Background: AWS (cloud infrastructure) is the only segment generating any operating income for Amazon. AWS reported a 28% YoY revenue growth and 11% YoY operating income growth in Q3CY22 with an operating margin of 26%. Reported numbers while not extraordinary (due to a decline in operating margin QoQ by 270 bps) look quite good given the current operating environment. However, when we looked under the hood, footnotes to these reported numbers, in the 10Q, paint a very different picture and led us to the evaluation of the AWS business segment discussed below in this article.
The Challenge: AMZN’s reported AWS operating margins are inflated due to a reduction in depreciation and amortization expense of $882 million in Q3CY22 compared to Q3CY22 due to this accounting change; AMZN increased the estimated useful life of servers from four to five years for accounting purposes. Moreover, changes in FX positively impacted operating income by $478 million for Q3 2022 compared to the same period last year. If we adjust for this accounting change & FX AMZN’s AWS segment operating income growth changes from 11% to -17% YoY and operating margin changes from 26% to 20%; a 1000-bps decline YoY. Hence while YoY Q3CY22 revenue growth of 28% looks impressive, in this environment, the growth was achieved at the cost of a drastic decline in profitability. There are two reasons for this, A) increasing competition is reducing profitability for all players in the Cloud Infrastructure (IaaS) market as this business is increasingly commoditized, and B) AWS is investing heavily for future growth and so this could be a temporary blip in margins while it is in a high investment phase. It will lead to AWS generating only a high teen operating margin, well below the 30% range margins it generated over the last two years.
Amazon’s response: AMZN started addressing the negative cash flow (negative operating income) issue in the retail segment by reducing warehousing and logistics development Q1-Q2CY22 onwards but continued focusing on unprofitable revenue growth in the AWS segment up until now (Q4CY22). It seems to have recently pivoted on this decision to pursue unprofitable growth and has now announced reductions across the board. We are not sure if this will help AMZN in the AWS (Cloud Infrastructure – IaaS) segment since its two deep-pocketed competitors continue to invest in the next layer of Cloud business, Cloud software (PaaS/DaaS/FaaS/Saas). According to industry chatter, GOOGL is hiring in the Cloud segment like a drunken sailor.
Competitive Dynamics: Amazon competes with two deep-pocketed companies MSFT & GOOGL in the Cloud Infrastructure (IaaS) Market, and both of them are not worried about margins from IaaS business. GOOGL has been generating operating losses in this segment for years and doesn’t expect to generate operating profit in the near future (next one-two years). MSFT clubs its Cloud software (PaaS/DaaS/FaaS/Saas) margins with Cloud Infrastructure (IaaS) margins in its Cloud business reporting segment and hence could continue to subsidize the low or no margin Cloud Infrastructure (IaaS) business with its Cloud software margins. Amazon does offer cloud software but not at the scale of MSFT & GOOGL (Cloud Native) since they are legacy software businesses that just moved to the cloud while AMZN doesn’t have a legacy software business.
Conclusion: AMZN had a first mover advantage in the increasingly commoditized Cloud Infrastructure market but is now losing market share to both MSFT & GOOGL since both of them are very good at Cloud software (PaaS/DaaS/FaaS/Saas) and focusing on the software layer while treating the Cloud Infrastructure (IaaS) as a no margin commodity business. Apart from being the first mover, Cloud Infrastructure (Iaas) does involve physical infrastructure & logistics where AMZN has an advantage while now as the market moves to the lucrative cloud software segment (PaaS/DaaS/FaaS/Saas), MSFT & GOOGL have a natural legacy advantage and AMZN will have to change its mindset to compete in this Cloud software segment (PaaS/DaaS/FaaS/Saas). Like any commodity business, AMZN is reducing costs by upstream vertical integration and successfully deploying its own server chipset Graviton. Graviton3 processors deliver 40% better price performance than comparable x86-based processors. However, GOOGL announced similar efforts (to develop Chipset for Cloud servers) in collaboration with Intel (hence MSFT is highly like to use the same). So, hardware may not be a large cost advantage for AMZN and it should focus on the more lucrative Cloud software segment (PaaS/DaaS/FaaS/Saas). One can never rule out a giant like AMZN from the competition but until we see some results on the cloud software side (PaaS/DaaS/FaaS/Saas), it’s advantage MSFT & GOOGL in the cloud market share fight. We estimate AMZN loses about 200 bps of Cloud Infrastructure (IaaS) market share for the next few years.
What’s built into the stock price: Market chatter around Amazon is mostly focused on when the retail business segment gets back to positive operating income and within retail primarily the international retail segment. What are the steps and cutbacks Amazon is taking in international retail expansion and EM’s primarily within international retail? Japan and developed EU countries within international are all profit-making while EMs are where AMZN has to spend a lot without any near-term (one-two years) operating profit in sight. AWS (Cloud Infrastructure) business has been the bright spot in AMZN’s story due to its consistent 30-40% revenue growth and 30-50% YoY operating income growth over the last few years. We think now the risk is that even if the retail business segment returns to positive operating profits, AWS may be inside the penalty box and the stock could continue to be under pressure even after the retail operating profit issue is resolved. This AWS segment decline is something that is not built into the stock price as of now. Almost all estimates show AWS growth continuing and retail limping back to profitability in 2H23.
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