Amazon (NASDAQ:AMZN) has enjoyed quite a ride over the last few years. Once a Wall Street darling, the stock’s fall from grace has been dramatic. The stock is down 40% over the past year and was recently down more than 50% from its high, as shown below.
The stock’s return to 2018 levels is either a tremendous opportunity or a vast money pit.
How did we get here?
Amazon was a massive beneficiary of the pandemic – until it wasn’t.
The boom in online shopping and financial stimulus during the pandemic boosted sales and investor sentiment. Unfortunately, the pandemic had other repercussions.
Echoes of the pandemic
We saw several headwinds in 2021 and 2022, such as:
- bottlenecks at ports causing logistical headaches and increased costs;
- a tight labor market that necessitated signing bonuses and wage increases;
- inflation and rock-bottom consumer sentiment weighing on margins; and
- and a strong US dollar (DXY) which crushed international profits.
All told, these challenges added billions in costs and sent two of Amazon’s three segments into the red.
Amazon operates three segments, North America, which consists of retail sales and subscriptions; International, which includes the same for areas abroad; and Amazon Web Services (AWS) which consists of cloud services like infrastructure, platform, and software. Only AWS turned an operating profit through Q3 2022.
The company is struggling to regain its footing, but there are several reasons for optimism among long-term investors, including this one that should be discussed more.
Services sales blast off
When COVID-19 pushed people into online shopping, Amazon enjoyed a massive boost in sales. By the end of 2021, product sales grew 50% over 2019 to reach $242 billion. Meanwhile, AWS enjoyed a surge as businesses benefited from hefty economic stimulus. Service sales increased by 90% from 2019 to 2021, reaching $228 billion.
Over the trailing twelve months (TTMs) from Q3 2022, service sales have overtaken product sales for the first time ever, and this remarkable trend deserves attention.
Service sales include AWS, advertising, subscriptions (like Prime), and third-party seller services. Basically, everything other than online and physical stores. The rapid rise is shown below.
Why is this important?
Service sales are much more desirable than product sales because they are significantly more profitable. For example, the AWS segment has an operating margin of 30%, while the North America and International segments had combined operating margins of 3% and 1.5% during the high-flying years 2020 and 2021, respectively.
Discount retail sales aren’t the road to riches. Services are.
These revenues are more predictable and consistent as well. This is especially important to long-term investors since economic volatility is often felt in consumer spending first.
Look to Microsoft
Microsoft (MSFT) is a tremendous example of a company that went from licensing products to selling subscription services. When Microsoft’s CEO Satya Nadella took over, he transformed the business to a cloud-based software-as-a-service (SaaS) model, which includes subscriptions for Microsoft Office and other software, and, of course, Microsoft Azure (AWS’s most prominent competitor).
The proof is in the pudding, as Microsoft’s results have been fantastic. Profitability is terrific, and investors can count on consistent results. Below are Microsoft’s steady service-based margins juxtaposed with Amazon’s erratic results.
Microsoft and Amazon are two very different companies, and Amazon needs its product sales to drive its other businesses, like Prime and advertising. However, its move to increased reliance upon services will help smooth results and increase profitability.
Speaking of advertising…
While we are on the subject, Amazon’s digital ad business is a force.
Companies bid on Amazon’s pay-per-click services to get their product front and center on Amazon’s website. You will see them as “sponsored products” or “sponsored brands” when shopping. It’s a terrific way to increase sales among tough competition.
Businesses need to be smart with ad budgets, especially in this economy. This means targeting consumers who are ready to buy. Providers like Alphabet (GOOG)(GOOGL) and Amazon do just that. Whether on Google Search or Amazon, if someone searches for a “6 ft HDMI cord” like I recently did, chances are excellent that they are ready to buy right then. Advertisers will pay top dollar for these opportunities.
As shown below, Amazon’s advertising sales have nearly tripled since 2019, and there is massive potential for more.
Other initiatives, like “Buy with Prime,” are coming. Advertising services will be a huge part of Amazon’s long-term success.
Amazon’s cash flow problem
Free cash flow has been a challenge recently, as shown below.
The headwinds mentioned above are a problem, but only part of the story. Capital expenditures (CAPEX) have ballooned from $18.9 billion in 2019 to $40 billion in 2020 to nearly $66 billion over the TTMs.
Breakneck increases in retail and AWS sales required these physical and technical infrastructure investments. The bad news is that the need coincides with other headwinds.
The cash-flow woes also come at an inopportune time for investors. While companies like Google-parent Alphabet are buying back significant shares while the stock price is low, Amazon cannot take advantage of this.
The good news is that CAPEX is an investment in the future and should begin to decline on an absolute and percentage of sales basis. Look for free cash flow to trend higher in 2023.
Is Amazon stock a buy?
Amazon stock has been a lightning rod lately. And for a good reason. There are encouraging signs and warnings.
Logistical bottlenecks, rising labor costs, inflation, and the strong dollar are all dissipating. Unfortunately, AWS growth is slowing, a recession appears imminent, and consumer sentiment is low. There could be rough times ahead, but long-term investors can buy shares at prices not seen in years.
Getting ahead of the curve
If you’re going to be in this game for the long pull, which is the way to do it, you better be able to handle a 50% decline without fussing too much about it. – Charlie Munger.
…the secret to survival is knowin’ what to throw away, and knowing what to keep. – The Gambler, Kenny Rogers
In my last article, New Year, New Strategy? Actually, No; Here’s Why we saw how many of the best investments in the previous 20 years experienced steep dips and furious recoveries. The key is to own terrific companies, hold for the long haul, and add opportunistically.
If Amazon were a ship at sea, it would have been hit by a hurricane, cyclone, and whirlpool, then lurched into port only to find that a tsunami is heading right for it. But investors should be proactive, not reactive.
Amazon is the world’s leading cloud services provider, has more than 200 million Prime subscribers, a burgeoning ad business, and a stranglehold on the growing US online retail market. Long-term investors who can handle short-term volatility should consider accumulating Amazon stock at these distressed prices.