Amazon Stock: This Too Shall Pass (NASDAQ:AMZN)

Amazon (NASDAQ:AMZN) recently released its 3Q22 earnings results. While there were some weaknesses in the form of European consumer sentiment worsening, lower margins in AWS as a result of higher energy costs, and slower productivity gains than expected, I think that this too shall pass. The near-term debate will focus mainly on where margins will go from here, how the company will turn around free cash flows to positive in 2023 and how demand will fare as consumer and business sentiment become more uncertain than in recent times.

Investment thesis

I have previously written about Amazon in earlier articles. While I think that the outlook for Amazon may look gloomy, the investment thesis for the company continues to remain intact.

Firstly, as a result of huge investments made into fulfilment capacity for the e-commerce business in the last two years, Amazon has found itself in a position where it will likely have more than sufficient capacity to meet the demands of the consumer and continue to maintain its leadership in the e-commerce space. There is no one other player that has made investments that can rival Amazon and thus, Amazon will continue to bring the best products to customers when they need it and at the fastest delivery times possible.

The second point is that while there might be some hiccups in the improvement and productivity and cost improvements it identified earlier in the year, The incremental cost headwinds continue to be a focus of management as I expect that Amazon will come out of this with a much more efficient cost structure by 2023.

Lastly, AWS continues to be a leader in the industry and while customers may be tightening their budgets in the near term, the long-term demand for AWS remains.

Overview of 3Q22 results

In 3Q22, Amazon reported revenue growth of 19% excluding the effects of FX, coming in at $127 billion, which was slightly below consensus, while there was a 14% miss on operating income as it came in at $2.5 billion while the market was expecting around $2.9 billion.

Retail business shows weakness in Europe

In terms of the topline retail results, retail revenues in North America came in 2% higher than consensus with 20% year-on-year growth, to $79 billion. This was offset by weaker international revenues of $28 billion which was down 5% year on year. Excluding the effects of FX, the growth excluding the negative effects was 12% year-on-year growth. Online Stores, Physical Stores and third-party Sales, Subscription Services, and Advertising came in in-line with market expectations

There are signs of a weaker retail sentiment, especially in the international segments. Amazon saw weakness in Europe as a result of the war in Ukraine as well as elevated energy prices in the region.

That said, I continue to see that Prime member engagement remains solid. With the investments in Lord of the Rings: The Rings of Power and Thursday Night Football, Prime Video acts as an acquisition tool for Prime. With the Lord of the Rings series, it attracted more than 100 million viewers to date and has resulted in more people signing up for Prime than any other Amazon Video original. In addition, the NFL Thursday Night Football brought in 15 million viewers in the first broadcast and resulted in the three biggest hours of sign-ups for Prime in the history of the company. With more new Prime members in the ecosystem, this enables more members to buy more on the platform, including the e-commerce side of the business.

In addition, the Prime Day in July was the largest one in the company’s history with 300 million items purchased, adding 4% to the 3Q22 revenue growth rate. In addition, Amazon is well positioned for the holiday season as it has the widest selection on its platform with sufficient inventory levels ready for the holiday season. I would expect that Amazon is thus ready to deliver in the coming months as it aims to improve on its overall delivery times and meet the peak consumer demand.

AWS feeling some pressure on demand and margins

AWS revenue came in softer than expected, with a growth rate of 28% excluding the effects of FX and operating margins of 26.3%. The AWS revenue number missed market expectations by 4% and the operating margins declined by almost 400 basis points year on year. The AWS revenue growth of 28% also decelerated 5% compared to 2Q22’s revenue growth of 33%. Breaking down the 400-basis point decline in operating margins, half of it came as a result of higher energy costs, and the other half was attributed to higher investments as well as wage inflation.

On a brighter note, AWS commitments continue to grow at 57% year on year to $104 billion in 3Q22 and the weighted average remaining life of the contracts is currently at 3.9 years. This, in my view, signals continued healthy overall demand for AWS. I would note that while listening to Amazon’s 3Q22 earnings call, management’s commentary continues to point to a healthy new customer pipeline, which is in line with the relatively strong AWS commitments.

That said, the deceleration of 5% in AWS revenue growth was a result of a group of customers pulling back their budgets, especially those that are more for experimental reasons, given the worsening macroeconomic environment. I think that this is expected given the current economic climate and I think that investors will be watching closely at what AWS growth will look like in the coming quarters to look for any signs that the drivers of growth remain intact.

When comparing AWS to other players in the cloud sector, Google (GOOG) Cloud grew 38% year on year and Microsoft (MSFT) Azure grew at 42% year on year excluding FC impacts, with a guide for 37% growth rate in the fourth quarter for Microsoft Azure.

As I have also recently reviewed Microsoft’s recent quarterly results, it is worth noting that Microsoft also experienced margin erosion from the rising energy costs, which resulted in the company providing guidance that margins were expected to be down 100 basis points, compared to the initial flat margins expected for the current fiscal year. As a result, I think that the higher energy cost is certainly affecting all cloud players negatively in the near term.

In addition, it is worth noting that Amazon has more small and medium businesses in its customer mix for AWS compared to that of Microsoft Azure. As a result, I would have expected AWS to come in weaker than Microsoft Azure given that the weakening macroeconomic backdrop is likely going to affect the smaller businesses to a greater degree and result in them shrinking their wallet size in the near term.

With no end in sight for the war in Ukraine, the global energy crisis continues, I think we will continue to see elevated energy costs which will impact AWS operating margins in the near term. As management continues to drive efficiency improvements in the AWS business, there will be incremental benefits to the margin profile of the business as the energy costs begin to normalize. As a result, I think that the AWS business will take a few quarters to show improvement on the margin front as it is affected by macro factors. On the demand side, AWS continues to see healthy demand, but the softer 3Q22 AWS revenues have probably spooked investors. That said, I think that the numbers are decent given that the entire cloud industry saw deceleration and AWS has a larger proportion of small and medium businesses in its customer mix than the other two large cloud players.

Progress on productivity improvements

As management continues to work towards improving the cost structure of the company to reduce the incremental $6 billion cost headwinds that they identified earlier, they fell short of their goal of $1.5 billion cost improvements in the quarter. They managed to bring $1 billion in improvements in productivity in fulfillment and transportation, including optimizing the density of the route, and number of deliveries per hour, and also improving fixed cost leverage.

Capital expenditures for the year will be focused on the infrastructure for AWS rather than fulfillment as well as transportation services. In fact, there was a reduction of $10 billion for fulfillment and transportation investments compared to the prior year as management calibrates the building out of fulfillment and transportation infrastructure to match the demand for e-commerce.

With regards to how management will bring costs down in the future quarters, there were three levers that management highlighted, namely productivity, fixed cost leverage, and inflation.

With productivity, management has made good progress on this front, and this is where they will continue to make productivity improvements to drive cost efficiencies. That said, the fourth quarter looks challenging for productivity given the high operational requirements during the holiday season.

With fixed cost leverage, management has taken the necessary steps to streamline capital expenditures to what is really necessary for future improvement in the capabilities of the company and reduced spending in areas it thinks it has sufficient capabilities in the near term.

Lastly, with inflation, this is a factor that management cannot really control that might bring in a certain volatility and randomness to management’s cost control efforts.

Guidance

One of the big focus points for Amazon’s 3Q22 was the guidance for the next quarter. The 4Q22 revenue and operating income guidance came in at $144 billion for revenues at the midpoint compared to the market consensus of $155 billion in revenues, representing a 7% miss in the guidance for revenues. In addition, the operating income guidance for 4Q22 was at $2 billion in the midpoint, 60% below the market consensus of $5.1 billion. Lastly, on capital expenditures, the company expects to incur approximately similar levels as last year, at $60 billion for 2022.

The revenue guidance for 4Q22 took into account FX headwinds of 460 basis points. With the greater miss in operating income guidance, this was a greater disappointment for investors as management expects slower gains in productivity, higher costs for Prime Video, and one-time charges for closing some of its businesses in the quarter to affect operating margins in 4Q22.

Valuation

My 1-year target price for Amazon is based on an equal weight of the DCF methodology and the EV/EBITDA method. As Amazon has traded at around 19x EV/EBITDA over the last 10 years, I assume an EV/EBITDA multiple of 17x. In addition, for the DCF model, I assume a terminal multiple of 15x and a discount rate of 6%.

My 1-year price target for Amazon is $165, representing a 60% upside from current levels. I think that the current risk-reward perspective will reward investors with a long-term perspective as there is a positive skew to the risk/reward profile of Amazon at current levels. While there may be near-term challenges in the form of a weaker macroeconomic environment that may affect e-commerce as consumer sentiment weakens and cloud computing as businesses scale back on their budgets, my valuation does take into account the current weakness and has been de-risked, in my view. Amazon continues to be attractive as a leader in both AWS and e-commerce with a sticky Prime membership business model.

Risks

Weakening macroeconomic environment

If the global macroeconomic environment were to worsen materially, this would be one of the biggest impacts to the business. This is because the e-commerce and AWS businesses will face a slowdown given the weaker consumer sentiment and lower consumer demand, as well as poorer business conditions leading to smaller IT budgets. If a recession scenario were to materialize, my financial forecasts for Amazon will have to be revised downward accordingly.

Competitive pressures

While Amazon is a leader in the e-commerce and cloud space, it competes against large players like Microsoft Azure and Google Cloud in the cloud computing space, while in the e-commerce space, an increasing number of competitors are embracing e-commerce and players like Walmart (WMT) and eBay (EBAY) could innovate and compete meaningfully with Amazon.

Conclusion

While the 3Q22 results may paint a gloomy picture, I would accumulate Amazon shares if there were to be a pullback. For the retail business, I think that while the global macroeconomic environment is rather uncertain, one thing that is certain is that Amazon continues to attract and retain Prime membership users. As a result of the recent successes in Prime Video with the Lord of the Rings series and Thursday Night Football bringing in a record number of new members, I think that the recurring nature of the Prime membership will serve as a strong competitive advantage in uncertain times. For the AWS business, while some segments were relatively soft, overall demand remains healthy and margins could be weak in the near term due to the higher energy costs. Lastly, management remains focused on cost and productivity improvements to achieve its goal to remove this cost headwind and return to positive free cash flows in the near term. My 1-year price target for Amazon is $165, implying a 60% upside from current levels. I continue to see Amazon as an attractive risk/reward opportunity for contrarian investors willing to take a longer-term view of the company.