Amazon (NASDAQ:AMZN) stock has been quite volatile lately. The online retail leader was down by more than 20% during the year leading to its latest earnings report, but things changed in a big way after Amazon reported better than expected earnings for the fourth quarter. In the last month alone, Amazon stock has risen by almost 30%, and it's now trading near its highs of the last 52 weeks, according to S&P Capital IQ.
Wall Street seems to believe Amazon will report improving profitability in the coming quarters, but that's far from a certain thing. In fact, there is a considerable chance that analysts could be disappointed in the middle term. Let's take a look at why this could happen and what it would mean for investors.
The "flipping the switch" theory
Over the last several years, Amazon has embarked on a series of aggressive growth projects demanding tons of money and producing rapidly growing expenses. Among other things, Amazon is putting its capital to work in areas such as building its distribution network, its cloud computing business, digital content, and hardware products.
These investments can be remarkably powerful when it comes to cementing Amazon's leadership position in online retail, and they can also plant the seeds of long-term growth in different industries. However, they are also a big drag on profit margins and free cash flows, which have been a major reason for concern regarding Amazon stock over the last several years.
After Amazon delivered better than expected profits in the last quarter, some Wall Street companies and media outlets seem to believe in the "flipping the switch" theory. That would mean the company is now focusing more on current profits as opposed to future growth, so earnings should continue increasing in the coming quarters.
According to the Financial Times, "Tuna Amobi, an analyst with Standard & Poor's Capital IQ, said investors see the fourth quarter profit as potentially implying a shift in focus toward profit and moderating spending." Offering a similar approach, an article in The Wall Street Journal starts with the following phrase: "Is Amazon.com finally getting serious about profits?"
Amazon is one of a kind
In most cases, companies tend to report higher or lower profits depending on variables such as industry conditions and management's ability to operate the business in a smart and efficient way. However, Amazon is a very particular case.
In a recent interview with Business Insider, Amazon CEO Jeff Bezos was asked a direct and straightforward question by Henry Blodget, editor-in-chief and CEO of Business Insider: "Let's just establish this once and for all, can Amazon make money?"
Bezos' clear response explains how Amazon is different from most other companies. He reminded investors that Amazon did in fact operate profitably from 2006 to 2011, but the company decided to invest its cash flows in promising new ventures, which are currently unprofitable.
Bezos compared Amazon to a company that built a profitable and well-established lemonade stand some years ago, and is now investing those profits in different initiatives such as a hamburger stand, a hot dog stand, and so on. In this example, the profitable lemonade stand would be Amazon's online retail business, and the money-burning initiatives could be areas like cloud computing, digital content, and hardware.
Amazon profit margins are under major pressure because management believes it makes sense to invest tons of money in opportunities with big growth potential. This is a long-term strategy, and just because Amazon did better than expected regarding profits in the last quarter does not mean Amazon will cut down on spending anytime soon. Those who believe Amazon is "flipping the switch" regarding profitability could be in for a disappointment over the coming quarters.
What this means for investors
Buying Amazon on the theory that the company will be making more money over the coming quarters could be a big mistake. That doesn't mean you won't find good reasons to invest in Amazon, but short-term profitability is not one of them.
With almost $90 billion in revenues, and growing 20% during 2014, Amazon is the undisputed king in online retail, and the company is getting stronger by the day from a competitive standpoint. Scale is a crucial advantage in discount retail, and Amazon Prime is a powerful tool to consolidate customer loyalty.
According to management, Amazon Prime membership increased by an amazing 53% year over year during the last quarter. While Amazon does not disclose the exact number of Prime members, the company says it has "tens of millions" of them.
Also, Amazon announced it will be reporting financial figures for its Amazon Web Services cloud computing division in the coming quarters. Amazon is a notoriously secretive company, however, it looks like the business is getting big enough to require more financial disclosure. Even if cloud computing is currently unprofitable, it's good to know that the company is making big inroads in this promising industry.
An investment in Amazon is an investment in the company's long-term future and the visionary talent of Jeff Bezos and his management team. Speculating on short-term profit figures is not a smart approach to the company. Amazon could disappoint Wall Street in the coming quarters. However, if you are investing in Amazon for the right reasons, and with a long-term horizon, this should be no reason to sell.