Amazon cloud cover looks fragile

Amazon Web Services (AWS) is the market leader in cloud computing. A slightly simplistic explanation of this business is that it owns servers that store data for other companies. The benefit for its clients is that they don’t have to pay to maintain their own servers and Amazon is good at keeping their data safe and presenting it back to them in useful ways.

Amazon was the first big player to move into this business and for years has maintained its market-leading position. In 2021, AWS operating profits rose 37 per cent to $18.5bn (£13.7bn), including $5.3bn in the fourth quarter. This meant cloud computing accounted for 74 per cent of group-wide operating profit.

Its growth is unlikely to slow down soon. The increasing adoption of 5G, the Internet of Things and AI means ever greater swathes of data are being generated. This will all need to be stored somewhere, which explains why Grand View Research expects the global cloud computing market to grow by 19.1 per cent a year until 2028.

Retail issues

When you strip out AWS, however, Amazon was in the red in the final quarter of 2021. North America swung to a $206mn operating loss, from a $2.95bn profit the year before, while international operations saw a $1.63bn loss (versus a $363mn profit in the fourth quarter of 2020). This is the first time Amazon has made a quarterly loss in its home market since 2015.

The reason for the negative returns is the large jump in operating costs caused by the pandemic, even as the accelerated adoption of online retail has turbocharged sales. The $408bn in net sales from non-AWS business in 2021 was two-thirds higher than in 2019. However, the increase in costs from rising shipping prices and higher wages has more than offset this.

In 2021, total operating expenses increased 22 per cent to $445bn. These costs were spread across the board with cost of sales (including salaries), fulfilment, technology and marketing all up by similar levels. Cost inflation is unlikely to clear soon and Amazon is now expecting group operating profit to be between $3bn and $6bn in the first quarter, down sharply from the $8.9bn generated in the first quarter of 2021.

One problem is that for all its cutting-edge technology, Amazon remains a labour-intensive business. It now has 1.6mn employees worldwide, and last year it increased its minimum wage by 36 per cent to $15 for 350,000 staff members. This was primarily to attract workers during the Covid-19-induced labour shortage, but wages are sticky and even if demand for its products falls, Amazon will find it difficult to lower workforce costs (short of automating all warehouse roles).

Based on data from the St Louis Federal Reserve, there is also evidence that demand for the kind of durable goods that Amazon specialises in will fall this year. In the five years to 2020, personal consumption of durable goods increased by 1 per cent per quarter on average, with very little deviation from the mean. During the pandemic, this shot up to 3.9 per cent as consumers shifted from consuming services such as cinema tickets and haircuts to goods they could order online. If consumption reverts to its long-term trend in the next year, that would equate to a 18.5 per cent fall.

Despite the shift to ecommerce, Amazon’s share of the US durable goods market also remained stagnant, as rivals such as Walmart and Target responded to the pandemic by increasing their investments in ecommerce. In the third quarter of 2021, Target’s digital sales increased 29 per cent following growth of 155 per cent the previous year.

Is advertising growth a mirage?

Amazon advertising has been growing nearly as fast as AWS. On Amazon's platform, retailers bid on certain key words and when these words are typed into the search bar their products appear at the top of the page. In the last quarter of 2021, these services generated $9.72bn of revenue, a 32 per cent rise year on year.

In Meta’s (US:FB) recent results, it announced advertising revenue would experience some headwinds because of the changes made by Apple (US:AAPL) that prevented third-party collection of user data. This data is used to target specific ads at customers. Amazon, however, doesn’t rely on third-party data as it knows exactly what its customers want to buy.

The issue with this advertising strategy is that it could start to cannibalise retail sales. When customers search for a product, the first few results they see reflect whoever has paid the most for prominent advertising space – rather than the best reviewed. It is now a worse product for both the customers and the retailers that can’t afford the advertising. This could push some sellers to join the growing numbers who are launching their own direct-to-consumer online sales channels. 

Founder and ex-CEO Jeff Bezos was famously obsessed with the customer experience above all else. “We’ve had three big ideas that we’ve stuck with for 18 years, and they’re the reason we’re successful: Put the customer first. Invent. And be patient,” he said in 2013. However, the new advertising product is arguably neither customer-centric nor inventive.

AWS competition grows

At this point, readers might ask 'so what?' After all, for years investors have been happy to back the break-even retail business, so long as sales are growing and the cloud computing cash machine continues to hum.

AWS has been an unqualified success, with profits rising in line with the colossal growth in demand for cloud services. However, there is a concern that it could lose future market share to its two biggest rivals. Since 2017, AWS has maintained a leading market share of around 32 per cent, according to Synergy Research Group. But over that time, Microsoft’s (US:MSFT) Azure service has risen nine percentage points to 21 per cent, while Alphabet’s (US:GOOGL) Google Cloud has climbed four percentage points to just under 10 per cent.

“We are seeing a lot more competition from Microsoft Azure, which benefits from B2B synergies. Millions of businesses use its Microsoft Teams – whereas the rest of Amazon’s business is mostly consumer-focused,” says Stephen Yiu, the Blue Whale Growth fund manager who recently sold his position in Amazon.

Likewise, Google has an advantage because of its market-leading position in machine learning. And while all three companies have AI products that help customers glean insight from their data stored on the cloud, Google can claim hardware superiority thanks to its Cloud Tensor Processing Units chips, designed to speed up machine learning tasks.

As well as improving products, the other way these tech giants can compete with each other is by lowering the price of their cloud subscriptions. Yiu compares the cloud services to the telecoms companies which, despite providing essential infrastructure to the communication revolution, saw their value decline as none were able to take a dominant market position. Although its sales have rocketed over the past two years, and some think cloud margins can tick higher admid the competition (America’s monopoly problem’, IC, 21 January 2022), AWS’s operating margin has shown signs of compression in recent quarters.

Waiting for the next trick

Amazon is still investing heavily. In 2021, spending on property and equipment increased 53 per cent to $61bn, while the company continues to file thousands of patents every year. Recent innovations span AI technology, drones and even a whip to send payloads into space.

These tech companies are shapeshifting business that are always capable of surprising investors with new profitable inventions or business lines. However, Amazon’s largest revenue segment by far remains retail and the coming year will be bumpy. A 17 per cent increase in its Prime subscription could help it return to a profit in retail (assuming no more rising costs and the company's forecasts for a $3bn sales uplift prove accurate).

But the job of tight margin management is never easy, and has real implications for profits. Since June last year, the consensus forecasts for 2023 earnings has fallen a quarter. Despite that considerable downward revision, the stock trades on 44 times next year's earnings and roughly in line with the price investors were prepared to pay at the same point in 2020 and 2021 (see chart). AWS is going to have to do ever heavier lifting to justify that price.