Amazon (NASDAQ:AMZN) has reported a significant decline in its Amazon Web Services operating margin in recent quarterly earnings. The operating margin of AWS declined from 31.1% in the year-ago quarter to 25.1% in the latest quarter, a staggering 600-basis points fall.
Despite a 35% year-over-year growth in revenue, the operating income grew by a mere 6%, excluding foreign exchange. One of the main reasons behind this sudden fall in operating income is the changing dynamics within the cloud industry.
Microsoft (NASDAQ:MSFT) is the chief rival of AWS. It reported 59% growth in its Azure cloud segment. The revenue base of Microsoft’s cloud segment has increased to a level at which it is competing with AWS on even the most lucrative of cloud deals. Microsoft recently won a $10 billion cloud contract from the U.S .Department of Defense. Amazon was another of the main bidders.
We could also see Microsoft emerge as the chief cloud option — outside of AWS — for clients such as Walmart (NYSE:WMT). These factors can curb the growth of AWS and also squeeze its margins. This will be the biggest headwind for Amazon stock in the next few quarters.
Negative Trends for AWS
The decline in overall operating income from Amazon was a bit shocking. Management cited growing shipping costs as one of the main reasons behind this decline. However, looking closely at all the business segments, we can see that AWS has played a key role in the fall of operating income.
Amazon reported 35% year-over-year revenue growth in AWS. This is a bit lower than in previous quarters, but it is still quite good. However, the operating income of AWS increased by a mere 6%. This is a big change compared to the year-ago quarter. AWS is the main contributor to Amazon’s operating income.
Hence, single-digit operating income growth in AWS played a big role in pulling down the overall operating income of the company. This also led to the first decline in company-wide operating margin in the last few quarters. Slower revenue growth and falling margins are a major challenge for Amazon stock
Microsoft Goes All-In
Microsoft is making an aggressive pitch to gain market share in the cloud segment. The revenue growth in Azure has been higher than in AWS for the past few quarters. In the latest quarter, Azure grew by 59% compared to 35% growth in AWS.
Microsoft does not break down the Azure revenues, but the consensus estimate is that it is right behind Amazon in terms of cloud market share. The commercial cloud revenue of the company which includes Azure, Office 365 commercial and Dynamics 365 reported year-over-year growth of 36% to $11.6 billion. More importantly, management mentioned that the gross margin of this segment expanded by 4 percentage points on a year-over-year basis. They forecast that this expansion will continue into fiscal 2020.
Microsoft Has the Advantage
In the long term, Microsoft has a number of important advantages against AWS. One of the biggest is that it is not Amazon. Clients in industries like retail, finance, healthcare and content streaming would like to avoid taking cloud services from Amazon as it is their main competitor. For example, Walmart made a strategic partnership with Microsoft in 2018 to buy cloud services. If Walmart were to buy the same cloud service from Amazon, it would only strengthen its chief rival.
Microsoft has been able to increase its revenue from India to over $1 billion on the back of the cloud push. This trend could repeat in other important international regions where Amazon provides retail services. Amazon is also focusing on its financial platform, which makes it a competitor to traditional financial players. Microsoft does not compete in this segment, making it a better alternative compared to AWS.
MSFT also has the advantage of high margins in other segments. While Amazon depends heavily on AWS to boost its profits, Microsoft has a more diversified profit base. This allows Microsoft to give greater discounts to gain market share. We have already seen this in the growth rates of Azure mentioned above. If Amazon wants to show respectable growth in AWS, it would need to give higher discounts. This will end up hurting its operating margin in this segment as well as the overall margins.
Impact on Earnings
Microsoft cloud growth will be the biggest headwind for Amazon stock in the next few quarters. It should be noted that recent estimates have valued AWS at a standalone valuation of over $500 billion, almost 60% of Amazon’s market capitalization. If the revenue growth in this segment falls substantially or there is a further decline in AWS operating margins, we could see a bearish sentiment towards AMZN stock.
AMZN stock’s trailing price-to-earnings ratio is close to 80. This is quite high if the company shows a negative trend in earnings per share. The fall in operating margin in the latest quarter has led to a big decline in EPS and also reduced future EPS estimates.
Investors should closely monitor the revenue and margin trends in AWS over the next few quarters. This will show if the recent results were due to some seasonal issue or if they are part of a long-term headwind.
My Takeaway on AMZN Stock
Microsoft is rapidly growing its cloud revenue which makes it a major challenge for AWS. In the latest quarter, Microsoft’s Azure showed a revenue growth of 59% compared to 35% by AWS. The gross margins of the cloud operations of Microsoft have also expanded by 4% while the operating margin of AWS has declined by 6 percentage points compared to the year-ago quarter.
Microsoft can continue to use its huge resources to build its cloud business. It will also be at an advantage due to the fact that it is a better option than AWS for many cloud consumers who view Amazon as their competitor. If the current trend of declining margins in AWS continues in the next few quarters, it could lead to negative sentiment towards AMZN stock.
As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.