Why Amazon’s AWS Revenue Slowdown is Good for Long-Term Returns: Understanding the Impact on AMZN, MSFT, and GOOG
Amazon (NASDAQ: AMZN) recently reported AWS revenue growth of 12%, a far cry from its growth rates 2-3 years ago and its historic growth rates. In this post, we will walk through why we believe the short-term slowdown in the cloud computing industry is a positive indicator for future revenue growth and profitability for the cloud computing industry, especially Amazon but also Microsoft (NASDAQ: MSFT) and Alphabet (NASDAQ: GOOG).
Background
Amazon, one of Recurve’s portfolio companies, is the world's greatest modern infrastructure utility company. Its two main businesses, Stores and AWS, are plug-and-play platforms for companies selling physical goods and for companies running their IT applications and workloads. They radically reduce the upfront investment of human and financial capital to operate e-commerce businesses and/or to develop and deploy significant IT capabilities. They allow any business to scale from startup size to significant scale with all the shared benefits of redundancy, security, reliability, and lower costs.
Rather than establish their own logistics and distribution infrastructure, merchants can use Fulfilled by Amazon (FBA) to carry your goods and distribute them to your customers. Furthermore, Buy With Prime allows merchants to use FBA on their own domains, providing the back-end fulfillment, logistics, and reverse logistics services that unshackle merchants from operational complexities so that they can focus on the two things that differentiate them: product development and customer acquisition strategies.
Similarly, AWS and other cloud platforms allow customers to flexibly access hyperscale-class infrastructure on demand, on a variable basis, at lower costs than they could provision for themselves. Few companies have the desire or need to build out their own data center facilities. Amazon brings best-in-class global infrastructure across multiple layers. AWS is much more than just a data center that virtualizes multiple customers' workloads to extract higher utilization out of servers. It is a complex, vertically integrated ecosystem built on proprietary and third-party hardware, software, fiber and networking assets, and more. My research on Cogent's new optical transport opportunities has given me new perspective on the technology and infrastructure requirements to run hyperscale cloud services. The capabilities all the hyperscalers build to provision these services globally with high reliability are incredible.
Putting AWS' Growth Slowdown in Context
Coming back to the original topic, AWS has suffered through a noteworthy slowdown in revenue over the last year. Customers have been optimizing their workloads, scaling back in areas where their businesses may have shrunk. For instance, a mortgage company may have scaled back significantly after mortgage originations fell -77% from Q1 2021 to Q1 2023. AWS' exposure to cyclicality is the main topic we want to discuss because we believe it is a very good thing for Amazon longer term. Let's dig into why.
I was a guest on a podcast recently (Telco in 20 [telcodr.com]) and I spoke about how most cable and telco companies are bad investments because their revenue streams no longer have any relation to consumption growth. The evolution of technological advances and of competitive forces have pushed consumer-facing cable and telecom companies into offering unlimited plans. This translates into all the incremental value within the ecosystem transferring to the application layer. The access layer takes a decreasing percentage of total value generated within the ecosystem. Look at the incredible value originated elsewhere in ecosystem, which ride on top of the access layer - Apple, Meta, Google, Netflix, Amazon, etc. - they are thriving in an unlimited data world, and so are customers.
Imagine if AWS offered its customers "unlimited" cloud computing resources for a monthly recurring price. Maybe they could get an instantaneous one-time burst of revenue from those customers, but they would no longer have access to consumption growth in the industry and AWS would still require significant capital expenditures to support customers. Thankfully, the public cloud industry has evolved to capture customers’ increasing usage. This is especially important given the long-term secular shift of workloads into the public cloud. On the Q4 2022 earnings call, Andy Jassy said this:
"I think it's also useful to remember that 90% to 95% of the global IT spend remains on-premises. And if you believe that, that equation is going to shift and flip, I don't think on-premises will ever go away, but I really do believe in the next 10 to 15 years that most of it will be in the cloud if we continue to have the best customer experience, which we have to work really hard at, which we're working to do. It means we have a lot of growth in front of us in the AWS business."
Although most companies utilize the public cloud today, third-party estimates suggest that only 20-25% of workloads have shifted to the cloud. Most companies adopting the public cloud are deploying new apps and workloads to the cloud, and have a path to sunset their legacy on premise applications. If we believe that the ratio will flip, i.e. that in the future, 80% of IT applications and workloads will run in the cloud, we want Amazon and the hyperscale cloud platforms to benefit from that growth. This long-term good pairs with short-term gyrations that may affect growth during cyclical slowdowns or customer optimizations. That's okay - their spending will continue to move toward cloud computing over time. If we want the upside from AI-driven consumption and from the long-term secular migration from on premise to the cloud, we also have to accept short-term volatility.
To puts some numbers around what's happened, AWS' growth slowed to 12% y/y in Q2 2023, down from a quarterly growth rate of 39.5% in Q4 2021. It experienced a reacceleration of revenue in 2021 from 30% in 2020 to 37% in 2021. Its backlog has swelled from $53b in Q1 2021 to over $122b in Q1 2023. The law of large numbers will naturally slow down its growth rate over time, but AWS has felt headwinds from optimization efforts and variable declines amongst customers. Again, this is a good thing - it means AWS can participate in the downside and the upside as consumption patterns change. AWS will benefit from sales growth on a per-customer basis as its customers shift more workloads to the cloud, all without needing to acquire the same customers again. Net revenue retention per customer should be well over 100% for a long time and operating margins should continue to expand as the incremental, consumption-based revenues flow through on lower incremental selling costs.
Conclusion
Despite recent consternation over AWS' growth deceleration over the last 1-2 years, its slowdown reveals a long-term healthy dynamic of variable revenues for variable consumption. This is the relationship we want in any business with long-term secular growth ahead of it.
Taking a step back, both Stores and AWS have sufficient competition to prevent Amazon from extracting monopoly-like returns. However, both end markets are so large (each trillions of dollars globally) that Amazon has the ability to invest significant capital at attractive normalized returns on capital, which it should generate by winning share through its customer-centric culture, superior scale, and attractive price/value to customers. That doesn’t mean every area of significant investment will pay off (somebody needs to pencil out how Kuiper will beat SpaceX for me), but Amazon’s reinvestment engine in its two large core markets is alive, healthy, and will generate significant long-term free cash flow.
Would we rather own a business that generates a 40% return on capital, but can reinvest $1b per year, or a company that can generate a 20-25% return on capital, but can invest trillions of dollars over its life? The answer may be different for each investor, but I'll happily take the company that can continue building and reinvesting trillions of dollars into attractive return streams, solving difficult problems for customers at massive scale. This is the journey that Amazon is on, as evidenced by its gross P&E invested over the last 10 years:
As mature as the business is today, Amazon is continuing to build aggressively, and it is investing in infrastructure and capabilities much more difficult and differentiated vs. competitive offerings at this size and scale. Its vertical capabilities in many key areas continue to unlock faster/better/cheaper capabilities across its platforms. Continued evidence of consumption-based revenues is one of the key components required to generate the significant cash flow and return on capital we expect from Amazon in the future.
