Even though Amazon (AMZN -0.48%) has had an incredible start to the year (its stock is up 25%), it's nowhere near its historical valuation levels. That means there may be a lot of upside left in the stock. Considering that Amazon reported a mediocre quarter, the business hasn't returned to its full potential, causing many investors to lose confidence in the stock.
I think this is a mistake, as most of Amazon's headwinds are temporary. The long-term trajectory for Amazon is still positive, and I think there are a few key reasons why investors should consider the stock right now.
Other segments are taking the reins from its online store
After Amazon became the go-to e-commerce store during the height of the pandemic, it spent heavily on building out its fulfillment infrastructure to satisfy the demand. However, people reverted to their usual in-person shopping habits after the risk subsided, which left Amazon with too much warehouse space and extra employees. This caused free cash flow (FCF) to drop into the outflow territory, meaning Amazon burned loads of cash each quarter.
To fix that, Amazon began enacting several cost-cutting measures, which have done wonders for Amazon's FCF.
AMZN Free Cash Flow (Quarterly) data by YCharts
While the job isn't done, it's trending in the right direction. Nowhere is this more evident than in Amazon's North American results.
In the first quarter, revenue from this segment was up 11% year over year, and it turned its first operating profit since third-quarter 2021. Among the winners in this business division were advertising services (up 21%) and third-party seller services (up 20%).
Its internal online stores continue to struggle, as its revenue was flat compared to last year. While this may be concerning, there are plenty of other growth segments to make up for this. Moreover, with its third-party seller services growing rapidly, its online commerce isn't in danger of slowing down anytime soon.
This is critical because Amazon's cash cow is slowing down.
AWS is starting to struggle
For years, Amazon Web Services (AWS) kept Amazon afloat with its rapid growth and extreme profitability. However, that is starting to change.
In Q1, AWS revenue only rose 16% year over year, but what's concerning is that it fell quarter over quarter.
| Quarter | AWS Revenue |
|---|---|
| Q4 2021 | $17.78 billion |
| Q1 2022 | $18.44 billion |
| Q2 2022 | $19.47 billion |
| Q3 2022 | $20.54 billion |
| Q4 2022 | $21.38 billion |
| Q1 2023 | $21.35 billion |
Data source: Amazon.
AWS hasn't historically displayed seasonality, so this drop isn't a good sign. Furthermore, its profitability is fading. In Q1 2022, its operating margin was an outstanding 35%. In 2023, this metric has fallen to 24%. Unfortunately, the pain is just starting for AWS.
In its quarterly conference call, management warned that AWS customers were looking to optimize their spending. By definition, spending optimization means cost cutting, so AWS will likely see revenue decrease in the second quarter.
However, these decisions are heavily influenced by a poor economic outlook. When the economic storms clear, the transition to cloud computing will resume, and Amazon's market leadership should help to kick-start this business again.
While its online store and AWS are struggling, there's still quite a bit of upside ahead. For that upside, you must pay a relatively cheap price for the stock.
AMZN PS Ratio data by YCharts
At about two times sales, Amazon is trading around the same levels last seen nearly a decade ago. Although the growth prospects aren't as great as they used to be, it's still a low price to pay for a stock with a high profitability potential once Amazon's cost-efficiency initiatives are complete. At these bargain prices, I'm confident Amazon will be a market-beating stock over the next three to five years, making now an excellent time to buy.
