Scale has proved crucial to Amazon’s success, allowing the technology titan to compete aggressively on price and to grow sales rapidly. But the heft of its operations comes with a weighty cost base, one that sits far less easily when sales are at risk of a rapid slowdown as recession looms in some of its largest markets.
Amazon, widely seen as a bellwether for the health of the American economy, has braced investors for a potential total wipeout of profits in its fourth quarter. Guidance of between zero and $4 billion in operating income, compared with $3.5 billion for the same period last year, was worse than analysts had anticipated.
The shares have fallen by just over $68, or 40 per cent, since the start of this year, but that does not make them cheap. They still trade at 73 times forward earnings, a way down from a three-digit multiple reached at the height of the pandemic but still broadly in line with the five-year average. That leaves plenty of room for the price to shrink further.
Amazon is overwhelmingly at the mercy of consumer spending. Online sales were up 7 per cent compared with the same period last year, but the real impact of rising energy costs — a key pressure on household budgets — has yet to fully hit. Rising fuel bills and the economic fallout of the war in Ukraine were blamed for a more marked slowdown in sales for its international business. The dollar’s rally has proven an even greater challenge for revenue growth, wiping roughly $900 million from international sales, which were 5 per cent lower than the year before.
Amazon Web Services, its cloud computing business, also looks like a less reliable source of earnings growth than it has been in the past. AWS has long picked up any slack left by the retail business, achieving annual revenue growth north of 30 per cent each quarter since the start of last year. Revenue growth slipped to 28 per cent on a constant-currency basis during the third quarter and was closer to the mid-20s in the back end of the quarter.
Cash-strapped companies are trying to cut back on their bills, according to Brian Olsavsky, Amazon’s finance chief, and AWS is obliging, including offering “alternative services”. Pressure on the top line has been compounded by rising operating costs, namely wage inflation and rising energy prices “materially” higher than before the pandemic. The operating margin sank to 26.3 per cent during the third quarter, its lowest level in almost three years.
Amazon is still nursing the pain caused by rapidly expanding its online fulfilment operations to meet a jump in online shopping during the pandemic. Its retail network has more than doubled in size in the past two and half years. Capital investment this year is forecast at $60 billion, in line with last year, when the prospect of stronger sales growth looked far more assured. A $10 billion reduction in fulfilment and transportation costs has been replaced with a $10 billion investment in technology and infrastructure, including expanding the cloud computing business.
The result of splurging? Free cashflow has been negative for four consecutive quarters, totalling an outflow of $19.7 billion over the third quarter. Analysts at Barclays forecast a free cash outflow of $23.3 billion this year, which the bank thinks will reverse to a positive $25.6 billion next year. But that forecast could prove too optimistic if sales slow more rapidly than expected or if the company fails to rein in costs as much as it hopes, something it has already found more difficult than expected during the third quarter.
Amazon might need to tighten its outflows more dramatically to convince investors it has the mettle to withstand a slowdown in spending.
ADVICE Avoid
WHY Weaker spending by consumers and businesses could cause earnings to miss market expectations
Lok’n Store
Lok’n Store is sitting on operating profits more than double the pre-pandemic level and net asset value growth of 82 per cent, gains that have prompted a 67 per cent rise in the self-storage company’s share price during that period. The question facing investors now: have profits peaked?
Higher occupancy justified increased pricing over the 12 months to the end of July, with the average rate on occupied space 13 per cent higher than the previous year. The strength of cashflows and heightened interest from institutional investors in the sector pushed adjusted net asset value ahead by a third over the 12 months to the end of July, a way ahead of market expectations. But a gloomier outlook and rising interest rates mean a lot has changed since then.
Analysts at finnCap, the house broker, have forecast £11.1 million in adjusted pre-tax profit for the present financial year, a 15 per cent decline on last year that reflects higher finance expenses and operating costs alongside flat sales. An average yield of just under 5.5 per cent represented a record low, but further compression this year seems unlikely, given that would-be acquirers of self-storage assets face higher borrowing costs.
Lok’n Store faces higher financing costs itself. All its £66.8 million in drawn debt is unhedged, which has pushed the average cost of debt up to 3.7 per cent since the end of July, from 1.7 per cent over the 12 months to the end of July. There is enough cash on the balance sheet — £46.5 million — to fund the completion of the four developments it has committed to, which will cost about £22 million. It doesn’t need further on the £100 million debt facility this year at least.
Developments in the pipeline are largely freehold and in prime locations, defined as being on busy roads, ideally on the front corner of a retail park and near a supermarket that attracts a lot of footfall.
The shares trade at a 7 per cent discount to the NAV forecast by analysts at Peel Hunt, another of the company’s house brokers, at the end of July next year. That seems logical, given the potential for a weakening in property values and more difficulty in raising prices as retail and business owners feel the pinch.
ADVICE Hold
WHY Shares could struggle as interest rates rise further
