For investors in Amazon.com, Inc. (NASDAQ:AMZN), it has been nothing but blue skies. So far this year, AMZN stock is up more than 35% — better than triple the gains of the S&P 500. However, storm clouds are finally threatening to rain on the parade of AMZN stock longs … and it has to do with the company’s most important business unit.
Sure, most investors think of Amazon in terms of its retail business. It offers a universe of goods at seemingly rock-bottom and can’t be beaten prices on its websites. And its entertainment businesses from its e-books to its video and music services are transforming how millions consume media.
Then there’s Amazon’s rapidly expanding delivery services, which can whisk an increasing number of goods from ink toner to fizzy drinks in a matter of hours to your doorstep with a few clicks on your tablet, laptop or mobile phone.
These businesses contribute the lion’s share of the top line. But what really drives the bottom line for AMZN has nothing to do with food, gadgets or videos. When it comes to what generates the profits needed to fuel the company’s expansion, it comes down to one unit.
Amazon Web Services.
Profits in the Cloud
Amazon Web Services might only represent a fraction of the company’s revenues … but it has been a major driver of AMZN stock over the past couple of years because of how much it has padded Amazon’s profits.
In the most recent quarter, AWS generated revenue of just $3.7 billion, but a net profit of $890 million. That’s more than the profit from all of the internet-related sales that despite $36 billion in revenue only resulted in earnings of $724 million.
So, when it comes to profits, AWS is the prime (sorry) business that Amazon and its stockholders must rely on.
AWS provides cloud computing services for a myriad of industries and companies. It uses its vast number of computer servers and data storage centers scattered around the globe to offer customers the ability to migrate their data and network services to Amazon, which then keeps them humming along as securely as it can.
The advantage of using AWS is that companies save on capital costs of buying and setting up costly data centers as well as operating expenses of hiring an army of IT guys and gals.
The market for cloud computing is big, and getting much bigger. According to the technology market analysts at Gartner, the market for cloud services is currently a bit more than $100 billion. But it projects that in rapid course, spending on cloud services will soon top over $1 trillion including related businesses of data centers, software and IT services.
That should be good for Amazon stock. AWS has been one of the early leaders in this market, as at the beginning of this year 600 of the Fortune Magazine 1,000 companies used AWS — or its early competitors, including Microsoft Corporation (NASDAQ:MSFT) and Alphabet Inc (NASDAQ:GOOGL) — for cloud-related services.
But the competition has been ramping up very quickly.
As more companies have migrated to the cloud, more competitors are stepping up against AWS.
Microsoft’s Azure cloud services is courting and winning over businesses from local mom-and-pops to far-flung global operating entities. And Alphabet — having restructured its businesses to resemble a company focused on profits rather than just on wild experiments — is honing its skills at offering its cloud products.
They’re being joined by a rapidly expanding list of cloud service providing competitors including International Business Machines Corp. (NYSE:IBM), Centurylink Inc (NYSE:CTL), Verizon Communications Inc. (NYSE:VZ) and NTT Docomo Inc (ADR) (NYSE:DCM) that are all rolling out and peddling cloud services.
While some of them are having some fits and starts, such as IBM — which just reported that the last quarter saw its cloud unit losing revenues by over 5% — the competition is forcing Amazon to cut its cloud fees and cater to more client demands. Over the past few years, Amazon has changed its cloud contract terms more than 70 times to compete along with a collection of discounts to keep and expand its cloud customer base.
That’s kept revenues climbing for AWS, but at a slower pace. For the first quarter, sales were up 43% — down from the 64% pace seen in the first quarter of 2016. Margins are compressing, too. While revenues slowed, they still grew, but Q1 AWS profits dropped a bit more than 4%.
The competition might not be winning, but it is having an impact.
Small Fries, Big Threats to AMZN Stock
Moreover, it’s not just the competition that threatens Amazon’s cloud business — but a growing number of cloud computing consultants.
These consultants — including a collection of privately held companies such as Cloudyn, Cloudability, Cloud Cruiser and CloudHealth — provide cost cutting advise to businesses either currently using or considering cloud services.
Some of these charge flat fees or a percentage of negotiated savings for cloud computing services. And so, each of these and their other peers are doing their best to ravage savings from Amazon and its competitors.
Bottom line, AMZN stock holders need Amazon Web Services to not only continue to expand revenue, but also to deliver profits to fund the bigger, yet less profitable businesses. Any further slowing in revenue gains or worse reduced net profits and Amazon’s rapid expansion into the blue skies of the markets might end in a stormy cloud of losses.
As of this writing, Neil George did not hold a position in any of the aforementioned securities.