Amazon.com (AMZN -3.10%) managed to eke out operating profit expansion in 2021 despite massive investments in its Amazon Web Services (AWS) infrastructure, fulfillment capacity, COVID safety measures, and labor force, all while battling inflation. For the full year, the online retail giant generated $24.9 billion in operating income, up $2 billion from the year before.
Management is guiding for first-quarter operating income of between $3 billion and $6 billion, which would be a considerable decline from the $8.9 billion it generated in the first quarter last year. However, I'm optimistic operating margins will actually expand for the full year. Here are five reasons why.
1. Lower depreciation expense
Amazon is making a big accounting change for AWS: It's increasing the useful life for servers from four years to five years and network equipment from five years to six years. As a result, it will lower its depreciation expense in the first quarter by $1 billion. The impact in future quarters won't be as significant, but it's still a lot of money that's moving to its bottom line.
While depreciation expense isn't a cash expense that will have an immediate impact on Amazon's cash flow, it's worth pointing out that this is a real cost savings. The change is a result of Amazon's engineers working to make its operations more efficient and extend the life of its equipment. Over time, that means a greater return on assets for AWS.
That said, management continues to invest heavily in the fastest-growing segment of its business. It spent over $20 billion in capital expenditures related to AWS infrastructure in 2021 and expects to spend even more in 2022.
2. A couple of important price increases
The big news from Amazon's fourth-quarter report was the inclusion of a price hike for Amazon Prime. The annual subscription price in the U.S. will climb $20, and the monthly price will go up by $2. All told, that could add about $1.6 billion in annual revenue, based on an estimated 80 million U.S. households subscribed to the service. And since Amazon has already made the investments to justify the price increase, that's practically all going to flow to the bottom line.
Similarly, Amazon is increasing the prices for many of its third-party seller services. Merchants will have to pay up to 12% more for Amazon's fulfillment fees, and they'll see their storage fees increase during nonpeak months. Again, these fee increases should result in higher operating margins, as Amazon has already done the work to improve its fulfillment speed and capacity.
Going forward, CFO Brian Olsavsky says he expects capital expenditures for fulfillment to match the growth of the underlying business -- third-party seller services and online retail. So, it should start to see significant leverage.
3. Reduced COVID-related expenses
Amazon spent approximately $5 billion on COVID-related expenses in 2021. While the pandemic continues to rage on with the omicron variant, Amazon's up-front investments and now widely available vaccines should help continue lowering the costs. Removing these expenses should help boost the bottom line.
4. Working through the labor shortage
Amazon saw its fulfillment problem turn from a capacity issue into a labor issue in the second half of 2021. Despite hiring 273,000 new employees in the second half of the year, it's still facing challenges. Specifically, the rise of the omicron variant in December 2021 and January 2022 meant Amazon paid for a lot of sick leave plus a lot of overtime, effectively tripling its labor expense in some cases.
Amazon increased its wages across the board at the end of the third quarter to attract new workers and keep up with inflation. Overall, the labor shortage problem resulted in more than $4 billion in additional expenses in the fourth quarter compared to the prior-year period.
The pressuress of the labor shortage and inflation should ease over the course of the year, with Amazon lapping the impact in the second half. That should allow its operating profits to normalize.
5. Growth coming from high-margin businesses
Perhaps the biggest reason Amazon's operating margin will expand in 2022 is that its growth is coming from two high-margin businesses. Amazon broke out the results of its advertising business for the first time with its fourth-quarter report. The segment grew 32% year over year, up $2.4 billion -- roughly 20% of total revenue growth for the quarter.
Meanwhile, AWS revenue is accelerating, despite its massive scale. The cloud computing business grew 40% year over year, adding $5 billion in revenue from the prior-year period -- over 40% of total revenue growth for the quarter.
Both advertising and AWS generate much higher operating margins than the core retail business. With these two businesses producing much of Amazon's revenue growth, margins will naturally expand.
Adding it all up
While Amazon's first quarter may see suppressed operating profits versus the prior year, investors should see a rapid expansion over the next few quarters as it leverages its assets and laps increased COVID and labor expenses.