Amazon Goes Big on AI to Bolster Cloud Dominance        

Amazon.com (NASDAQ: AMZN)

U.S. Mega Cap / Consumer Discretionary / Broadline Retail

The Anthropic Topic

The upcoming Prime Day may be top of mind for Amazon.com consumers — but for Amazon investors, it's all about artificial intelligence (AI).

Last week, 'The 'Zon' announced a plan to invest as much as $4.0 billion in Anthropic, a San Francisco-based developer of AI systems. Anthropic is best known for its 'Claude' AI assistant, which it touts as being "helpful, harmless and honest."

Taking a minority stake in the business will help Amazon assert its position as the world's top provider of cloud infrastructure services. With Microsoft making a large bet on OpenAI's ChatGPT, the move is primarily intended to fend off a looming Azure threat. Incidentally, Anthropic co-founders Dario and Daniela Amodei worked at OpenAI through late 2020. 

Along with Google, IBM and Alibaba, top cloud companies are scrambling to boost their AI capabilities because the technology is poised to play a significant role in global digital transformations. Digital transformation refers to an organization using computer-based technologies to digitize its operations, products and customer interactions. A major part of this shift is e-commerce, an area to which Amazon needs no introduction. This makes the company's cloud offering, Amazon Web Services (AWS), a natural complement to its massive online shopping operation.

The Amazon-Anthropic hookup will see Anthropic tap AWS as its primary cloud platform for mission-critical workloads. An advocate for responsible generative AI deployment, Anthropic will train its AI foundation models using the AWS Trainium and Inferentia machine learning chips.

While Anthropic has been an AWS client since 2012, the expanded relationship is expected to give AWS customers early access to unique features that help them customize their AI models via Amazon Bedrock. This could be one more reason enterprises choose AWS for their digital transformations — and could help Amazon distance itself from Microsoft. Through the end of the second quarter of 2023, AWS held a 32% to 22% market share advantage over Azure.

AI Launches Are Accelerating

With the widely available fully managed Amazon Bedrock service, customers now have more choices than ever when building generative AI applications. On Thursday, Amazon kept the AI buzz going by unveiling several add-on offerings:

Amazon Titan Embeddings, a large language model (LLM) that converts text into numbers known as embeddings, will allow customers to develop search, personalization and retrieval-augmented generation (RAG) capabilities. In the next few weeks, customers will also be able to leverage Meta Platform's Llama 2, a next-gen LLM model designed for dialogue use cases. Amazon CodeWhisperer gives developers AI-powered code suggestions that help them be more productive. Amazon's QuickSight business intelligence (BI) service is rolling out new generative BI authoring capabilities that will allow analysts to create customizable visuals based on natural-language commands.

The flurry of new AI tools comes a week after Amazon brought the power of AI to its consumer electronics business. In conjunction with the launch of the Fire TV Stick 4k Max (and complementary six-month subscription to MGM+), new generative AI features have been added to Fire TV's voice search, allowing viewers to find entertainment content through speech.

Amazon's full-throttle approach to integrating more and more AI into its technology is well-founded. From retail and healthcare to advertising and agriculture, AI is already profoundly impacting how we work and play. With ChatGPT as the accelerant, businesses and organizations spent over $136 billion on AI last year. That figure is forecast to grow 37% annually and reach $1.8 trillion by 2030.

Some emerging technologies prove to be short-lived fads. Given the investments pouring into this year's hottest tech topic, it's highly unlikely that AI is one of them. If it is, the stock market may be in a world of hurt. 

Government Lawsuit Overhang

Amazon's AI showcase was dampened last week by news that the U.S. Federal Trade Commission (FTC) and 17 state attorney generals filed an antitrust lawsuit. The suit alleges that the company used its near-monopoly status to charge third-party merchants high fees and to raise shopper prices. Based on the market's initial reaction, this negative development ramps Amazon's risk profile — and could make the stock unusually volatile until a settlement is reached. With this said, investors shouldn't overreact because:

The lawsuit has been almost four years in the making. In 2019, the FTC opened an investigation into Amazon for possible antitrust violations. In contrast to government efforts to break up Alphabet and Meta Platforms, breaking up Amazon into retail and AWS doesn't appear to be on the table. Even if it were, this would be a relatively simple process — and could even create shareholder value. Amazon has deep legal and financial resources. While the suit will undoubtedly be a costly distraction, the company is better suited than most to respond with minimal investor impact. The legal process will probably drag on for years — especially with so many states involved. The outcome may be a stiff settlement that dents Amazon's cushy balance sheet, but near-term financial results won't be affected.

Regarding financials, Amazon's recent profits still pale compared to 2021 but are on course to return to early pandemic levels.

Q2 Results Crush Expectations

Amazon's second-quarter report couldn't have gone much better. Revenue was up 11% year-over-year to $134.4 billion, which topped both management's guidance and consensus expectations. After posting a $0.20 per share loss in the prior year, earnings per share (EPS) came in at $0.63, which exceeded analysts' $0.35 estimate. Online shopping sales increased 4%, and subscription sales (including Prime) jumped 14% — but the highlight was AWS.

In response to challenging macroeconomic conditions, cloud customers have been paring back spending on cloud infrastructure in recent quarters. But in Q2, management noted that customers shifted from "cost optimization" mode to deploying new workloads, leading to 12% AWS revenue growth. And while the cloud side of the business represented just 17% of total revenue, it accounted for 70% of total operating income.

This is a key distinction between how consumers and investors think of Amazon. To the average American, Amazon is the website you turn to to find just about anything and then wait for speedy delivery. To investors, Amazon is a cloud infrastructure business with an online shopping side hustle.

This is why investors shouldn't get too worried about negative e-commerce headlines — or too excited about positive ones. Amazon's profits start and end with AWS. To shareholders, it's profits that matter and ultimately drive Amazon's market value. AWS's role in dictating stock performance will only get more pronounced as digital transformations unfold and exciting new technologies like AI accelerate global economic growth.

Expensive…But Room for P/E Expansion

For the recently completed third quarter, Amazon management projects that sales will grow 9% to 13% from last year. The company does not provide EPS guidance, but Wall Street sees this translating to a sharp profit improvement. The latest consensus EPS estimate for Q3 is $0.58, less than in Q2 but more than double what was recorded a year ago. When Amazon reports Q3 results later this month, a beat similar to what we saw last time could help the market forget about the lawsuit — and the stock recoup its recent losses.

Since climbing as high as $145.86 in mid-September 2023, AMZN shares have pulled back nearly $20.00. This probably amounts to a healthy correction, with mega cap valuations flying high in 2023. The stock traded well above 100x trailing earnings during last month's peak. Currently carrying a P/E ratio of 99x, AMZN is no doubt still expensive. From 2018 to 2022, it traded at an average P/E of 73x. 

Things get more palatable, though, when we look at what lies ahead. With cloud customer spending in recovery and Amazon.com sales improving, the Street anticipates that 2024 EPS will be $3.15. That's not far from where they were in 2021. More importantly, it equates to a 2024 P/E ratio of just 40x, well below the stock's historical average.

Given Amazon's growth track record and outlook, this is a valuation growth investors can live with (if not one that's too low). Combined with the prevailing sentiment that lawsuit fears are overblown, Wall Street stands by one of its favorite names. Since the FTC suit news broke, over a half dozen analysts have reiterated their AMZN buy ratings. The consensus price target of around $176 implies a nearly 40% upside.  

Bottom Line

The emergence of ChatGPT has sparked unprecedented investment in AI technologies that help improve productivity and lower costs. This has put Amazon in an enviable position of being a top destination for enterprises seeking to develop their own generative AI models to advance their digital transformations. The FTC lawsuit against Amazon has added risk to the stock, but along with broad market weakness, has presented an opportunity for existing and prospective AMZN bulls.

 

Source MarketBeat