Weaker AWS Margins Will Drag Amazon Profitability

  • Operating margins could struggle in the upcoming quarter.
  • This is due to AWS as the foreign exchange impact will become a headwind to earnings.
  • Furthermore, Capex will likely re-accelerate in FY'16, which reasserts that Amazon is in an investment phase.

Analysts/investors are getting more concerned with Amazon's (NASDAQ:AMZN) operating margins given the company’s prior earnings miss. The situation may soon normalize, but given the company’s patchy track record of operating profits, investors should be more conservative on Amazon’s consolidated operating margins despite potential for margin uptick in the current quarter.

Amazon is still expanding, and it plans to rapidly expand its retail presence in India, which will require enormous front-end investment given infrastructure limitations and rapid adoption of smartphones. In India, Amazon has a 15% market share of the online commerce marketplace, and it’s anticipated that its fulfillment capacity will rapidly scale to match the growth of the market. Furthermore, FBA (Fulfillment by Amazon) is also suffering due to capacity limitations, which led to cost deleveraging given the lack of capacity investments in prior years. Amazon will be building 1.8 million sq. ft. of fulfillment space in Kansas and California, which will cost appx. $200 million given prior construction comparisons. The added footprint should capture some of the incremental demand for FBA by retailers as FBA grew by 70% y/y according to Deutsche Bank. Last time I checked, Amazon’s Capex declined from $4.9 billion to $4.6 billion between FY’14 and FY’15, so I do anticipate some re-acceleration to Capex, but at a less aggressive pace than sales growth.

Furthermore, Amazon is offering incentives for retailers to clear up some of the inventory at Amazon’s fulfillment centers. The incremental capacity build out combined with the reduction of non-performing inventory should net out to some margin recapture. Furthermore, the capacity should stabilize in Q1’16 as Q4’15 (every Q4 in general) tends to have the highest capacity utilization, which reduced operating efficiency in that specific quarter. As such, I can see recovery of margins despite concentrated investment into fulfillment centers for 3rd party retailers. The growth of the segment is off of a relatively high base, but the cost of fulfillment centers is relatively nominal on a per square foot basis when compared to datacenters. Furthermore, the incremental revenue from FBA isn’t broken out separately, so it’s hard to determine to what extent it impacted gross margins.

The weakness in gross margin was driven by FBA, according to Amazon:

I'll point out that the demand for FBA services was very high, nearly 50% of our third party units, again, were FBA. And the demand for space and services was very large by our seller base, which was great from a lot of standpoints, but did exceed our expectations. But did make our warehouses rather full and did cause us to incur some additional variable costs in the US.

Prior to Q4’15, investors thought Amazon was signaling an improvement in cost-leveraging due to massive economies of scale. Instead, the lack of investment in fulfillment caught up with Amazon, which indicates that Amazon will need to re-capture the lost Capex by investing even more in the current fiscal year. While I’m fairly confident that the incremental investment won’t be so significant as the prior phase where they had invested $13.9 billion from 2010 to 2013, it’s worth noting that Capex will tick higher throughout the year.

Following a 36% EPS miss in Q4’15. I believe analysts are starting to get more conservative on forecasts. This reduces expectation risk, which diminishes the possibility of an earnings miss in the upcoming quarter. However, the broad implications of foreign exchange aren't captured in every analyst model, so please keep this in mind.

4-9-16 AMZN pic 1

Source: Deutsche Bank

As it currently stands, AWS operating margins are expected to drop a little going into Q1’16. This typically happens following a pricing reduction. However, as capacity utilization increases, datacenter components are updated to next-generation Intel chips, so the cost synergies then tend to offset the decline in pricing because the TCO (total cost of ownership) advantage is more back-half weighted when building data center capacity. Since AWS remains Amazon’s biggest profit center the drop-off in profitability could turn into a headwind. Furthermore, we have to take into consideration the currency headwinds. I know, I’m stating headwinds rather than tailwinds coming out of a quarter where the dollar weakened across the board.

However, the weakness in upcoming earnings is mostly driven by Amazon’s billing of AWS in US dollars. So, the translation effect doesn’t actually occur the way you would imagine it. Instead, Amazon does pricing recapture to avoid the impact of negative currency headwinds. But on the flip side, Amazon’s billing of services gets negatively affected whenever the dollar weakens because Amazon doesn’t recapture the pricing in the opposite direction. So, whenever the dollar gets expensive the pricing is reflected in terms of foreign currencies at the dollar adjusted rate, which boosts the usage billing. But, when the dollar declines, Amazon’s inflated pricing gets reversed, and so it gets cheaper to purchase the same amount of storage/computing resources, which is why the impact from currencies puts pressure on Q1’16 earnings/sales figures.

As such, investors should be a little more cautious, because I haven’t received any other model revisions for currency with the exception of Deutsche Bank’s for the upcoming quarter. However, the consensus seems to have already modeled a modest decline in margins due to the reduction in pricing. So, some of the risks could be captured but for partially the wrong reasons? In either case, the negative currency headwinds from AWS gets offset by the positive currency impact from the retail component. Therefore, the real source of concern isn’t the revenue figure, but rather the bottom line results for Q1'16 as retail will likely outperform in the next quarter.

I continue to reiterate my buy recommendation, but investors may need to wait on the sidelines to see how the dust settles following the upcoming report.

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