e-commerce giant amazon (Amazon -0.21%) Back in 2006, AWS launched the now ubiquitous Amazon Web Services. It took a while for the concept of cloud computing to really catch on, but today, AWS generates more than $20 billion in revenue every quarter.
Unlike Amazon’s core e-commerce business, AWS has extremely high profit margins. In the third quarter of 2022, AWS reported an operating margin of 26%.
The AWS and cloud infrastructure market has continued to grow over the past decade. Startups are defaulting to cloud computing, and enterprises are increasingly shifting workloads to the cloud. With roughly 34% market share, AWS is the default cloud provider for many businesses. In the long run, it seems likely that demand will continue to grow at a healthy rate.
However, AWS may now face its first major headwind since it became Amazon’s main profit engine.
canary in the coal mine
Amazon’s management has said AWS customers have become more concerned about their cloud computing bills amid tough economic conditions. Chief Financial Officer Brian Olsavsky said on the third-quarter earnings call in October: “…when I talk about enterprise customers in AWS, yes, we’ve been working with customers to lower their bills. . We do see some consumers cutting their budgets and trying to save money in the short term.”
Amazon reported a 27% year-over-year increase in AWS revenue in the third quarter, but Olsavsky said that growth had slowed to around 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 to AWS customers is the first sign of slowing growth in the all-important cloud business.The latest financial reports of memory chip manufacturers micron (mu -1.10%) Provides further evidence that a downturn in the cloud infrastructure industry is looming.
Micron makes DRAM and NAND memory chips. Although the company does not break out sales to data center customers, Micron has seen those customers hold back. “In the data center, we expect cloud memory demand growth in 2023 to be well below historical trends due to the significant impact of key customer inventory drawdowns,” CEO Sanjay Mehrotra said on the latest earnings call.
Given the size of AWS, one of the major customers mentioned is almost certainly AWS. Cloud infrastructure providers built memory chip inventories based on growth expectations, but those expectations proved too optimistic, and they are now slowing their expansion in response to weak demand growth. Micron thinks this will be an issue throughout 2023.
AWS profits could take a hit
Amazon’s cloud business is almost capital-intensive, and profitability depends entirely on utilization. All the servers, chips and networking equipment that fill Amazon’s data centers incur depreciation charges, whether they’re fully used or not. These fixed costs exist no matter how much revenue is generated.
During periods when Amazon can accurately predict future demand, it can adjust the expansion of its infrastructure to meet that demand and maintain high utilization. However, if companies overestimate future demand and build excess capacity, utilization rates can drop.
Amazon appears to be somewhat overbuilding its cloud business, based on Amazon’s statements about slowing spending by customers and Micron’s statements about sluggish memory chip sales to cloud providers throughout 2023. AWS’s operating margin fell about 4 percentage points year-over-year in the third quarter, suggesting the company is expanding too quickly.
Investors should brace for a deterioration in AWS’s profitability when Amazon reports its fourth-quarter results in a month or so. Disappointing results from AWS did little to help the stock recover amid massive losses in the retail business.
John Mackey, chief executive of Amazon subsidiary Whole Foods Market, sits on The Motley Fool’s board of directors. Timothy Green has no positions in any of the stocks mentioned above. The Motley Fool has a job at Amazon.com and recommends it. The Motley Fool has a disclosure policy.