The Case for Amazon Stock Weakens With Declining Cloud Service Margins

Rapid decline in AWS margins will have a major impact on other segments

Amazon (NASDAQ:AMZN) reported a surprising decline in AWS operating margin in the recent quarterly earnings. The quarterly revenue growth was 35% compared to the year-ago quarter. This is a modest decline from earlier quarters when the growth rate was in the 40s. However, the bigger headwind for AMZN stock is the slowdown of growth in the operating income metric of AWS. This metric grew by a paltry 9% compared to year-ago quarter. Besides shipping expenses, the fall in operating margin of AWS is the main reason for overall margin decline of Amazon.

Why Declining Cloud Service Margins Could Threaten Amazon Stock
Source: Sundry Photography / Shutterstock.com

The operating margin for AWS in the recent quarter was 25.1%, which is 6 percentage points lower than the 31.1% operating margin reported in the year-ago quarter. A large part of the valuation in Amazon stock is dependent on AWS. Recent estimates have valued AWS at over $500 billion or more than 60% of the current market cap of Amazon. The ability of Amazon to withstand the next recession is also dependent on the performance of AWS.

AWS also funds other big investments made by Amazon to diversify its revenue base and increase its growth potential. If we continue to see margin decline in AWS for the next few quarters, it could lead to a big bearish sentiment toward Amazon stock.

The Most Important Metric

While many analysts focus on the overall revenue growth rate of AMZN, we also need to look at the operating margins of the segments, especially AWS. 

Net sales and operating income of AWS for the past few quarters

Source: Amazon Filings

AWS reported an operating income of $2.26 billion on revenue of $8.99 billion. In the year-ago quarter, the operating income was $2.07 billion, while the revenue was $6.67 billion. While the revenue increased by 35% on a year-over-year basis, the growth in operating income was only 9%. Excluding the impact of foreign exchange rates, the operating income growth was 6%. 

Source: Amazon Filings

Just a couple of quarters back, the operating income growth was as high as 84% on a YoY basis. In comparison to that, a 6% growth in operating income in the latest quarter seems problematic. It should be noted that the decline in revenue growth has not been that huge. Hence, the biggest reason for a decline in operating income growth is the fall in margins.

In the year-ago quarter, AWS had an operating margin of 31.1%. There has been a continuous decline in this metric in the last few quarters. In the recent quarter, operating margin came at 25.1%, which is a decline of 6 percentage points or 600 basis points from the year-ago quarter.

Why Does It Matter?

The single biggest reason for the rapid growth in Amazon stock over the last decade has been the success in the AWS segment. According to recent estimates by Cowen analyst John Blackledge, AWS could have a standalone value of $505 billion. This is over 60% of the market cap of Amazon.

Besides the standalone valuation, AWS is also intrinsic in the success of other segments. Amazon funds a large number of new investments in content, shipping, international location, devices and other initiatives through its profits in AWS. Without AWS, it would be very difficult for Amazon to make similar scale of investments. Amazon has lately showed rapid growth in high margin advertising business, but AWS is still the main profit center for the company. Hence, if AWS shows a squeeze in margins, it will have a big impact on the future growth sentiment for AMZN stock.

Change in Trend

It is too early to make a definite prediction on the future margin trend of AWS. However, investors should closely follow this metric in the next two-three quarters. As shown above, AWS has shown only 6% growth in operating income, excluding F/X, despite a 35% revenue growth. This means that the company is not able to gain any income on incremental revenue. Further challenges in this segment can also lead to a negative growth rate in operating income. 

Recent news has mentioned that Microsoft (NASDAQ:MSFT) has gained a $10 billion cloud contract from the defense department. AWS was touted as the main player for this contract. Failure to gain this contract by AWS will also have future repercussions on the growth and margin for this segment. It is likely that Microsoft will have good tailwinds in gaining future cloud contracts from other federal agencies.

It should be noted that the rivalry between Microsoft and Amazon’s cloud segment will continue to grow in the next few quarters. Microsoft has huge resources and other profitable businesses that should allow the company to aggressively price its cloud services in the near term. This should force AWS to give similar discounts, further squeezing its margins.

Impact on Valuations

Amazon’s operating income declined by 15% in this quarter. In the year-ago quarter, the company reported operating income of $3.72 billion, while it showed an operating income of $3.15 billion in the latest quarter. Despite healthy revenue growth of 25%, the operating income declined significantly due to a decline in margins. AWS is a major contributor to Amazon’s overall operating income. 

Amazon reported a 15% decline in operating income.

Source: Amazon Filings

Many analysts point to the growth in shipping expenses as a reason for decline in margins. However, lower margins in AWS is also a very important cause for the fall in Amazon’s operating income. If AWS would have reported operating income growth similar to its revenue growth of 35%, Amazon’s overall operating income decline would have been in low single digits. 

Amazon’s recent operating margin decline has led to a downward adjustment of future EPS estimates. This is very important for Amazon stock as it is already trading at a price-to-earnings ratio that’s close to 80.

I am still bullish about the long term growth potential of Amazon stock. However, the revenue and margin trends in AWS in the next few quarters will be vital for the future outlook on the stock.

Investor Takeaway

AWS has reported a mere 6% year-on-year growth in operating income, excluding F/X, on revenue growth of 35%. This is a sign that the company is facing immense competition in this segment. Microsoft is the main rival of AWS and it is aggressively pursuing new deals. This could force AWS to give bigger discounts to attract new clients which will hurt its future margins. 

AWS contributes a significant portion of Amazon’s operating income. Hence, any slowdown in the operating income of AWS will have a big impact on the overall income of Amazon. This was clearly visible in this quarter when Amazon’s operating margin declined due to lower margins in AWS. Investors should look closely at the performance of this business in the next few quarters to gauge the long-term potential of Amazon stock.

As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/12/amazon-stock-weakens-with-declining-cloud-service-margins/.

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