Having Flawless Execution in 2023 is Essential for Amazon

There is no doubt that Amazon shareholders are tired too, and are ready for a return to better times, as we all are (we know we are). In order to answer this question, let's look at what life would look like back then. In what ways do they differ from the past? Throughout this article, we explore what we think the company needs to do to turn the ship in a year that is likely to bring more pain for tech and growth companies.

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Revenue Is Not The Problem

First of all, let's start from the top. Since its inception, The Everything Store has had no trouble generating revenue over the years, with the company's Q4 of 2022 being one of its best quarters on record.

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Amazon's revenue chart, to that point, looked like a steady upward-and-to-the-right stairway, with a steady increase on the right as well. Similarly to most retailers, Amazon also suffers from some seasonality when it comes to its e-commerce business with sales typically increase in the holiday-packed third quarter.

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It has always been the company's inability to generate profit that has been the problem, as it were. Long-term bulls will point out that this is a deliberate decision on their part. Amazon, they say, could always be profitable at some point in the future, but instead, the company's leadership prefers to plow profits straight back into the business so that it can grow even further.

Amazon has also been able to rely on its resident cash cow, Amazon Web Services (AWS), to cover any shortfalls in the e-commerce business that may arise from time to time.

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Despite the fact that the story of Amazon's inflection point has held up for many years, we believe it is about to change. The interest rates are rising, a recession appears imminent, and we believe that Amazon's strategy will need to change in the coming years. There is a big question that needs to be answered: can Amazon simply flip the switch to profit mode and switch itself back on?

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Operating Margins Suffering

Considering that Amazon doesn't require any assistance with generating revenue, it's imperative that we focus on costs instead. There were not many bright spots for investors in the holiday-filled Q4 due to the holiday season. As an example, take a look at this snapshot from the Q4 earnings announcement:

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In summary, we must conclude that in Amazon’s e-commerce business during the busiest quarter of the year–the quarter in which shoppers are supposed to spend money hand over fist, and in which Amazon has posted record-breaking revenues–Amazon has lost money. In terms of operating income, most of the company's income is supplied by Amazon Web Services, which is also experiencing a number of issues of its own.

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This is a very disheartening situation for investors. The situation is made more alarming when we consider that Amazon's e-commerce business has a negative working capital model, which is, in theory, supposed to provide a little bit of structural rocket fuel to the organization.

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Amazon's customers pay most of their purchases at the time of purchase (every time you make a purchase on Amazon.com), whereas Amazon has credit terms with its suppliers in order to pay them. This results in the company always being able to bring in cash before it is due to pay its bills. Amazon has likely not even posted a majority of the cost of goods sold expense for all the sales it made in Q4, which makes the operating loss that much more painful-Amazon has also suffered a loss in its e-commerce business last quarter (Amazon also suffered a loss in its e-commerce business last quarter).

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Turning The Ship

There is no doubt that everything described above seems to have been the business-as-usual mindset at Amazon for quite some time–invest in growth at all costs, and losses today are acceptable if we can generate free cash flow in the future.

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In an era of rising interest rates, this is going to be all the more important in the coming years. There is little doubt that Amazon has been more adept at leveraging growth against low-interest-rate debt than almost any other company in the world.

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Although Amazon's leverage levels have remained relatively constant over the years, its overall debt has grown considerably.

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With time, this debt will become more and more expensive to service, and it will become more and more difficult to raise new debt. In the near future, this is likely to squeeze margins and force us to make a decision about how to deal with the situation.

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Another issue that has been on our radar is Amazon's declining return on capital [ROC], which has been causing us a lot of concern. In fact, the followers of our blog will know that we place a high emphasis on this metric, as we believe that in order for companies to generate long-term returns for shareholders, they need to consistently generate a return on capital that exceeds their cost of capital.

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Currently, Standard & Poor rates Amazon's debt as AA by Standard & Poor's, and the current options-adjusted spread on AA corporate debt is 71 basis points. We can conservatively estimate that Amazon's current cost of capital is 8.5%, which is in line with the WSJ prime rate, which currently sits at 7.75%. Over the long term, earning a 2.3% yield on invested capital will simply not be sufficient if you want to succeed.

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Therefore, we ask...

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Will the Growth Continue?

As we look back upon Amazon's longstanding bull argument, let us take a moment to consider how it could essentially turn profitable at any time, and that its narrow margins and minimal profits are a strategic decision on Amazon's part. Amazon is a company that is focused on growth at all costs, as we have mentioned before. On the fourth quarter call, Amazon's CEO Andy Jassy provided analysts with some perspective regarding Amazon's growth in the past as he elaborated on: 

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AS I ADDRESSED DIRECTLY THE NORTH AMERICAN STORES QUESTIONS, I THINK OUR — PROBABLY THE #1 PRIORITY THAT I SPENT TIME WITH THE TEAM ON IS REDUCING OUR COST TO SERVE IN OUR OPERATIONS NETWORK… IT’S IMPORTANT TO REMEMBER THAT OVER THE LAST FEW YEARS, WE’VE — WE TOOK A FULFILLMENT CENTER FOOTPRINT THAT WE’VE BUILT OVER 25 YEARS AND DOUBLED IT IN JUST A COUPLE OF YEARS. AND THEN WE, AT THE SAME TIME, BUILT OUT A TRANSPORTATION NETWORK FOR THE LAST MILE ROUGHLY THE SIZE OF UPS IN A COUPLE OF YEARS. AND SO WHEN YOU DO BOTH OF THOSE THINGS TO MEET THE HUGE SURGE IN DEMAND, YOU’RE GOING TO — JUST TO GET THOSE FUNCTIONAL, IT TOOK EVERYTHING WE HAD. AND SO THERE’S A LOT TO FIGURE OUT HOW TO OPTIMIZE AND HOW TO MAKE IT MORE EFFICIENT AND MORE PRODUCTIVE.

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This is a complicated topic that needs to be unpacked in its entirety. As a quick aside, I think it's good to hear Jassy talk about the elephant in the room, which is cost. What raises our antennae, however, is his comment at the end of the article. Considering that Amazon admits that there is a lot to do in terms of figuring out how to optimize the fulfillment network that the company has built over the years, it tells us that the company may have gotten ahead of its skis in terms of cost and manageability as far as the fulfillment network is concerned.

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The fact that there will be a lot of work involved, and that Amazon will not be able to switch instantly from 'profit mode' to 'revenue mode', is also something that seems to us to be a fairly clear admission.

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The Bottom Line

In order for Amazon's stock to have a successful year in 2023, it must impress investors. The following are the things that we look forward to seeing from the company going forward. With AWS headwinds expected to persist for at least the next few quarters, we believe that it is time for the other businesses to step up and shine as a result.

1. Reduced costs and increased margins for the North American e-commerce business (plus free cash flow, to boot).
2. Efforts should be made to rationalize some of the losses in the International segment, where losses seem to be the norm rather than the exception.
3. RxPass has been successfully launched, and we expect that the amount of household Prime sharing will decrease as this feature rolls out, which we discussed in our story about RxPass (you can read our story here).

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Our disclosure: We are long Amazon, but we are concerned about how well the company will be able to execute in what is arguably its most challenging environment since the dot-com crash.