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5/30/2013
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Amazon Cloud Pricing Threatens Tech Titans

Amazon Web Services is on track to be a $24 billion annual infrastructure-as-a-service supplier within a decade, Morgan Stanley says. That's bad news for Red Hat, Oracle, SAP, Microsoft, IBM and Brocade.

In one sense, the report signals that the investor community is starting to recognize what senior VP Adam Selipsky and other AWS officials statements have been saying for some time. Amazon has brought a retailer's low-margin attitude to IaaS, and is piling on top of that infrastructure what appears to be more and more like traditional IT services -- load balancing, automated deployment and scaling, etc.

Selipsky launched that line of thought more than a year ago in an InformationWeek interview, when he said, "A lot of technology business is a good business with high margins. But that's not Amazon's strategy ... Amazon's approach reflects its roots in the business of retail. We drive the scale of business and lower prices."

Amazon.com, the online retailer, doesn't break out revenue for Amazon Web Services, but best estimates from Macquarie Capital, an Australian equities research firm, put them at $2.1 billion in 2012, likely to grow to $3.8 billion in 2013 and $6.2 billion in 2014. On that basis, Macquarie analyst Ben Schacter concluded that AWS as an independent business could be valued at $19 billion by 2015. But the Morgan Stanley authors are the first researchers to take Amazon's early growth and project it forward a decade to $24 billion in 2022.

There could be reason to doubt that projection. As its online retail operation has grown rapidly, Amazon.com has cloaked what it was spending on its Web services unit by declining to break it out as a separate business unit. The retail operation now runs on the same cloud infrastructure as AWS services, so the expenses of the two are intertwined, and Wall Street analysts haven't had the opportunity to criticize Amazon's AWS spending because they don't know what it is.

On the other hand, it's clear at least some of the AWS build-out has been financed by Amazon.com's strong cash flow. As long as retail sales are increasing rapidly, CEO Jeff Bezos and the rest of Amazon.com management don't have to explain how much they are spending on AWS. The infrastructure can be built out, financed out of free cash flow, where the money coming in always exceeds expenses. That's easier than being limited by AWS's early revenue-generating capability.

That surplus has been shrinking of late, according to Amazon.com's first-quarter earnings report. Free cash flow peaked in 2010 as Amazon's sales expanded rapidly, amounting to $2.32 billion for the year. In the first quarter of 2013, it was $177 million, an 85% decline over the year before, although the quarter included the purchase of $1.5 billion of office space. While sales continue to increase, the rate of increase has slackened, inhibiting spending from free cash flow and bringing Amazon closer to a more detailed accounting of its costs. Another measure: sales have increased an average 31.4% a year for the last eight years; net income has increased 2% a year.

Instead of net income and profits, Amazon is entering new businesses, such as its expanded Kindle Fire tablet business, its Zappos acquisition, its Instant Video movie and TV show streaming business, and its Prime retail business, where it eliminates customer shipping costs and guarantees quick delivery in exchange for an annual fee. All of these, like AWS, require investment in distribution centers, video production by Amazon Studios and other infrastructure.

Bezos and company are bent on building a juggernaut of future cloud services and online retailing. And they are likely to succeed in doing so as long their investors have confidence in the way they're managing the company. Its stock price is up 600% over that previously mentioned eight-year period, and closed Thursday at $266.83.

But Amazon is also facing increasing competition from Google, which just started its own B2B online retail service, eBay, Apple, Microsoft, Yahoo, and Wal-Mart, among others. To some extent, it's set a pattern that other successful Web companies can emulate, and Amazon is now in competition with other growth companies for the same space. That may mean sales and free cash flow continue to slow and, potentially, its soaring stock price will start gliding back to Earth.

If that happens, then Bezos' ability to justify his investments will come under review, if not criticism. And the threat that Amazon poses to the traditional IT companies may abate somewhat, as they gain time to adjust to the new circumstance and try to stage their own entrants into the field.

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