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Amazon (AMZN -7%) stumbled a bit with its Q1 results last night. While investors were right that Amazon saw a boom in sales from the pandemic, the online giant had some operational issues as it dealt with a huge influx of orders, which impacted margins and EPS.

Let's dig into the headline results and AWS:

• In terms of the headline numbers, AMZN beat analyst expectations for revenue but EPS at $5.01 was a $1.22 miss, which is quite a lot.
• The guidance is mixed and Q2 revenue of $75-81 bln is in-line, however, operating income guidance of $(1.5)-1.5 bln was well below consensus of $3.73 bln.
• AWS segment revenue was a bright spot as it rose 33% yr/yr to $10.22 bln.
  • This growth is not as robust as its rival Azure posted this week at +59%, but AWS is a good bit larger so its growth rates will not be as impressive.
  • The +33% growth was generally in-line with recent quarters: +35% in 3Q19 and +34% in 4Q19.

Beginning in early March, AMZN says it experienced a major surge in demand, particularly for household staples and essential products (health/personal care, groceries, and home office supplies). At the same time, demand for discretionary items (apparel, shoes) fell sharply. This large demand shift resulted in operational challenges.

AMZN had to hire 175,000 new employees and its network had to pivot to shipping priority products within 1-4 days and longer wait times for non-priority items. It also increased grocery delivery capacity by more than 60% and expanded in-store pickup at Whole Foods, which increased costs.

So, what caused the EPS shortfall? For one thing, AMZN says the incremental revenue on the lower ASP essential products basically came in at cost. Plus, AMZN had $600+ mln in COVID-related costs in Q1, including lower productivity as AMZN provides for social distancing, purchasing PPE for employees, higher wages during the pandemic, and hundreds of millions of dollars to develop COVID-19 testing capabilities. These COVID costs are expected to jump to $4 bln or more in Q2 when AMZN faces a full quarter of pandemic issues.

Overall, Amazon was hit by a one-two punch in Q1. It saw a sudden surge in demand for some categories and a huge drop off in other categories. AMZN can handle these types of disparities when it has time to prepare (holidays, Prime Day), but this was sudden and dramatic. The second punch was much higher COVID costs and the need to hire/train 175,000 new employees. The stock has been on a tear, up more than 40% since mid-March. Investors got the big boost in sales they expected but the cost side was a bit bumpy.