Like many high-growth technology stocks, Amazon.com (NASDAQ: AMZN) has sold off hard in 2022, but it bounced back a bit prior to its recent stock split. Investors without access to fractional share purchases have had the chance to buy Amazon shares at a lower price for a week now, so it’s time for shareholders old and new to refocus on the company’s fundamentals.
While Amazon Web Services is booming, Amazon’s retail business is struggling. Free cash flow has gone negative, but management has also begun repurchasing stock. Amid all these cross-winds, here are the main issues investors should monitor for the rest of the year.
“Still have work ahead of us” in the retail business
The big reason Amazon sold off so much this year is the retail business. After it aggressively built out capacity during COVID-19, demand has slowed as things reopened. Since the capacity build operates with a lag, Amazon has actually overbuilt in the near term.
Complicating matters, Amazon’s head of worldwide retail, David Clark, just announced he would be leaving the company. That adds another layer of uncertainty to the mix, and it’s also an open question as to whether Clark left on his own, or if he was forced out due to recent problems. Of note: Clark just became CEO of logistics start-up Flexport. In the blog post announcing Clark’s retirement, CEO Andy Jassy admitted: “We still have more work in front of us to get to where we ultimately want to be in our Consumer business.”
Amazon noted too much capacity, too much hiring, and high fuel prices as contributing about a $6 billion headwind last quarter, with each component accounting for about $2 billion each. $4 billion of these added costs should stick around this quarter, as the company will need to grow more to fill its capacity, and fuel prices have remained high.
Things to watch in the second half: Productivity, capacity, shipping
First, I’d expect to see progress on the labor front this earnings report. Amazon has the ability to slow or freeze hiring, so investors should assess profitability and the company’s headcount, which it discloses. This was the most “fixable” of Amazon’s problems.
For the over-capacity, investors may not see any improvement until the second half. That’s because Amazon needs to grow into its capacity, and Prime Day moved from the second quarter last year to the third quarter this year. So, revenue may not grow sufficiently to fill its capacity until Prime Day and then the holiday buying season. Look out for management’s forward guidance and commentary on this front on its next earnings call.
In the meantime, the Wall Street Journal recently reported Amazon is looking to sub-lease space to other tenants in the distribution centers and warehouses. Amazon is reportedly looking to sublet about 10 million square feet of space, with the potential to do more. That 10 million square feet would account for about 2% of Amazon’s total owned and leased square footage at the end of 2021.
Finally, investors should keep an eye on shipping costs. Last quarter, worldwide shipping costs were up 14% even though paid units shipped were flat at 0%. Typically, Amazon has higher shipping costs than paid units, as it monetizes its units in various ways, such as Prime subscriptions and advertising; therefore, investors should see if the spread between costs and units sold widens or narrows. Unfortunately, with fuel prices on the rise, shipping costs could remain high.
Is AWS margin expansion for real?
Turning to Amazon Web Services, last quarter, there was a big step-up in AWS operating margins, which rose from 29.8% to 35.3% quarter-to-quarter. This was largely due to an extension of the useful life of its servers. Investors should also monitor whether AWS is able to maintain these higher margins, or if there is some mean-reversion.
If the new higher operating margin proves to be the new baseline, that could help Amazon’s stock as a whole. That’s because AWS is probably the most valuable part of Amazon, as its most profitable business. AWS made $67 billion in revenue over the past 12 months while growing in the mid-30% range. It seems set to grow for years, perhaps into the multiple hundreds of billions, so a 5% expansion in its eventual operating margin could mean big things for Amazon’s intrinsic value.
It all comes down to profits
Amazon has long gotten a pass from investors in terms of showing current profits for much of its corporate life, but since 2018, Amazon’s profits have taken off. Investors may now be expecting more consistent profitability year in and year out, especially as interest rates have risen. Thus, after the pandemic boom, they haven’t taken very kindly to recent year-over-year declines in operating profit, even as revenue has grown.
The main question across all of these factors is: Will Amazon be able to control costs in an inflationary environment? And where will its operating margins ultimately end up?
Amazon is a large and complex business, so all the aforementioned factors will need to be examined to get the full picture heading into the second half.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Billy Duberstein has positions in Amazon. His clients may own shares of the companies mentioned. The Motley Fool has positions in and recommends Amazon. The Motley Fool has a disclosure policy.