Growth Stocks: Amazon

8:55 AM October 25, 2022

Amazon is set to release its results next week in what could be a crucial report. Stocks have rallied more than 14% in recent days as investors grapple with mixed signals from the market.

Amazon (AMZN.US) will publish its third quarter financial results next Thursday, October 27, 2022, after the market close. Anyone interested can listen to the presentation live on Amazon's investor relations website.

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The company offered projected guidance of a 13% to 17% increase in sales to reach $125 billion to $130 billion and nearly $0 (yes $0) to $3.5 billion in operating income. Sales growth hasn't been a problem recently, as shown below, but operating income has been hard to come by.

source: Amazon


Why is the operating result reduced?

Operating income has taken a significant hit since the height of the pandemic. The initial spending boost from the pandemic, economic stimulus and increased online shopping have given way to less favorable behavior.

First, while the company initially benefited from the stimulus that supported the economy, rising wages and a tight labor market ultimately added billions in costs to the bottom line. This prevailed in mid to late 2021 and continues to this day.

Afterwards, logistical issues plagued the supply chain for much of 2021 and these challenges persist. This adds costs to retail margins that are already tight. This also contributes to inflation globally and in the US it's known that inflation is adding to fuel costs and, well, pretty much everything else.

The strength of the US dollar has taken its toll on international results. Sales in this segment fell 12% in the second quarter year-on-year, but only 1% when adjusted for foreign currency changes. Operating income fell from a profit of $362 million to a monstrous loss of $1.8 billion last quarter.


But is there something else to pay attention to?

Management has done an admirable job of executing in this challenging environment. During the first half of 2022, gross margin has only fallen by a little over 1%. In fact, the most significant increase in expenses is not at the level that we might expect. Spending on technology and content has increased the most during the first half of 2022.

This is excellent news. Investing in technology and content, including research for new products and servers, equipment, and other expenses for AWS and other companies, will generate future revenue and profit. Until the second quarter, Amazon has spent $33 billion in this area, 25% more than in the first half of 2021.


Cloud business: AWS

Amazon Web Services (AWS), the world's largest cloud service provider, is Amazon's largest source of revenue and has lately been the only consistent profit center. The segment produced $19.7 billion in sales last quarter and $5.7 billion in operating income. Amazon hit a run rate (annualized sales) of $79 billion for AWS last quarter, and total sales will likely shadow the $80 billion this year by a wide margin. Amazon's cloud business consistently posts operating margins close to 30%.

This segment has been so successful that it nearly supports the entire $1.17 trillion market capitalization of Amazon on its own. The segment has grown 35% so far in 2022 and, barring something drastic, will easily surpass $100bn in revenue in 2023 with a good head start.

AWS has a stranglehold on the cloud infrastructure market of more than 33%, surpassing Microsoft's Azure (MSFT) and far outpacing Alphabet's (GOOG)(GOOGL) unprofitable Google Cloud.

source: Amazon

Microsoft is a profitable and growing software as a service (SaaS) company, valued at approximately nine times its sales (P/S). It is more diversified and consolidated than AWS, but it is not growing at the same rate.

AWS could fetch a valuation of 9x to 10x times next year's sales, or $900 billion to $1 trillion, as a stand-alone entity on the open market. This means that the rest of the company is relatively cheap at the moment.


Other quick hits

AWS sales could reach $21.4 billion if the company maintains the 33% growth it achieved in the second quarter. Anything lower would be a bit disappointing.

Advertising growth has slowed a bit but was still strong in the second quarter at 18% to $8.8 billion. Amazon has generated $34 billion in digital ad sales in the last 12 months, which is impressive considering where this revenue stream started. Sales in this segment were so insignificant that the company didn't even report them separately until recently.

In 2022, total service revenues exceeded product sales for the first time, as shown below.

source: Amazon

Why is this important? Service sales are higher margin and are also recurring, like AWS and subscriptions. This is fantastic news for shareholders. Hopefully this trend will continue and the gap on the chart above will widen. A more service-oriented Amazon will be more profitable, produce better cash flows, and make more money for shareholders.


Where are Amazon shares?

Amazon shares have fallen more than 38% so far this year, but have recovered 14% since their recent low on October 14, as shown below.

source: xStation5, AMZN.US (D1)

Before the recent rally, a strong positive reaction to the results was expected. There was too much negativity included in the price, dragged down by the global context. But this week we will see if the short-term rally has a longer duration.

Judging by the tone of last quarter's guidance, it should come as no surprise that operating income will be on the low end of estimates. The massive success of AWS has increased spending on infrastructure, which will increase depreciation expense and hurt operating income. Because of this, the market could react negatively before digesting the details of the earnings report.

Today, Amazon's valuation is too convincing. The company continues to become a service-based business that will drive margins and cash flow, and once the retail headwinds subside, which could stretch into 2023, the bottom line should see a big boost, and price of stocks will likely follow the positive trail developed in 2020 and 2021.

Dario Garcia, EFA
XTB Spain


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