Amazon Q4 2022 Quick Take: 2 Immediate Risks In AWS
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Summary:
- Amazon.com, Inc. delivered mixed fourth quarter results, combining an impressive revenue beat that was supportive of a resilient holiday shopping season, and an EPS miss that was indicative of AWS challenges.
- In addition to continued pressure from its Rivian investment and restructuring charges, Amazon’s most profitable cloud-computing business continued to decelerate at a faster pace than expected.
- The latest results indicate a shift in the cloud demand environment, raising two critical risks at AWS that will continue to overshadow improvements in e-commerce and Amazon’s burgeoning ad business.
Noah Berger
Amazon.com, Inc. (NASDAQ:AMZN) reported an impressive revenue beat in the fourth quarter despite the tough operating backdrop due to rapidly deteriorating macroeconomic conditions. However, earnings missed by a “wide margin,” underscoring how recent cost-optimization initiatives implemented have likely yet to flow through its results.
Adding to pressure on the Amazon bottom-line remains its investment in Rivian Automotive, Inc. (RIVN), which drove a “pre-tax valuation loss of $2.3 billion,” as well as other restructuring charges that have likely occurred in the quarter to account for the recent reduction in force (“RIF”) as well as ongoing facility footprint optimization efforts. Although Amazon’s forward outlook came in tepid (+4% y/y to +8% y/y) when compared to previous March quarters, it remained in line with market expectations given elevated uncertainty in the consumer. This will likely become more prevalently felt across corporate America – at least through the first half of the year.
Since mid-July, analysts have cut 2023 consensus earnings-per-share estimates by nearly 8%, with the lion’s share coming during the two most recent earnings season. Each quarter, the cuts have become progressively deeper…If the trend continues, analysts’ downward revisions this quarter should be expected to be even steeper than they have been in the past, translating into consensus 2023 EPS outlook cuts of as much as 5% to $215 by the end of February.
Source: Bloomberg News.
Admittedly, the bar was set low for Amazon, too, especially given the pace of slowdown observed in recent quarters. Investors have largely held onto cautious optimism, bracing for results from an uncertain fourth quarter holiday season at Amazon’s e-commerce segment due to the subdued consumer that looks to be taking a turn for the worse soon, as well as anticipation for greater calls for “cloud optimization” that could weigh on Amazon Web Services (“AWS”) demand. Meanwhile, advertising sales continued to be a growing bright spot for the company, as we had expected, expanding 19% y/y.
In addition to macroeconomic headwinds and other industry-specific challenges such as pulled-forward demand during the pandemic that will continue to unwind and normalize within the foreseeable future across both e-commerce and cloud-computing, AWS – the key source of Amazon’s cash flows – also faces an inevitable trajectory of deceleration as it grapples with two looming threats – namely, the combination of growing cloud optimization calls from customers and the sheer size its market share has grown into in general.
However, Amazon’s moat in not only e-commerce, but also AWS. Its industry-leading margins are likely to cushion some of the impact and usher the company through a sustained path of structural expansion without losing out meaningfully to competition. With cash flows generated from AWS alone likely the core driver of Amazon’s consolidated market cap today, and a durable secular growth backdrop in which the cloud segment remains poised to capitalize on, AMZN stock continues to exhibit promising longer-term upside potential from current levels.
AWS Deceleration
AWS revenues grew 9% y/y (+12% y/y cc) in the fourth quarter to $149.2 billion, with a moderate guidance for the current quarter indicating further deceleration ahead. However, AWS sales – where Amazon’s bread and butter is at – decelerated substantially, growing only 20% y/y to $21.4 billion, underperforming consensus estimates of 23% y/y growth. This was already downward-adjusted based on the currently challenging macroeconomic environment, as well as key competitor Azure’s (MSFT) caution of looming weakness last week.
As discussed in our previous coverage on AMZN stock, gradual deceleration at AWS from here on out is largely the consensus call among investors, despite broad-based digitization and cloud migration trends still in the early innings. Specifically, the sheer size of AWS’ leading market share, combined with a shift in corporate narratives towards a more cautious strategy in migrating workloads to the cloud (e.g., growing calls for optimization; increasing multi-cloud strategy adoption) supports the narrative that “the last mile is always the hardest.”
Today, AWS holds a leading 34% share in the global market for public cloud-computing solutions, leading Azure’s 21% and Google Cloud Platform’s (GOOG, GOOGL) 10% by wide margins still. Yet, it is more likely than not for that gap to narrow going forward due to challenges facing the sheer size of AWS’ operations. To put into perspective, AWS has been expanding at a 5-year CAGR in the 20%-range, while competitors like Azure and GCP have been catching up in the high 30% to 40% range. This has accordingly raised concerns in recent quarters over whether the segment can achieve the level of growth that market has priced into the stock.
Meanwhile, the growing shift in customer demands for an enhanced cloud migration strategy has also made it more difficult for AWS, as well as the broader cloud-computing industry, to penetrate new opportunities. Specifically, the pricing power that hyperscale once held due to the industry’s previously limited expertise in supporting seamless cloud migration strategies have now shifted to customers who are more aware of their options (thanks to growing competition in the field) and demand an optimized balance between performance and cost (discussed further in the following section) in ongoing digitization efforts.
For instance, the growing adoption of a multi-cloud strategy makes an immediate risk to AWS by diluting its upcoming share of as much as 30% of corporate IT budgets that will be allocated to building out their respective cloud infrastructure alone. This is because AWS has long been a primary cloud service provider in the industry already, making it potentially more difficult for the segment to partake in customers’ expansion efforts. And normalizing growth rates at AWS in recent quarters is likely reflective of this new reality.
Given AWS is already the dominant public cloud service vendor on the market, it is hard for it to take further advantage of increasing multi-cloud momentum. In a recent sentiment check survey performed by RBC Capital Markets, about 57% of corporates looking to ramp up investments in cloud have noted AWS as a potential beneficiary over the next 12 months, compared with 73% for GCP and 71% for Azure. AWS is also starting to lose share to key rival Azure amongst large enterprise cloud spending – the latter has taken over AWS as the leading public cloud service provider for enterprises generating more than $5 billion in annual revenues, acquiring more than 50% share in the cohort while AWS only captures a little more than 30%.
Source: “Is Amazon a Buy After Q3 2022 Earnings? The Cloud is Dissipating.”
And the looming macroeconomic challenges are also compounding pains ahead, risking a tightening of the cash flow tap at AWS. However, while the next mile for AWS on capitalizing on enterprise cloud adoption growth – the largest cloud spending segment – will likely become more difficult, growing AI momentum could potentially re-accelerate the industry’s total addressable market (“TAM”) expansion and compensate for the near-term challenges.
Specifically, demand from the high performance computing (“HPC”) segment continues to exhibit robust momentum, especially with the recent frenzy created by OpenAI’s ChatGPT that has raised awareness of how seemingly complex AI models can now be applied in mass market use cases. This will likely further fuel an “exascale AI era” in which AWS is ready to take on.
The cloud-computing unit already facilitates multiple exascale computing offerings on its marketplace to capitalize on the next era of AI opportunities, while also continuously improving its in-house designed processors to address growing performance demand required by the increasingly complex workloads. AWS’ launch of the Graviton3 server processor last year, which powers its EC2 (or Elastic Compute Cloud) instances, has been designed to optimize performance for increasingly complex computing workloads, spanning:
“application servers, microservices, HPC, CPU-based machine learning inference, video encoding, electronic design automation, gaming, open-source databases, and in-memory caches.”
The latest generation boasts “up to 25% better compute performance” when compared to its predecessor, the Graviton2, and addresses the demanding requirements of HPC applications that could potentially overtake the currently dominant enterprise cloud spending segment and drive AWS’ double-digit growth trajectory over the coming years.
Cloud Optimization
Meanwhile, the growing discord on cloud optimization across the broader enterprise cloud spending segment will likely become the next-greatest challenge to AWS and the broader cloud-computing industry. Specifically, “cloud spend optimization,” which refers to customers’ growing demand to “enhance applications, performance, and business needs in the cloud while eliminating costs and inefficiencies”, will likely compound the near-term macro-related challenges (e.g., higher energy costs; FX headwinds) and add more structural pressure to AWS’ margins.
With the ongoing macroeconomic uncertainties we’ve seen an uptick in AWS customers focused on controlling costs, and we’re proactively working to help customers cost-optimize, just as we’ve done throughout AWS’ history, especially in periods of economic uncertainty.
Source: Amazon 3Q22 Earnings Call Transcript.
This is consistent with the slight narrowing in AWS’ operating margins in the fourth quarter, which went from 26% in the third quarter and 30% in 4Q21 to 24% in the three months through December 2022. While Amazon management had previously pinned the deceleration to expected “[fluctuations] over time as [AWS balances] investments versus renegotiating pricing with the long-term customer commitments…, offset by increasing productivity and efficiencies in [its] data centers,” the continuing downward trend in the segment’s profitability, though still attractive, underscores new structural cost challenges ahead.
While we expect the related cost headwinds to further eat into AWS’s margins over the near- to mid-term, the segment continues to exhibit sustained scalability across its operations that would potentially lead to moderation of related impacts on longer-term profitability.
Continued innovation, such as the incorporation of the Graviton3 processors into its EC2 instances, will not only allow AWS to further penetrate cloud spending opportunities across wide-ranging verticals, but also help it enable customers to do more with less and address the growing demand for cloud spending optimization. And in return, ensuing scale would accordingly help AWS restore “great cost for performance ratios” over time to reinforce the segment’s attractive margins that have long been a driving force in the stock’s uptrend.
I would say this is [one of the] real valuable points about cloud computing is that it’s turning fixed cost into variable for many of our customers. And we help them save money either through alternative services or Graviton3 chips. There’s many ways that we have to help them lower their spending and still get great cost for performance ratios.
Source: Amazon 3Q22 Earnings Call Transcript.
This is also consistent with CEO Andy Jassy’s reaffirmation on his optimism “about the long-term opportunities for Amazon,” bolstered by its continued commitment to investing prudently in order to capitalize on future secular growth trends:
In the short term, we face an uncertain economy, but we remain quite optimistic about the long-term opportunities for Amazon. The vast majority of total market segment share in both Global Retail and IT still reside in physical stores and on-premises datacentres; and as this equation steadily flips, we believe our leading customer experiences in these areas along with the results of our continued hard work and invention to improve every day, will lead to significant growth in the coming years. When you also factor in our investments and innovation in several other broad customer experiences (e.g. streaming entertainment, customer-first healthcare, broadband satellite connectivity for more communities globally), there’s additional reason to feel optimistic about what the future holds”.
Source: Amazon 4Q22 Earnings Results.
The Bottom Line
Despite the two looming risks to AWS’s forward performance, Amazon’s cloud-computing unit will likely continue to boast a strong competitive advantage to peers. Specifically, the unit’s double-digit profit margins still makes it easier to cushion the impact when compared to peers like GCP – which is still unprofitable – and absorb the near-term cost headwinds and challenges stemming from the shift in enterprise demands.
Amazon’s robust operating cash flows, which increased by 1% y/y to total $46.8 billion during full year 2022, also allows AWS to further its moat in building out hyperscale capacity to address cloud-computing opportunities from verticals beyond the maturing enterprise spending segment. Paired with improving utilization in its retail arm, positive margin impacts from recently implemented cost-cutting initiatives flowing through the broader business as the year progresses, and supportive longer-term secular growth trends, Amazon stock remains primed for sustained upside potential from current levels.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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