The e-commerce giant Amazon (AMZN -0.21%) launched the now ubiquitous Amazon Web Service in 2006. It took a while for the concept of cloud computing to really catch on, but today, AWS is generating over $20 billion in revenue every quarter.
And unlike Amazon’s core e-commerce business, AWS sports very high profit margins. In the third quarter of 2022, AWS reported an operating margin of 26%.
Growth has been relentless for AWS and the cloud infrastructure market over the past decade. Startups are choosing cloud computing as their default, and enterprises are increasingly moving workloads to the cloud. AWS has grabbed around 34% of the market, becoming the cloud provider of choice for many businesses. In the long run, it looks like demand will continue to grow at a healthy pace.
However, AWS may now be facing its first major headwind since emerging as the main profit engine for Amazon.
The canary in the coal mine
Amazon management has already indicated that AWS customers were starting to care a lot more about their cloud computing bills amid a tough economic climate. CFO Brian Olsavsky said during the third quarter earnings call in October: “…when I talk about enterprise customers on AWS, yes, we’ve worked with customers to lower their bills. We see that some of the customers are cutting their budgets and trying to save money in the short term.”
Amazon reported 27% year-over-year revenue growth for AWS in the third quarter, but Olsavsky said growth had slowed to an average rate of 20% by the end of the quarter. For Amazon’s fourth-quarter guidance, the company assumed this 20% growth rate would continue.
Amazon’s warning about the behavior of AWS customers was the first indication that growth for the all-important cloud business was slowing. The latest earnings report from the memory chip maker Micron (MU -1.10%) provides further evidence that a downturn for the cloud infrastructure industry is well on its way.
Micron manufactures DRAM and NAND memory chips. Although the company doesn’t sell to data center customers, Micron is seeing those customers pull away. “In the data center, we expect cloud storage demand in 2023 to grow well below the historical trend due to the significant impact of inventory reductions at key customers,” CEO Sanjay Mehrotra said in the recent earnings call.
One of those key customers mentioned is almost certainly AWS, given its size. Cloud infrastructure providers built memory chip inventories based on growth expectations that turned out to be overly optimistic, and now they are slowing expansion to account for weakening demand growth. Micron believes this will be a problem throughout 2023.
AWS profits could take a hit
Amazon’s cloud business is about as capital-intensive as it gets, and profitability is all about usage. All the servers, chips, and network equipment that fill Amazon’s data centers incur depreciation expenses, regardless of whether they are being fully utilized. Those fixed costs are there regardless of how much revenue is generated.
When Amazon can accurately predict future demand, it can adjust its infrastructure expansion to meet that demand and keep usage rates high. But if the company overestimates future demand and builds excess capacity, the utilization rate can decrease.
Based on what Amazon has said about customers slowing spending and what Micron has said about depressed sales of memory chips to cloud providers through 2023, it appears that Amazon has overbuilt its cloud business to some extent. Operating margin for AWS decreased about 4 percentage points year-over-year in the third quarter, suggesting the company expanded too quickly.
When Amazon reports its fourth-quarter results in a month or so, investors should brace for a deterioration in AWS profitability. At a time when the retail side of the business is producing giant losses, disappointing results from AWS won’t help the stock recover.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon.com. The Motley Fool has a disclosure policy.
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