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1 sign that Amazon's cloud business could be in trouble

techsm5

e-commerce giant Amazon (AMZN -0.21%) launched the now-ubiquitous Amazon Web Services in 2006. It took a while for the concept of cloud computing to catch on, but today AWS generates more than $20 billion in revenue every quarter.

And unlike Amazon’s core e-commerce business, AWS boasts sky-high profit margins. In the third quarter of 2022, AWS recorded 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 by default, and enterprises are increasingly moving their workloads to the cloud. AWS has captured around 34% of the market, becoming the default cloud provider for many companies. In the long term, it seems likely that demand will continue to grow at a healthy pace.

However, AWS may now face the first substantial headwind since becoming Amazon’s main profit engine.

Canary in the coal mine

Amazon management has previously indicated that AWS customers have started worrying a lot more about their cloud computing bills in a tough economic climate. Chief Financial Officer Brian Olsavsky said on the third quarter earnings call in October, “…when I’m talking about enterprise customers in AWS, yes, we’ve been working with customers to lower their bills. We’re seeing that some of the consumers 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 slowed to an average rate of 20% by the end of the quarter. For Amazon’s fourth quarter forecast, the company assumed that this average growth rate of 20% would continue.

Amazon’s warning about AWS customer behavior was the first indication that growth in the massive cloud business was slowing. The latest earnings report from the memory chip maker Micron (MU -1.10%) provides further evidence that a downturn in the cloud infrastructure industry is well on its way.

Micron manufactures DRAM and NAND memory chips. Although the company does not sell its sales to data center customers, Micron sees these customers opting out. “In data centers, we expect cloud memory demand in 2023 to grow well below the historical trend due to the significant impact of inventory reductions at major customers,” said CEO Sanjay Mehrotra. during the last call for results.

One of those key customers mentioned is almost certainly AWS, given its size. Cloud infrastructure providers have stockpiled memory chips based on growth expectations that have proven to be overly optimistic, and they are now slowing expansion to account for weaker demand growth. Micron thinks this will be a problem throughout 2023.

AWS Earnings Could Take a Hit

Amazon’s cloud business is about as capital intensive as it gets, and profitability comes down to usage. All of the servers, chips, and networking gear that populates Amazon’s data centers incurs depreciation expense, whether or not they’re fully utilized. These fixed costs are there regardless of the revenue generated.

During times when Amazon can accurately forecast future demand, it can scale its infrastructure expansion to meet that demand and maintain high utilization rates. But if the company overestimates future demand and builds excess capacity, utilization rates can drop.

Based on what Amazon said about slowing customer spending and what Micron said about declining memory chip sales to cloud providers throughout 2023, it seems likely that Amazon has oversized its cloud business to some extent. AWS’ operating margin fell about 4 percentage points year-over-year in the third quarter, suggesting the company grew too quickly.

When Amazon releases its fourth quarter results in about a month, investors should brace themselves for deteriorating AWS profitability. At a time when the retail side of the business is producing huge losses, disappointing results from AWS aren’t going to help the stock recover.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a board member of The Motley Fool. Timothy Green has no position in the stocks mentioned. The Motley Fool holds positions and recommends Amazon.com. The Motley Fool has a disclosure policy.

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