A headline about Amazon that should scare scientists and engineers

A headline about Amazon that should scare scientists and engineers“Amazon stock tanks after disappointing profit”

That’s the headline. The article is about Amazon’s most recent quarterly financial performance. You can see what happened to Amazon’s profitability by looking at one of its own charts:

Amazon net income, 2015 Q3 through 2016 Q3

Earnings sank, after three consecutive quarters of growth. Investors hate that.

Rewind the clock in your head. Imagine you’re anxiously awaiting Amazon’s Q2 2016 financial results. You know that the company reported $513 million in Q1 earnings. The results finally come out, and…boom! Amazon reports Q2 earnings of $857 million. That’s a huge sequential jump.

The big earnings jump from Q1 to Q2 resets expectations. Now you’re anxiously awaiting the Q3 2016 results. They finally come out, and…thud! Amazon reports “only” $252 million in quarterly earnings, a 70% decline from the previous quarter. That’s how you get a 5% stock price decline in a single day. It’s all about performance relative to expectations.

How did Amazon’s profitability vary across its business?

We know what happened. Amazon’s profitability went way down sequentially*. Even though profitability improved year-over-year, investors seemed to care more about the sequential comparison.

(*Sequentially means in sequential quarters, or Q3 2016 versus Q2 2016, in this case. Year-over-year means the same quarter in both years, or Q3 2016 versus Q3 2015. These are the two fundamental comparisons you’ll see in almost every single news report about corporate financial performance: sequential and year-over-year.)

Since the sequential comparison seemed to matter so much, let’s dive in. The chart below shows the quarterly operating margins for each of Amazon’s segments. (Note that operating margin is operating income divided by net sales.)

Two of Amazon’s segments are geographic: North America and International. Amazon’s third segment is specific to one of its services: Amazon Web Services (AWS). Amazon describes AWS this way:

Amazon Web Services (AWS) is a secure cloud services platform, offering compute power, database storage, content delivery and other functionality to help businesses scale and grow.

Amazon operating margin by segment, 2016 Q1 through 2016 Q3

We can immediately see what happened to Amazon’s profitability. The earnings of the North America and International segments eroded considerably from Q2 to Q3. Meanwhile, AWS margins continued to improve. Importantly, the improvement in AWS profitability was not enough to offset the erosion from the other segments.

Why did the Amazon’s non-AWS business suffer?

Sure enough, the very first question on Amazon’s quarterly conference call was about the profitability of the non-AWS business:

Douglas T. Anmuth — JPMorgan Securities LLC

Thanks for taking the question. The International retail segment margin was the lowest we’ve seen in quite a while. I was hoping you could provide some of the key drivers there in terms of the drag and any color on how to think about the incremental international investment that might be impacting the 4Q guide. Thanks.

Brian T. Olsavsky — Amazon.com, Inc.

Sure. Thanks, Doug. Yes, specifically to International, we are seeing expansion to support selection, expansion at fulfillment network increases. We’re also investing in digital content and additional Prime benefits, fresh location Prime Now. But by far the biggest individual thing is the investment in India that we continue to make and very excited about it, the initial reaction in India from both the customers and also sellers. So that is essentially the International margin guidance in Q4.

Did you catch that? The reason profitability is down is because Amazon is investing in its business.

Profitability, i.e. margin, relies on a simple equation: revenue minus cost. Amazon’s revenue is growing. The only reason it would have declining profitability is if costs were increasing more quickly than revenue.

There are tons of ways costs can grow more quickly than revenue. Maybe you’re paying more to buy the raw materials you use to make your products. Maybe you’re paying more in transportation, to get your goods into the hands of distributors, retailers, or customers. Maybe you’re paying larger salaries to recruit the top talent your business needs.

That’s not what’s happening to Amazon. Amazon’s business is growing. In order to meet the demands of more and more customers, Amazon has to build more fulfillment centers. They have to pull together more content, so more customers find their services attractive. They’re having to make infrastructure investments in India, which has a massive economy but less development than what we have in the U.S.

Why should scientists and engineers be scared?

Amazon’s business is growing. In order to meet increasing demand, Amazon has to invest in itself. Those investments require cash.

In other words, Amazon has a choice. It can inflate its current profitability by not investing itself, which sacrifices future growth. Or it can invest in itself, sacrificing profit dollars today for growth tomorrow.

Investors, when faced with Amazon’s decision, expressed their disapproval. Amazon’s stock fell by 5% in a single day. Investors would rather have those profit dollars for themselves, instead of trusting Amazon’s executives to invest those dollars wisely in their own business.

As scientists and engineers, that’s a huge problem. We’re basically competing with investors for funding. Companies can cut back on R&D budgets and show greater profitability today. Investors will cheer. Those dollars could be used for stock buybacks or dividend payments.

Or, companies can invest more in R&D today, expecting that investment to bear fruit tomorrow. But investors don’t like that. That means fewer dollars to line the pockets of shareholders.

The compensation of corporate executives is weighted very, very heavily toward stock price. Executives have every reason in the world to try to pump up their company’s stock. In other words, executives have every reason to steer dollars away from research and development, and toward direct payments to shareholders. That’s a scary reality for scientists and engineers.

With these incentives in mind, I find it highly commendable, borderline courageous, for the Amazon folks to sacrifice today’s profitability in favor of tomorrow’s growth. As scientists and engineers, we should applaud their decision-making, and hope other executive teams follow their lead.

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