Amazon: All Eyes On A Single Number

Summary:

• Amazon.com, Inc. has diverse business segments which can deliver growth over the long term.
• However, in the near term, the stock trajectory will depend largely on the growth of operating income in Amazon Web Services.
• AWS has delivered the entire operating income of Amazon in the last few quarters as the North America and International segments reported losses.
• The YoY revenue growth and operating margin of AWS have seen declines in the last few quarters due to tougher comps which are hurting the overall operating income growth of AWS.
• Despite tough comps, Amazon’s AWS could be a surprise winner in this quarter, which can improve the positive sentiments toward Amazon stock.

Amazon.com, Inc. (NASDAQ:AMZN) stock has rebounded in the last few weeks after seeing a massive decline following Q3 2022 earnings. Wall Street eagerly awaits the Q4 2022 earnings report (expected Thursday February 2), which will show if the stock can justify its recent bullish run. The single most important metric in the Q4 2022 earnings report will be the revenue and operating margin numbers of Amazon Web Services (“AWS”). Due to losses in the North America and International business in the last few quarters, AWS has delivered the entire operating income for the company.

AWS has shown a slight decline in YoY revenue growth in the last few quarters. At the same time, there has been a dip in the operating margin. This has led to a significant decline in the operating income growth of AWS. In the previous quarter, AWS reported a mere 1% YoY growth, excluding the impact of Forex fluctuations. AWS will face tough comps in Q4 2022 earnings report as well as Q1 2023. If AWS can show reasonable YoY revenue and operating margin improvement in Q4 2022 earnings report, we could see a bigger bullish sentiment in the stock in the near term.

Beyond the near-term fluctuations, AWS has a very long growth runway which should allow this segment to gain a good standalone valuation.

Focus on a single metric

Amazon is a behemoth with diverse businesses. However, the stock trajectory in Amazon stock for the next few weeks and months will depend on the operating income of AWS. There was a massive correction in the stock after Q3 2022 earnings report. One of the key reasons was the modest growth numbers reported within AWS segment.

Figure 1: Net sales growth of AWS in the last few quarters.

There was also a dip in the operating margin numbers of AWS in the last quarter.

Figure 2: Steady decline in the operating margin of AWS in last two quarters.

Due to a decline in YoY revenue growth and a dip in operating margin, the YoY operating income from AWS declined massively in the last quarter. AWS reported a mere 1% YoY operating income growth after excluding F/X impact. One of the reasons behind this decline was the sluggish demand in cloud services market and tougher comps faced by AWS compared to year-ago quarter.

Some of these negative factors will continue to play a major role in the earnings report for Q4 2022. AWS reported 40% YoY revenue growth in Q4 2021, which was the highest growth number in the past few quarters. It would be tough for AWS to face this tough comp from the year-ago quarter. Similarly, the operating income increased by 46% in Q4 2021, which would make it challenging for AWS to report a bigger jump in operating income in Q4 2022.

Besides the tougher comps, there has also been a slowness in demand for AWS in recent months due to sky-high inflation and many companies readjusting their requirement due to macroeconomic headwinds. On the positive side, AWS will face a lower negative impact due to F/X. There has been a rebound in Euro compared to the dollar which should improve the dollar-denominated revenue and operating income numbers for AWS.

AWS does the heavy lifting

Amazon is showing steady improvement in advertising, subscription, hardware sales, logistics, and a number of other business segments. However, AWS is still doing most of the heavy lifting in terms of operating income for Amazon. In the previous quarter, the North America business segment reported loss of $412 million while the International business reported loss of $2,466 million. These are massive losses that were reported despite the growth of the high margin advertising business.

Figure 3: Advertising revenue is still less than 50% of AWS segment.

Advertising business is one of the key growth drivers for future profitability in Amazon. There have been good growth numbers in the advertising business over the last few quarters. However, it is still less than 50% of AWS in terms of net sales. The growth in advertising, subscription, and third-party services has not been able to reduce the overall losses in North America and International segments.

Figure 4: AWS delivered all the operating income for Amazon in recent quarters.

Massive investment in logistics is one of the key factors behind the big losses in North America and International regions. Better logistics will be a strong moat for Amazon in the long run, but it is a major drag on the profitability of the company in the short term.

During this period, the importance of AWS will increase as it will deliver the cash flow required for investment in other business segments.

Short term vs long term

Amazon’s management has always focused on the long term. This has served the company well in terms of new growth runways like advertising, hardware, subscription, and other businesses. AWS will likely face strong headwinds in Q4 2022 and Q1 2023 due to tough comps and slow demand growth. This can hurt the bullish sentiment toward Amazon stock in the near term.

However, long-term growth projections for AWS are still very good. Gartner has estimated that overall cloud spending will increase by more than 20% in 2023. Beyond 2023, AWS is likely to be in a good position to leverage its market leadership position to deliver good margins and take advantage of the robust demand for cloud services.

Figure 5: Gartner estimates a good year for growth in cloud business as the headwinds of 2022 decline.

Impact on Amazon stock

The performance of AWS will continue to have an overwhelming impact on Amazon’s overall profitability and stock sentiment in the near term. Due to tough comps, the expectation for YoY growth from AWS business must be tempered. If Amazon is able to deliver decent growth numbers in the revenue and operating income metrics for AWS in Q4 2022, we should see a sustainable bullish sentiment toward the stock.

Investors with a longer-term investment horizon can take advantage of any dip in Amazon stock during the next few months which are likely to be volatile. Despite some near-term headwinds, Amazon has strong fundamentals and has businesses like advertising, subscription, hardware, logistics, and others which should give the company a long-term growth runway.

Getting a stand-alone valuation of AWS is quite complex due to the lack of many peer companies which trade solely on their cloud business. Bloomberg mentioned that Alex Haissl, a Redburn Ltd. analyst, has estimated AWS to reach a valuation of $3 trillion. This would be three times the current valuation of Amazon. There are other Wall Street analysts who are quite bullish about AWS.

However, a back-of-the-envelope calculation also shows that AWS will be the key driver for Amazon stock in the next few years. The trailing-twelve-months revenue of AWS is $76.5 billion with TTM operating income of $23 billion. Even with a modest 25% annualized revenue growth (which is lower than the growth rate reported by AWS in last few quarters), the annualized net sales in AWS division should cross $150 billion by end of 2025. At a 26% operating margin (which is lower than the average 30% margin reported in last few quarters), AWS should deliver operating income of $40 billion by 2025. If we assign a valuation multiple of 25 to AWS, the standalone valuation of this business segment should be over a trillion dollars by 2025.

Amazon also gains a massive flywheel effect from its AWS earnings. As the operating income of this segment increases, Amazon can divert the profits in building logistics, video streaming, subscription, hardware, and other businesses. Hence, the contribution of AWS to Amazon stock is higher than the valuation suggested by the standalone calculation.

Investor takeaway

AWS should continue to be a key driver for valuation growth of Amazon.com, Inc. stock. There are strong headwinds for AWS in Q4 2022 earnings report. This includes tough comps, slower demand, and a challenging macro environment. On the positive side, AWS would gain a F/X tailwind due to a better Euro level compared to the dollar. If Amazon is able to deliver even a modest YoY growth in revenue and operating income of AWS, it will lead to an improvement in bullish sentiment towards the stock.

The long-term growth trajectory of AWS is quite strong as shown by the recent Gartner report which estimates over 20% growth in cloud spending for 2023. The standalone valuation of AWS should reach over $1 trillion by 2025 even if we estimate modest revenue and margins in the next few quarters. Investors with longer-term investment horizons can still gain good returns from Amazon.com, Inc. stock as profits from AWS are used to build other key growth segments for the company.

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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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