Noah Berger
Amazon’s stock (NASDAQ:AMZN) has lost more than 30% of its market value this year. Investor confidence in the stock has been weak since Amazon’s core commerce business took a sharp turn from the pandemic-era boom to underutilization earlier in the year. The inefficiencies had left Amazon in a scramble for aggressive cost-cutting opportunities – spanning abandoned capacity expansion to swift shutdowns of unprofitable projects. And now a looming economic downturn risks spurring further consumer weakness ahead, casting a shadow over any possibilities for a rapid recovery in its core commerce business within the near term. This is further corroborated by management’s conservative view on prospects in the current quarter, projecting 2% to 8% revenue growth inclusive of FX headwinds, despite cautious market optimism for a seasonality-driven boost in the current quarter.
Meanwhile, AWS has largely been the backbone of any bullish thesis supporting the stock this year, making up for the core commerce moat’s shortfall as a result of both earlier mismanagement on capacity and utilization, and impacts of the unexpected economic downturn that has come down hard and fast. Yet, the AWS cloud that has largely shielded Amazon from a greater selloff is showing signs of dissipation. While AWS take-rates in the third quarter remained resilient, with cloud spending amongst the IT environment still viewed as critical to stay economically and operationally competitive, there are growing signs of market share erosion – which has long been expected given the massive magnitude of the segment and long streak of double-digit growth that appears to be falling behind that of peers. While Wall Street as long been unanimously bullish on Amazon, we believe that link is starting to weaken, especially as AWS’ impressive growth streak is starting to show early signs of moderation.
Amazon’s stock currently trades at a whopping 70x forward earnings, while the large-cap peer group trades at an average of about 28x. However, it is important to consider that the company’s margins have been battered this year due to non-cyclical factors (e.g., utilization mismanagement), which has contributed to a significant diversion between its earnings and sales valuation multiples. By taking Amazon’s sales multiples (e.g., forward EV/sales and forward price/sales) as a gauge for its market value relative to peers instead, which makes a better reflection of its normalized business performance relative to peers’, the stock remains undervalued, supporting longer-term upside potential.
However, given Amazon’s dissipating cloud strength, and ongoing consumer weakness that will continue to put pressure on its core commerce business within the near term, the stock will likely be subject to greater vulnerability to volatile market sentiment over coming months until the macro-overhang subsides. This is especially true given investors’ increasing preference for profitability under the current market climate – meaning that while core commerce’s profit margin improvement in the third quarter is welcomed, it will need to ratchet up further at a sustained pace to keep up with anticipated deceleration in AWS, and alleviate the latter’s burden of having to carry Amazon’s consolidated valuation prospects.
Is AWS At Risk?
AWS is currently the leading public cloud service vendor, accounting for about a third of the global market share. It also continues to lead its key rivals, namely Microsoft’s Azure (MSFT) and Alphabet’s Google Cloud Platform (GOOG / GOOGL), by wide margins. Specifically, Azure is a distant second, commanding about 20% of the global cloud market, and GCP about 10% in third place.
AWS has been a key driver of Amazon’s valuation given its impressive growth and margin expansion trajectory, acting as a key “barometer” of the company’s future prospects – especially in recent quarters, compensating for the growth slowdown and deteriorating profit margins in the core commerce segment. Despite Amazon’s likely conservative outlook for AWS implied through modest consolidated growth for the current quarter – which we view as a welcomed and reasonable move to temper investors’ expectations given the business’ massive size, and consistent with Azure’s modest guidance earlier this week. It is important to recognize that cloud spending remains resilient given “secular shift and prioritization for corporates”.
Yet, after sustaining more than six quarters of consecutive 30%-plus y/y growth, the segment is starting to show signs of structural deceleration, with third quarter growth coming in at 28% on a constant currency basis compared to the same period last year – an imminent occurrence given its massive magnitude of growth and business volume achieved in recent years. AWS’ multi-year compounded annual growth rate in the past five years has moderated to about 26%, while Azure’s is at the 40%-range and GCP at the high-30%-range.
And while AWS remains the unmatched market leader by wide margins, the gap is gradually narrowing. Specifically, recent third-party data shows that spending intentions for Azure and GCP are on the rise, as corporates turn to a multi-cloud strategy for benefits that include “risk mitigation, reliability/redundancy, multi-function availability, and mostly importantly, cost-efficiencies”.
Given AWS is already the dominant public cloud service vendor on the market, it is hard for it to take further advantage of increasing multi-cloud momentum. In a recent sentiment check survey performed by RBC Capital Markets, about 57% of corporates looking to ramp up investments in cloud have noted AWS as a potential beneficiary over the next 12 months, compared with 73% for GCP and 71% for Azure. AWS is also starting to lose share to key rival Azure amongst large enterprise cloud spending – the latter has taken over AWS as the leading public cloud service provider for enterprises generating more than $5 billion in annual revenues, acquiring more than 50% share in the cohort while AWS only captures a little more than 30%. And while AWS remains the market share leader in the largest cloud spending segments – namely, medium-sized enterprises with annual revenues spanning $1 billion and $5 billion, and small enterprises with annual revenues of less than $1 billion – rivals Azure and GCP are catching up fast. AWS currently commands about 60% of global cloud market share across medium-sized enterprises, while Azure accounts for more than 40%; and across small enterprises, AWS commands about a 40% share while Azure and GCP account for 30%.
Implications of a Potential AWS Slowdown
What these trends, paired with tempered expectations from management’s forward guidance provided, imply is that AWS is likely headed towards the beginning of moderation, with its high-flying growth coming to a gradual deceleration as it continues to take advantage of secular demand for cloud-computing solutions over coming years. Meanwhile, the rapid growth it once enjoyed will now likely rotate to peers as they benefit from the increasing adoption of a multi-cloud strategy across the corporate sector, effectively narrowing their respective market shares’ distance from AWS’.
With AWS being Amazon’s core profit engine, the increasing pace of moderation will likely bode unfavourably for the stock’s near-term performance – especially as its core commerce segment also reels from souring consumer sentiment ahead of a cyclical downturn. This means whatever Amazon is doing now to improve its core commerce’s growth and profit margins – whether it is slashing budgets for non-profitable projects, dialing down the pace of fulfilment capacity expansion, slowing the pace of hiring, and/or improved value proposition to drive increased Prime demand – needs step it up a notch further, as AWS’ strength may not overshadow core commerce’s near-term weakness much longer to uphold Amazon’s valuation prospects.
Looking ahead, these trends may also push investors to look for new areas of growth and profitability in the company – especially advertising, which represents another secular demand environment as digital ad formats rapidly displace traditional channels like linear TV, radio and paper. As discussed in our previous coverage on the stock, Amazon’s advertising business benefits greatly from its first-party data advantage, which reduces reliance on third-party user data that now faces “signal [loss] dynamics” stemming from Apple’s (AAPL) privacy policy changes implemented last year. The value of this competitive advantage is further corroborated by resilience and momentum demonstrated in Amazon’s advertising business (+30% y/y; +9% q/q) in the third quarter despite cautions advertiser spending ahead of a looming economic slowdown, which reinforces robust forward prospects. Recent market research has also echoed similarly favourable trends for Amazon’s growing advertising business, a high-margin revenue stream that will continue to contribute positively to the company’s bottom-line over the longer-term:
Retail media advertising will increase from $31 billion this year to $42 billion in 2023. The bulk of it comes from Amazon’s product search but all other large retailers are now developing advertising sales through keyword search or display ads on their apps and websites. Retail media is mostly fuelled by consumer brands reallocating below-the-line, trade-marketing budgets from in-store towards digital retail networks, as a greater percentage of retail sales comes from e-commerce. Furthermore, retail-owned media networks are mostly immune from the privacy-based limitations on data usage and targeting, that display or social media owner’s face, because they can leverage their own first-party data.
Source: Magna Advertising Forecast, U.S. Fall Update (September 2022)
Final Thoughts
We remain optimistic that Amazon will be able to maintain and restore strength to its core commerce moat, though the undertaking may take longer-than-expected given near-term macro headwinds beyond the company’s control. In the meantime, AWS will continue to be the core saviour of Amazon’s valuation. But considering it may not be able to hold onto the role much longer ahead of imminent deceleration, Amazon’s stock might become more susceptible to further downtrends in tandem with the souring near-term market outlook. In the near- to medium-term, we believe investor expectations for core commerce improvements will increase despite anticipated consumer weakness to make up for potential deceleration in AWS, with more focus diverted towards momentum in Amazon’s ad sales, an emerging core profit engine. For now, Amazon’s stock will likely become less protected from increasingly fragile market sentiment over coming months as expectations adjust, which could potentially create better entry opportunities for eventual upsides once consumer headwinds subside.
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