The big story within Amazon’s (NASDAQ:AMZN) AWS is the continuous improvement of its operating margin. In Q4 2017, the trailing-12-month operating margin of AWS segment was 24.8%. In the latest quarter, the TTM operating margin has increased to 29.1%. This 430 basis point improvement in the operating margin of AWS has helped the company show a robust increase in overall operating margin and EPS. This should help AMZN stock in the next few quarters.
While the growth rate in other segments has been low, AWS continues to show an over 40% growth rate. This trend will help in increasing the revenue share of AWS, which will also improve the future operating margin potential of the company.
Investors should look at this developing trend to gauge the long-term growth potential of Amazon stock.
Economies of Scale for AWS
High growth in AWS has not been at the expense of margins. On the other hand, in the past few quarters, we have seen its operating income growth exceeding the revenue growth. In the last quarter, AWS reported 41% growth in net sales while the operating income grew by 59%. The TTM operating margin has improved from 25.2% in Q1 2018 to 29.1% in Q1 2019.
Operating income growth surpassing net sales growth in AWS for the past six quarters. Improvement in ttm operating margin. Source: Amazon Filings
Despite fierce competition from other giants, Amazon has been able to maintain its market share. It has also improved the pricing power, which has helped in increasing the margins. Good growth at a higher revenue base in AWS is a big positive for Amazon stock.
Future Growth Potential for Amazon Stock’s AWS
In its recent report, Gartner projected 17.5% growth in the public cloud market in 2019. The infrastructure services segment will show growth of 27.5%.
Source: Gartner
Amazon stock is in a good spot to capture a good percentage of incremental revenue in this segment, though it will face higher competition in some international regions as Alibaba (NYSE:BABA) expands its presence outside China. Alibaba’s management has mentioned earlier that they will be focusing on cloud growth. Heavy investments and discounts offered by Alibaba in international regions can put some pressure on Amazon’s cloud business.
However, the margin differential between AWS and Alibaba cloud is still very high. In the last earnings, Alibaba reported a negative 4% operating margin in the cloud segment, while AWS boasts close to a 30% operating margin.
The increase in trade tensions between the U.S. and China can be another setback for Alibaba’s cloud efforts. Bigger cloud clients in Europe, UK, Australia and India might choose Amazon over Alibaba to prevent long-term disruptions in services. Despite higher pricing, AWS can win big deals compared to Alibaba cloud due to the ongoing tariff increases.This new trend should help Amazon stock as the trade rhetoric continues to increase.
Increase in Revenue Mix for AMZN Stock
We have seen a slowdown in net sales growth from Amazon. At the same time, AWS has continued to grow at over 40%. This will help in increasing the revenue share of AWS within overall net sales.
In the latest quarter, the revenue share of AWS increased from 11% to 13%. An increase in the operating margin of AWS and continuous growth in its revenue share portends good news for Amazon stock. We should continue to see significant improvement in operating margin and EPS in the near future.
Amazon’s operating income has increased from $1.93 billion in the year-ago quarter to $4.42 billion in the latest quarter. In the same time period, operating income of AWS increased from $1.4 billion to $2.22 billion. Hence, out of the total increase of $2.5 billion in operating income, AWS contributed $0.82 billion, or close to a third of the increase.
Increase in the revenue mix will further increase the contribution to operating income and lead to bigger impact on EPS. Investors should closely follow this trend and look at the margin improvement potential in AWS.
Investor Takeaway
AWS has reported another quarter of good growth rates. However, it has also seen a big jump in operating income, which has helped in increasing the operating margin of this segment.
AWS has contributed close to one-third of the total operating income increase over the year-ago quarter. As the revenue share of this segment increases, we should see bigger impact on Amazon’s operating margin.
Gartner has forecasted robust growth in this industry, which should also be a good tailwind for AWS and boost the bullish sentiment towards AMZN stock.
As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.
