Amazon: Profit Growth Driven by Cost-Cutting, Not AI-Increased Revenue (Valuation Downgrade)

Investment Thesis

of Amazon (NASDAQ: AMZN) stock hit an all-time high last week, buoyed by optimism over the rise of artificial intelligence. In my previous analysis, I upgraded the stock from hold to buy in August 2023, driven by a cheap valuation and possible return to retail sales and cost management. Since then, the stock is up 37%, beating the S&P 500’s 21.5%. However, given the recent expansion in valuation multiples, I believe this AI hype is a bit premature. The company’s main growth driver is still its retail business. While the recent increase in capital investment in AWS infrastructures will drive its long-term growth trajectory for its cloud segment, I do not believe that AWS can significantly move the needle to improve its top-line growth in the near term.

The over 200% improvement in revenue over the previous year was not primarily from revenue growth, but from operational efficiency due to mass layoffs and cuts in marketing spending. Therefore, I downgrade the stock to hold from buy as the current risk pricing is becoming less attractive, especially given potential cyclical weakness in consumer spending, which could create headwinds for its retail business and advertising.

Still more than 80% of revenue comes from retail

Many people are discussing how GenAI will improve the growth trajectory of AWS and its advertising business. According to the Bloomberg article, AMZN hit a $2 trillion market cap last week, largely due to its AI optimism. However, we have yet to see a strong return to growth in its total revenue. We know that AMZN’s net retail sales (82.5% of its total revenue) remain on a low-teens growth trajectory. In particular, its sales in Online Stores maintain high single-digit growth. The company is strategically prioritizing the high-growth cloud business related to AI technology, as its online store revenue mix decreased from 49% in the first quarter of 2021 to 38.1% in the first quarter of 2024. Meanwhile, AWS’s revenue mix has grown, reaching nearly 20% of total revenue in the last quarter. Despite this change, the company still relies heavily on retail sales to maintain its growth trajectory. As shown in the chart above, total retail sales growth has re-accelerated since the first quarter of FY2023, supporting my previous bullish view on the stock over the past few months.

Although Q1 FY2024 total revenue beat estimates, the pace of growth slowed slightly QoQ. Furthermore, the company is expected to see a continued QoQ slowdown in Q2 FY2024, based on its growth outlook of 7% to 11%, which is below market consensus. Management on the earnings call attributed this to a headwind of about 60 bps from the impact of FX. Therefore, we may see slower retail sales growth in the upcoming earnings report compared to Q2 FY2023, justifying my cautious view as the stock hit an all-time high.

Profit growth boosted by layoffs and marketing cuts

The company’s bottom line has improved significantly over the past few quarters. Let’s focus on the green columns in the chart, we see that similar margin levels in Q1 FY2021 and Q1 FY2024. I believe the main difference between these two periods is that the high EBITDA margin in Q1 FY2021 was driven by strong revenue growth, while the margin in Q1 FY2024 was due to reduced operating expenses.

We saw that AMZN’s total revenue growth in Q1 FY2021 was 45.7% YoY, while in Q1 2024, it was only 11.6% YoY. I think that achieving strong earnings growth while cutting general and administrative and marketing expenses is unsustainable in the long term. The negative annual growth trend in these expenditures since the third quarter of FY2023, as shown by the blue and red lines above, further supports this.

According to another Bloomberg article, AMZN is cutting hundreds of jobs, including 27,000 corporate roles, as part of a cost-management plan following a pandemic-era hiring boom. Therefore, I am skeptical that further stock growth from here will be driven primarily by cost cuts. Management also implied a GAAP EBIT margin of 8.2% in Q2 FY2024, down from 10.7% seen in Q1 2024. However, could the AI ​​boom structurally shape the company’s overall growth outlook? Let’s check out his cloud computing business.

Growth Drivers: AWS and Advertising Business

AWS’s revenue mix has expanded steadily over the past few years, from 12.4% of total revenue in Q1 FY2021 to 17.5% in Q1 FY2024. However, a significant rebound in growth due to the current AI frenzy is yet to be seen. However, it is encouraging to see AWS’ GAAP EBIT margin reach an all-time high of 37.6%. While job cuts in the Cloud computing division may have contributed to this improvement, management explained that this was mainly due to infrastructure management and fixed costs.

Meanwhile, advertising revenue continues to maintain over 20% annual growth in the last quarter. Management attributed this strength to sponsored products and continued improvements in connectivity and measurement capabilities for advertisers. However, the advertising business segment currently accounts for only 7.5% of total revenue, which is not very significant.

Significant capital investments in FY2024

During the earnings call, management indicated a significant increase in capital spending on a year-over-year basis in FY2024, driven primarily by higher infrastructure capital to support growth in AWS, including generative AI. They define capital investment as the combination of capital plus equipment finance lease. Looking at the chart above, we note that this ratio is below the average of the last three years, but has started to increase in the first quarter of FY2024. I believe AMZN is making the right move by increasing capital investment to support the AWS infrastructure, especially in the generative AI efforts. Unlike other software companies like Microsoft ( MSFT ), AWS takes time to become a major driver of growth in its top-line revenue growth.

ASSESSMENT

I upgraded the stock to buy in August 2023 as AMZN’s valuation multiple was cheap amid a possible return to growth in its core retail business. The stock currently trades at 3.5x EV/Sales TTM, which is roughly in line with its 5-year average of 3.46x. Meanwhile, according to the Seeking Alpha consensus, AMZN is expected to generate non-GAAP EPS of $5.74, implying 33.6 times FY2024 non-GAAP P/E. This multiple is also in line with the Nasdaq 100 index. Therefore, I think the stock is not trading at a premium and currently fair value.

CONCLUSION

In conclusion, while AMZN stock rose to an all-time high driven by market optimism around its cloud AI business, the company’s main driver of growth remains its retail sales. Despite AWS’s strong growth potential, the segment has yet to contribute significantly to its top-line growth. Furthermore, the recent improvement in revenues has been largely due to cost-cutting measures rather than revenue growth, raising sustainability concerns. With possible cyclical weakness in consumer spending and a moderate growth outlook, the current valuation appears in line with my expectations. Consequently, I am downgrading the stock from buy to hold, given the less attractive risk-reward profile at this time.