The scent from year 2000 is in the air. The Nasdaq is trading above 5000, climbing to record highs on internet companies reporting earnings that have come in better than analyst expectations. That’s what markets believe, anyway. Similar to 15 years ago, not many people want to be the party poopers. I’m here to tell you earnings aren’t all that headlines are making them. Sure, growth stories like Amazon and Google have revolutionized the way we live, but these companies are also being valued as if the future growth will be executed perfectly. At current multiples, investors are not pricing in the risks.
Amazon (AMZN) Nears All Time High on First Quarter Results
Amazon’s overall revenues rose 15% to $22.72B, beating analyst expectations of $22.4B. Operating income for the quarter was $255M, a 75% increase over the $146M 2014 figure. The online retailer reported a net loss of $57 million, or 12 cents a share, narrower than estimates of 14 cents loss. When compared to the 2014 number though, this figure was a huge step back, as Q1 2014 income was $108M. The company forecast an operating loss of $500 million to an operating income of $50 million for the second quarter.
Amazon investors tend to ignore bottom line profits. After all, the company is sporting a market cap of over $180B on virtually no profits. Investors are betting the company will be the leader in a disruptive online world that includes shopping, streaming and cloud storage.
What really excited the street though was Amazon’s Web Service (AWS) business. Amazon disclosed that this cloud computing service had revenues of $1.57B, up 43% from last year’s $1.1B, and operating income of $265M, up only 8% from 2014. Not only was AWS bigger than the market expected, but it was also one of Amazon’s few profitable operations.
For rational investors, such news should be short lived. Other large players are focusing operations in this growing cloud computing service. For example, Microsoft Windows Azure and Google’s App Engine are just barely trailing AWS, according to Talkin’cloud. As more competitors crowd the market, pricing power is diluted and profit margins, which are already tight, shrink.
With Amazon’s cloud service, competition is a risk many are overlooking. The company trades at sky high multiples on the premise that it will one day “grow” into its valuation. This is widely speculative and puts great pressure on the stock (and company) to execute without any setbacks. With competition like Microsoft (MSFT), Google (GOOG) and IBM (IBM) concentrating on the cloud, what happens if (when?) Amazon’s already thin profit margins are sliced? AWS’s Q1 2015 operating income growth over 2014 may have answered this question. Revenues for the unit grew 43%, but income only 8%.
I believe income margins will continue to decline as the cloud space becomes more competitively crowded.