It has been a year that Amazon.com (NASDAQ:AMZN) investors would rather forget, with shares falling 25% in comparison to the NASDAQ's 14% gain. While Amazon's revenue growth remains unquestioned, it's the lack of profits and continuous spending that has finally caught up to the stock. This, along with the performance from Amazon Web Services (AWS), will ultimately decide AMZN's fate in 2015.
Will 2015 Be The Year Of Profits?
Amazon's logic of "spending now to grow larger later" is nothing new, but with over $85 billion in trailing 12-month revenue, investors have understandably started to ask whether the company will ever create profits. Some have even questioned if Amazon is capable of turning a profit, or growing revenue without the excessive spending.
Granted, popular blogger Benedict Evans figures that Amazon could've created four-times higher free cash flow, to $4 billion, over the last year if not for rising capital expenditures. While Amazon CEO Jeff Bezos is unlikely to abandon the strategy that ultimately led to the company's greatness, it will be interesting to see how new initiatives can drive margins higher.
These include travel, payments, advertising and other services, allowing Amazon to leverage its enormous network to provide services that are typically high-margin businesses. Various publications have reported that Amazon will soon enter the online travel space to compete with the likes of Priceline (PCLN). If accurate, Amazon would enter a high-margin business that collects commissions of around 15% on hotel and travel bookings, with the biggest expenses being technology and marketing-related.
Further, the Wall Street Journal reported (registration/subscription required at the link) that Amazon is prepping an advertising platform for both its own and third-party sites. Currently, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) powers the advertisements seen on Amazon.com, but reportedly, Amazon will take the $1 billion worth of ads on its site and become the full beneficiary of those revenues.
While Amazon is unlikely to ever create advertising and travel businesses the size of Google and Priceline, it could still generate healthy profits from these businesses. Google has an operating margin of nearly 23% over the last 12 months, while Priceline's is even higher at over 36%, much better than the sub-zero percent from Amazon's existing business.
That said, how quickly Amazon rolls out these services, combined with how well it performs in other high-margin businesses like payments, will be a big storyline into 2015. If Amazon can create just $500 million in revenue from these new businesses next year, at an operating margin of 20% (lower than Google and Priceline), that's $100 million in operating income, significantly more than it earns from its $85 billion business. Further, it might just be enough to create investor optimism and push the stock higher.
Can AWS Grow Its Market Share?
While Amazon's cloud business, Amazon Web Services, accounts for only 5% to 6% of its total revenue, the segment is responsible for a huge chunk of its valuation. Back in November of last year, Evercore gave AWS a $50 billion valuation. This was based on a few things.
First, AWS had seen 700% usage growth in the year prior and analysts expected more than $8 billion in total AWS revenue by 2015. This supported the 32% share of the cloud infrastructure services market that AWS held, according to Synergy Research, and the fact that AWS's revenue consistently outperformed its competitors, at 65% plus, in an industry growing at 50% annually. Lastly, given Amazon's overwhelming market share, combined with the fact that cloud services in general are expected to grow rapidly in the coming years, a $50 billion valuation made sense.
However, the unexpected has since occurred: Amazon's seemingly dominant place in the cloud infrastructure space has been challenged by Microsoft (NASDAQ:MSFT), IBM (NYSE:IBM) and Google. Specifically, each of these three companies have outperformed Amazon in revenue growth for two consecutive quarters, especially Microsoft, and have forced Amazon to lower service prices several times in 2014.
That said, Amazon's market share in cloud infrastructure services has dropped from over 30% last year to 27% as of the third quarter, according to Synergy Research. Meanwhile, Microsoft has grown its share from about 6% to 10%.
Clearly, Amazon.com has run into some unexpected problems with AWS. Therefore, investors have to believe that Amazon's stock losses in 2014 are highly connected to the fact that AWS revenue growth is slowing, cloud competition is intensifying and AWS's share of the fast-growing market is smaller than it was in 2013. In fact, an investment research firm that specializes in corporate breakups, called The Edge Consulting Group, recently predicted that Amazon will spin off AWS next year, which could be a huge catalyst that creates substantial cash.
But more importantly, the firm estimated AWS's valuation in the open market to be $38 billion, meaning its value to Amazon's stock might be even lower right now. Amazon has lost $45 billion of its market capitalization this year. As a result, The Edge's assessment of AWS versus Evercore's estimate last year theoretically implies that AWS's devalue in 2014 is responsible for more than 25% of Amazon.com's valuation losses this year.
Amazon's 2015 will be highly dependent on how AWS performs. According to the company, demand for AWS has never been stronger and contracts lost to rivals are an exception, not a rule. Also, despite large investments from Microsoft, Google, IBM, and Oracle (NYSE:ORCL) in the cloud, AWS still has five times more computing capacity than any of its competitors.
Thus, there are a lot of factors that weigh in Amazon's favor, but will the company grow its market share with AWS, and reflect the $50 billion valuation in its stock? The answer to this question is unknown, but will certainly be important to the performance of Amazon's stock next year.
Whether Amazon's margins rise and its "Other" (AWS) revenue growth accelerates will be closely watched in 2015. If so, Amazon's stock could very well return to all-time highs, as expected revenue growth of 18.5% next year is certainly deserving of a premium valuation multiple, especially as the company gets more serious about international expansion and online grocery retail.
All things considered, with margins in full focus and AWS a key segment of the future, investors shouldn't expect AMZN to recover unless there are some serious improvements in both areas, thereby making margins and AWS the most important catalysts for next year.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.