enormous one-time costs. So is Amazon running out of reinvestment opportunities that would keep a lid on its profit margins?
Amazon's reinvestment approach
Amazon is notorious for reporting relatively low profit margins. For a long time, the company was even mocked for being a "nonprofit." In 2013, journalist Matthew Yglesias famously wrote that Amazon is "a charitable organization being run by elements of the investment community for the benefit of consumers."
This was always a misunderstanding, of course. Amazon has always been interested in being profitable and generating cash over the long term. It's just that it's always had the good fortune of having a culture that prioritized reinvesting today to maximize its future cash flows.
In founder and CEO Jeff Bezos' 1997 letter to Amazon shareholders, he wrote, "When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows." And at the Amazon 2011 shareholder meeting, Bezos described how Amazon was "willing to be misunderstood for long periods of time."
In other words, Amazon simply does not care about how much accounting profit it reports in the short term. It is always willing and eager to reinvest heavily in growth opportunities at the expense of near-term profits. As a result, Amazon has grown its net sales at an incredible pace -- net sales are up over 11-fold over the last 10 years.
Surging profit margins
Amazon's overall profit margins have always been relatively modest, primarily due to the heavy and continuous investment spending it does. Consider the areas the company is investing in that we know about -- fulfillment center expansion, drone delivery research, Amazon GO technology, thousands of software engineers focused on the Echo device and Alexa software, billions of dollars on Prime Video content, free 1-day shipping with Prime, physical retail expansion, including grocery stores, book stores, and the Amazon 4-Star concept. The list goes on and on, and then there are all the areas of investment that we might not know about yet.
But Amazon's profit margins are starting to creep up, despite all its reinvestment spending. For example, in the company's second quarter that ended in June, it reported a 6.6% operating profit margin. That was up from 4.9% in the prior year's second quarter. The biggest contributor to that is the rapidly growing Amazon Web Services (AWS) business, which has operating margins over 30%. As higher-margin AWS becomes a larger piece of the Amazon pie, it naturally contributes to higher overall profit margins.
But the remarkable thing is that Amazon spent $4 billion during the second quarter alone on COVID-19-related expenses, including higher hourly wages through the end of May, a one-time $500 million "Thank You" bonus for employees in June, as well as personal protective equipment (PPE), enhanced cleaning of facilities, and other fulfillment expenses. But these expenses shouldn't be permanent -- COVID-19 is unlikely to last forever. Without these temporary COVID-related expenses in the June quarter, Amazon's operating profit margin would have been about 11.1%, instead of the 6.6% it reported. That would be the highest operating margin Amazon's ever had.
The capacity to reinvest
That begs the question of whether Amazon could be running out of big new areas to reinvest in. The company is now at a scale where AWS alone is contributing over $3 billion of operating profit per quarter. That should only increase as AWS continues to scale. The third-party marketplace and advertising businesses are surely chipping in strongly as well. At what point will these cash flows dwarf the company's ability to reinvest?
There are certainly more areas to reinvest in. Amazon appears to have big ambitions in the grocery store segment with its Amazon GO Grocery and Fresh concepts. Once the company nails down the optimal store model for the grocery segment, if it hasn't already, it will probably seek to deploy billions into opening more grocery stores. And Amazon also acquired autonomous car technology company Zoox earlier this year. It could make sense for Amazon to reinvest billions into that technology. There are likely other areas as well.
Long-term investors should hope the company can reinvest larger and larger sums, because that should maximize the long-term value of the business. But it does get harder to reinvest larger and larger sums, so the days of Amazon being a low-margin business could be numbered.