Amazon Stock: My ‘Margin-Call’ (NASDAQ:AMZN)

The call

Back in the first quarter of 2021 Amazon (NASDAQ:AMZN) reported its highest ever quarterly operating margin of 8.2%, by which even management was surprised. Only after a few quarters the same metric dropped to the lowest level for the past several years in Q4 2021 just to hit a new low again in Q3 2022 with 2%:

I think it was clear for investors that the jump in margins after the pandemic won’t be sustainable as running at 100% capacity isn’t something you can do as a business for an extended period of time. However, I assume not many of us suspected that soon margins will converge close to zero.

Looking at the current tendency itself leaves not much room for optimism, but this time I believe a positive surprise could be around the corner. Depending on the timing and size of recently announced layoffs I think margins could have already bottomed in the Q4 quarter making 2023 a comeback story from an operating margin perspective. I believe this will be the main driver of share price performance this year rather than widely expected softening topline growth figures in a fragile economic environment.

In the following analysis I’ll make a deeper dive into the different factors that contributed to the steep fall in margins in previous quarters, also quantifying their contribution. I think this is essential in order to understand from which sources an improvement in margins could come from. Afterwards I’ll show the progress Amazon has made on these fronts and look at how much space there is for further improvement. Finally, I’ll analyze further factors that could significantly influence margins this year and thereafter.

As FX movements have a much smaller effect on Amazon’s bottom line than in the case of sales I won’t take them into consideration in the following analysis.

Wage inflation and operational disruptions in the aftermath of the pandemic

The first important change from an operating cost perspective happened during Q3 2021 to Amazon, when the continued hiring spree of the company met an emerging shortage of available workers. This has coincided with the disruption of supply chains globally coupled with the accelerating increase of raw material prices like steel, the most essential construction material of the company’s fulfillment centers. Furthermore, trucking prices continued their steep rise, which coupled with disruption in logistics put strong pressure on the company’s bottom line as well.

Based on the Q3 2021 earnings call these costs amounted to an extra $2 billion yoy in that quarter and were expected to increase to $4 billion for Q4 2021 (what happened indeed), when a full quarter of these was expected to hit the bottom line:

We estimate the cost of labor, labor-related productivity losses, and cost inflation to have added approximately $2 billion in operating costs in Q3, particularly in August and September. Our Q4 guidance range anticipates that these costs will approach $4 billion in Q4 as we see a full quarter’s impact of these effects and a higher seasonal unit volume. – Brian Olsavsky, CFO on Q3 2021 earnings call

Out of these $4 billion additional yoy costs in Q4 2021 around $2 billion have been tied to cost and wage inflation (like newly introduced sign-on incentives), while the other $2 billion have been tied mainly to costs related to operational inefficiencies that manifested in underutilization of the company’s fulfillment and logistics network.

The latter was the result of management’s previous decisions in the wake of the Covid fueled demand boom to increase these network capacities significantly. In the second half of 2021 with Covid restrictions easing globally it turned out that the strong demand growth on the company’s online marketplace won’t last forever. However, most of the additional fulfillment and logistics capacities have been already in place or in the implementation process resulting in lasting overcapacity.

One important effect of these on operating performance is disproportionally high depreciation expense, which Amazon has to bear until it doesn’t grow into these capacities. Below on the chart we can see that depreciation expense has still grown dynamically after Q3 2021, when it was already clear that the pandemic fueled sales boom is losing steam:

Note that both in Q1 2020 and Q1 2022 Amazon increased the useful life of its servers, which resulted in lower depreciation expense of ~$1-1 billion. Excluding this, Q3 2022 depreciation expense would have been around $11 billion, an almost 40% increase from Q2 2021.

Amazon started to dial down CapEx expectations for 2022 at the beginning of the year and announced on the Q3 2022 earnings call that it will keep its total 2022 CapEx spending constant at 2021 levels of ~$60 billion. This is a massive change after CapEx grew from $40 billion in 2020 to $60 billion in 2021. This will significantly restrict the growth of depreciation expense in the future forming an important part of potential cost savings.

From overstaffed to understaffed

Q1 2022 brought a significant change in the trend of preceding quarters as the quick subsidence of the Omicron variant led to a sudden oversupply in Amazon’s employment network. While the costs of operational disruptions resulting from overcapacities in the fulfillment and logistic network still prevailed a new extra penalty box has kicked in with approximately the same negative yoy effect of $2 billion. These two, supplemented by the $2 billion negative effect of inflation made up a ~$6 billion extra cost base in Q1 2022 compared to a year earlier. This has been dampened somewhat by the extension of the useful life of servers resulting in $1 billion savings.

Compared to the total expense base of $113 billion in the quarter the extra $6 billion made up around 5% of it. Although not a fully realistic assumption, but in order to put things into perspective: If we exclude these $6 billion extra costs the operating margin of Amazon would have been 8.3% in the Q1 2022 quarter ($9.7 operating profit vs $116.4 billion sales) instead of 3.2%, a new all-time high.

For the Q2 2022 quarter, Amazon managed to reduce these incremental costs to $4 billion from the previous $6 billion mainly by better aligning labor demand and supply within its fulfillment network. Still, the additional headwinds from cost inflation (e.g.: increased trucking and shipping prices) and the suboptimal utilization of its fixed cost base (e.g.: underutilized fulfillment and logistics capacities like warehouses) contributed to $2 billion incremental costs compared to a year earlier.

For the Q3 2022 quarter Amazon expected $1.5 billion additional cost savings mainly by a more effective utilization of its fixed cost base, but eventually came shy of it by $0.5 billion. This left the company with a $3 billion extra cost base in Q3 from the original $6 billion, 2/3 resulting from cost inflation and 1/3 resulting from suboptimal fixed cost leverage.

I believe a substantial part of these costs will be mitigated in the Q4 2022 and Q1 2023 quarters providing room for improving margins. In the following I will outline the details of this thesis and quantify potential impacts on Amazon’s operating margin.

Fading external cost pressures

Beginning in Q2 2022 inflation started to bite significantly into people’s pockets globally, which was further amplified by steeply rising interest rates and falling asset prices. This has led to pessimism among consumers rarely reflected in consumer confidence indices:

This has resulted in softening realized and expected demand leading supply chain bottlenecks to ease. This process is still ongoing, but it already resulted in significant changes that could materially impact the bottom line of companies like Amazon.

One important change has been in the price of shipping costs. The global container freight rate index is already lower than 2 years ago:

Air freight prices came off also significantly from their 2022 highs:

Somewhat surprisingly to me freight trucking prices are holding up quite well, but we have seen some consolidation here recently as well:

Finally, prices paid for raw materials seem to be falling steeply as measured by the ISM Prices Index:

In my opinion, these trends won’t change quickly as central banks are still tightening worldwide preventing global growth to recover meaningfully anytime soon. This will aid the margins of Amazon and could shave off from the $2 billion extra costs related to inflation that were still in play in the Q3 2022 quarter.

This effect is further amplified by steeply falling natural gas prices, which made a huge peak in Q3, but have since fallen back to levels close to the start of Russia-Ukraine war:

The same effect in European natural gas prices has been even more pronounced:

Based on the Q3 2022 earnings call only the AWS segment of Amazon itself suffered 200 basis points of operating margin compression (compared to two years ago) due to rising energy prices mainly resulting from the phenomenon above. In dollar terms this could have amounted to ~$400 million. I believe if prices stay around similar levels in Q1 at least the half of this negative impact could be mitigated, not speaking of the same effect in other segments of the company.

Finally, on the cost inflation front increasing wages have put the company’s bottom line under pressure as well. Management decided to take action recently and announced further lay-offs taking the total number of leaving employees to ~18,000. As an average employee at Amazon earns around $100,000 a year this could reduce annual wages by ~$2 billion, if we also account for payroll taxes paid by the company. That’s ~$0.5 billion in one quarter, which will be fully reflected first in Q2 2023 as the severance packages paid to leaving employees will hurt the bottom line in Q4 2022 and Q1 2023.

Based on the fact, that cost inflation at Amazon’s retail business cost an extra ~$2 billion yoy still in the Q3 2022 quarter I believe there will be at least $1 billion savings simply from the favorable improvements in transportation costs and raw material prices. Furthermore, the rapid decline in energy prices will also favorably impact the company’s bottom line starting from the Q4 2022 quarter. I assume this effect will have at least $0.2 billion positive impact for Q1 2023 (half the $0.4 billion negative impact in Q3 2022) if prices stay around current levels. Finally, recently announced job cuts could decrease costs by ~$0.5 billion per quarter.

Altogether, I expect around $1.7 billion yoy savings related to these categories. This will be further amplified by cost optimization efforts of management coming mainly from decreasing and regrouping capital expenditures, which I will explain in the following.

Cautious CapEx in 2022 will aid bottom line in 2023

Back on the Q4 2021 earnings call Amazon management expected 2022 CapEx spending to further increase over the $61 billion in 2021. One part of this was related to infrastructure investments in the AWS business that made up 40% of CapEx in 2021. Another large CapEx category, transportation was also expected to increase yoy in 2022 at that time, making up 25% of 2021 CapEx. Finally, investment in fulfillment centers was the only big category (making up 30% of CapEx spending in 2021) expected to moderate yoy.

As the year progressed management began to dial back expectations for transportation and fulfillment center CapEx, making the following comment on the Q3 2022 earnings call:

For the full year 2022, we expect to incur approximately $60 billion in capital investments, which is broadly in line with what we spent in 2021. This represents an estimated reduction in fulfillment and transportation capital investments of approximately $10 billion compared to last year, as we’ve continued to moderate our build expectations to better align with demand. And this is offset by an approximately $10 billion year-over-year increase in technology infrastructure, primarily to support the rapid growth, innovation and continued expansion of our AWS footprint. – Brian Olsavsky, CFO

Firstly, as a side note this implies that investors should expect proportionately lower depreciation expense in the North American and international retail businesses, while increasing depreciation expense in the AWS segment. So, one shouldn’t panic if AWS margins will face some further pressure even if energy prices decrease, because it will have to do with increased investments in infrastructure, which is actually a sign of strong demand in the cloud space.

Secondly, and more importantly the flat CapEx in 2022 over 2021 means that Amazon’s fixed asset base has grown much slower in recent quarters and probably will do so in the upcoming ones (details on that expected on the Q4 earnings call at the beginning of February). Looking at the following charts we can see that the company’s fixed asset base has grown remarkably since the middle of 2020 (blue bars), but this has materially slowed down in recent quarters to yoy growth of ~20% (green bars):

The slower growth in the company’s fixed asset base has resulted in similarly slower growing depreciation expense even if they spent proportionately more on servers and network equipment. These assets have meaningfully shorter useful life than most other fixed assets resulting in higher depreciation compared to the value of the asset. Decreasing growth of depreciation expense was strongly amplified by management’s decision to increase the remaining useful life of servers and network equipment at the start of 2022. This has decreased depreciation expense by ~$1 billion per quarter (the estimated beneficial effect of this is marked by the empty red bars for 2022):

From the chart above we can see, that (excluding the effect of increasing useful life for servers and network equipment) depreciation expense growth didn’t slow down meaningfully in recent quarters making it an important source for further cost cuts.

Based on management comments on the Q3 2022 earnings call there was a sequential $1 billion improvement from Q2 to Q3 on that front as the company has grown into its spare capacities. However, this was shy by the previous $1.5 billion plan leaving further $0.5 billion room for improvement. Based on management comments I believe there is a good chance that this won’t materialize already in Q4, but rather in Q1 2023:

It’s hard to improve productivity much in the fourth quarter, because it’s just a period of like maximum stress on the operations, and we’re trying to fulfill every order in a very quick way. But we’re — our goal is to leave ourselves in a really good, strong condition for a fast start on a lot of initiatives in Q1 of next year. – Brian Olsavsky, CFO on Q3 2022 earnings call

This comment from the CFO suggests that we shouldn’t expect a strong rebound in margins when the company reports Q4 2022 results, but Q1 2023 could signal finally a turnaround. This is also in line with the usual seasonality of the company’s operating margin, which is usually the highest in the first quarter of the year.

I assume that this usual rebound will be aided by the $1.7 billion yoy of cost savings detailed in the previous section and the further $0.5 billion resulting from slower growing depreciation expense compared to Q3 2022. These potential estimated cost savings of $2.2 billion could increase Amazon’s operating margin by almost 2% in the Q1 2023 quarter in my opinion. This is one important reason I dare to assume that the Q3 or Q4 operating margin this year could have been the bottom for Amazon for the foreseeable future.

Although there could be further room for cost improvement from other sources (e.g.: holding back recently jumping marketing expense after successful launch of The Lord of the Rings: The Rings of Power and Thursday Night Football) these are even harder to quantify, thus I will move to the analysis of sales-based effects on operating margin.

A winning combination: High margin businesses are growing the fastest

Although the improving cost outlook is a significant positive from an operating margin perspective the most important driver of the company’s bottom line will be the strong growth in its high margin businesses, which are AWS, advertising, and third-party seller services:

I think this chart puts it quite well, why investors should take advantage of the recently depressed share price of Amazon. The businesses regarded as cash cows for the company show a clear tendency of making up a larger and larger share of the grand total. AWS, advertising, and third-party seller services accounted for 36.2% of total net sales in 2019 and have grown to 45.6% for 2022 YTD. Their beneficial effect on margins has been overshadowed by suddenly spiking costs in the aftermath of the pandemic, however, as things are getting back to normal again, I think Amazon can’t simply spend so much that it could avoid margin explosion in the coming years. If we look at these businesses one by one, we can see that their growth momentum is still not fading.

Firstly, looking at third-party sellers they made up 58% of all units sold on Amazon in the Q3 2022 quarter setting up a new record and growing 2%-points yoy:

Although it’s not possible to determine an exact operating margin for this business from the company’s website we can see that it charges referral fees typically between 8 and 15% for each item sold on top of fulfillment fees if sellers use Fulfillment by Amazon. Furthermore, there is a subscription fee for the company’s third-party seller service, which aids the margin of the business further. Based on this I assume these fees should make the third-party seller business a double-digit margin business even without taking advertising sales into account.

Speaking of advertising, according to management most of the revenue generated in this business is tied to sponsored products and brands mostly in North America. Even in the current fragile macroeconomic environment these sales are holding up very well compared to competitors:

Although the unfavorable FX effect from the strengthening dollar hasn’t hit Amazon’s ad business equally hard and Prime Day in Q3 gave a boost to the company’s ad sales, it’s still conspicuous that it strongly outperforms its larger rivals. There is a detailed article on vox.com on Amazon’s advertising, which I suggest reading as it gives great insights into the topic. For those who want a shorter explanation why Amazon’s ad business could be superior to major rivals here is a short summary from management on the Q2 2022 earnings call:

Right now, we still see strong advertising growth. Again, it’s got be a positive both for the customer and for the brand. I think our advantage is that we have highly efficient advertising. People are advertising at the point where customers have their credit cards out and are ready to make a purchase. It’s also very measurable. And when people are looking, companies are looking to potentially streamline or optimize their advertising spend, we think our products compete very well in that regard. In addition to maybe longer term things like brand building and brings new selection to bear in front of customers. – Brian Olsavsky, CFO

Furthermore, Amazon is only in the early innings to expand its advertising from consumer websites to its streaming and other services like Twitch, Freevee, Amazon Music, Fire TV and others. These have great potential to unlock as well. With this I think the company’s ad business will be a main driver of operating margin growth in the future especially if we look at current operating margins of 30-35% for Alphabet (GOOG) (GOOGL) or Meta (META).

Finally, the crown jewel of Amazon’s profit engine in recent years, AWS is still running hot growing sales by 28% yoy (exiting Q3 in the mid-20s) even with an annual revenue run rate of ~$80 billion. Although this growth rate shows some slowdown from the 40% at the beginning of the year Amazon has increased its CapEx spending for the business from ~$24 billion in 2021 to ~$34 billion in 2022 (information based on Q1 and Q3 2022 earnings calls). This shows continued confidence of management and should pave the way towards future strong growth.

Looking at AWS margins they took a hit recently from increased investments (i.e.: higher depreciation) and rapidly increasing energy prices resulting in a 26.3% operating margin in Q3 2022 instead of the ~30% investors got used to recently. As I have shown previously there are good news on energy prices, however, increased investments should weigh on profitability for some time resulting in an AWS operating margin a few percentage points lower than typical for the past several quarters.

Based on the above I think the long-term fundamental setup for Amazon is very appealing and now is a good chance for investors to take advantage of this. As the high margin businesses grow their share the company’s operating margin could increase year by year surpassing the previous standards of around 5%. The magnitude of this margin expansion is dependent on several factors, but my best guess is that this effect could add at least 1%-points to operating margin per year in the upcoming years without accounting for further margin improvement in any of Amazon’s businesses.

Valuation with different scenarios

Valuing the shares of the company is not the most straightforward topic as Amazon is still investing a lot in its future growth. As a result, the company’s shares are valued more aggressively than the shares of most other megacap companies:

Currently, shares trade at 85x TTM EV/EBIT compared to just ~10 for Meta or ~20 for Microsoft (MSFT), which seems quite a large difference.

However, if we incorporate some of the future growth into Amazon’s valuation and look at the same valuation metric in 5 years’ time the picture becomes entirely different. For this I have assumed 3 scenarios: a conservative one, where operating margin will be 10% for 2027 assuming that current cost saving efforts won’t be followed by other ones and the different segments don’t expand their margins further. In this case margin growth is mostly the result of the increasing share of high margin businesses. In the realistic scenario I assume an operating margin of 15%, which is still less than half of Alphabet, Meta or Microsoft, but it incorporates some positive effects from the company’s growing scale and current investments. Finally, I believe an optimistic scenario would be an operating margin of 20%, which is still not unrealistic but is dependent on several factors.

Taking analysts’ 2027 sales estimates as a basis and calculating current enterprise value for Amazon results in the following EV/EBIT multiples for the different operating margin scenarios:

If we look at the current EV/EBIT multiple average for the total US market (I assume it’s a good comparison as we are not in an inflated valuation environment anymore) it is currently tracking around 22 according to the recently updated dataset of Aswath Damodaran. In 5 years’ time, I assume Amazon will be still a ~10-15% growth company with further room for improving margins implying a higher valuation than the market average. However, if we conservatively compare the EV/EBIT estimates of the three scenarios with the current multiple of the market of 22 it still implies 80-260% potential upside with 170% percent for the realistic scenario.

Based on this analysis I think there is considerable value to be unlocked in the business of Amazon in the upcoming years, which will be reflected in a significantly increasing share price over a 5-year time horizon. As margins could start improving anytime soon, I think this should mark the start of the turnaround for shares after stagnation in 2021 and a steep drop in 2022.

Risk factors

I believe the most important risk factor for the margin fueled turnaround thesis is a potential larger than expected decline in Amazon’s revenues resulting from the current global macroeconomic backdrop. If sales would decline in a pace that the company couldn’t match with corresponding cost reductions it could further pressure margins before the turnaround begins. Even if this would happen it wouldn’t alter the long-term picture, however it would change the picture from a timing perspective. I think if sales didn’t deteriorate materially in Q4 2022 or throughout January the improving operating margin outlook could be already reflected in Amazon’s Q1 2023 guidance. However, if sales would come under pressure this could take more time.

Another risk factor that could postpone the turnaround in margins is Amazon’s management itself. Although most recent quarters suggest that the company has cut back significantly on its previously planned CapEx for 2022, we still don’t know what their plans are for 2023. This is another important factor to look out for on the Q4 2022 earnings call. Amazon spent ~$61 billion on CapEx in 2021 and is expected to stick to the same amount in 2022. If management would announce a significantly higher budget for 2023 this could increase depreciation expense materially resulting in deteriorating margins. As Amazon depreciates 5-6% of its net property, plant and equipment a quarter a CapEx plan of +10-15% yoy for 2022 wouldn’t hurt the bottom line that much. However, an increase of a somewhat greater extent could have a much more noticeable impact.

Finally, another important risk factor is potential further cost inflation that cost Amazon already billions this year. As shown previously most external input costs show moderation, although continued wage pressures are probably an exception. It’s worth to keep an eye on that as well.

Conclusion

Amazon’s bottom line has seen extreme fluctuation in recent years. I believe this may have come to an end and a new era of rising margins has begun. Share price should follow increasing profits making current depressed levels an excellent long-term entry point. Even in a conservative valuation scenario, share price could almost double in 5 years with significant upside potential.