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Amazon Stock Is Facing Margin Pressure in AWS

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Rohit Chhatwal
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Amazon (NASDAQ:AMZN) may have reported a slight slowdown in AWS revenue growth in the latest quarter. But for investors, what is more important is the substantial fall in AMZN stock’s operating income growth rate. That will have substantial negative effect on Amazon stock. 

Amazon Stock Is Facing Margin Pressure in AWS
Amazon Stock Is Facing Margin Pressure in AWS

Source: Volodymyr Plysiuk / Shutterstock.com

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For the past few quarters, Amazon has been reporting improvement in the operating margin of AWS along with rapid revenue growth, which helped in faster growth of company-wide operating income. The rapid improvement in operating income of AWS helped Amazon post better overall income and EPS.

Management has not mentioned any specific reasons for a slowdown in AWS growth in this quarter. Slower growth of 37% in revenue and 24% in operating income could be a seasonal issue. Microsoft’s (NASDAQ:MSFT) Azure also posted lower growth numbers compared to previous quarters. Amazon depends on income from AWS to make investments in other segments. 

Is It A Macroeconomic Issue?

The year-over-year operating income growth numbers for the past few quarters in AWS were very promising. Before the last quarter, the growth rates in operating income from Q1 2018 to Q1 2019 were 67%, 84%, 75%, 57%, and 51% respectively. The revenue growth for these quarters were 48%, 49%, 46%, 46%, and 42%. We can clearly see that the operating income was growing much faster than revenue growth for these quarters due to improvement in margins.

However, in the latest quarter, the revenue growth was 37% while operating income growth was only 24%. This shows a massive reduction in operating margin while the revenue growth is getting squeezed.

Source: Amazon Filings

This does not augur well for the bullish sentiment for Amazon stock. It remains to be seen if this is a seasonal issue. Microsoft’s Azure also posted a slower growth rate of 64% compared to previous quarters. 

Source: Microsoft Filing, ZDNet

One of the reasons could be a general economic slowdown as the trade war delays greater investments by companies in their cloud infrastructure.

The slower growth of operating income compared to revenue growth by AWS shows pricing pressure in the market. AWS had a trailing-12-month revenue of over $30 billion with an operating income of $8.6 billion. It is also possible that AWS is starting to see the effect of a large base where it is difficult to show incremental growth rates of a few quarters ago.

Impact On Overall Business for AMZN Stock

Amazon has increased its investments in other segments like shipping, video content and hardware by using AWS as a cash cow. Hence, Amazon’s growth in other segments will depend on a strong performance in AWS. 

Amazon’s management recently announced a massive investment in building its own shipping platform which will allow one-day delivery. This requires ongoing investment over the next few years. Similarly, Amazon is increasing the investment in video streaming as it battles with Netflix (NASDAQ:NFLX) and other new players entering this field. The video and music expense in the recent quarter was $1.8 billion which is about 85% of the operating income of AWS.

Amazon has also been able to sustain high losses in several international markets like India because of the strong operating income from AWS.

Source: Amazon filing

All these segments — like video streaming, international markets, new services and faster delivery — should help the company in improving its growth runway. However, without the juicy margins and profits of AWS, it would be difficult to sustain losses in these segments.

Future Valuation of Amazon Stock

Amazon reported a year-over-year dip in operating margin for the entire company in the latest quarter. This was after a long-term trend of continuous improvement in operating margin. The management mentioned that it was because of heavier investments in shipping infrastructure in the last quarter.

However, I believe a bigger contributor to the decline in operating margin was AWS.

Fig: Operating margin and EPS for past few quarters.

Amazon reported 4.86% operating margin compared to 5.64% in the year-ago quarter. The $5.22 EPS in this quarter was better than the year-ago quarter due to faster revenue growth. 

The trailing-12-month EPS for Amazon is $24 while the EPS estimates for two fiscal years ahead is close to $50. This would require massive improvement in operating margin as the revenue growth is showing signs of settling in teens. A big chunk of additional operating income would need to come from AWS as most of the other segments are in the early growth phase. Hence, if we see another quarter or two of slower revenue growth and operating margin growth within AWS, it could lead to a build-up of bearish sentiment towards Amazon stock. 

I still believe that Amazon is a good buy-and-hold option, but it would be important to keep a close eye on the future trend within AWS.

Investor Takeaway

Amazon reported a relatively slower growth of 37% in its AWS segment in the latest quarter. However, the more important metric was the massive slowdown in operating income growth which came at only 24% compared to 84% in the year-ago quarter. Azure, the chief rival of AWS, is also reporting a slowdown in growth rates.

It’s important for investors to closely watch the future operating income trend within AWS to gauge the margin expansion possibility within the company.

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

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