The Cloud business is Amazon.com, Inc. (NASDAQ:O:AMZN)’s most profitable, fastest growing and highest margin operation. Amazon Web Services (AWS) contributed 52% of Amazon’s total operating profits in 3Q2014, yet only 8% of the overall revenue in the quarter.
The year 2016 is modeled as an investment year for AWS. Investments in AWS will span footprint expansion and feature additions. The idea is to keep AWS on the lead or widen its lead over the competition so that it can continue eating up market share in the public cloud space.
In any case, Amazon understands the challenge ahead and is willing to temporarily sacrifice AWS profits on the altar of long-term growth.It is speculated, and rightly so, that the next two years of cloud disruption will be more heated than the past 10 years.
Recent industry developments give credence to the observation that the next two years will be marked by grueling cloud competition than the last decade. Alphabet's (O:GOOG) recently hired a VMware Inc (N:VMW) veteran, Diane Greene, to teach it how to sell cloud to enterprises. Google (O:GOOGL) made the move to hire Greene at a time when Dell is seizing up VMware’s parent, EMC Corporation (NYSE:N:EMC), in a $67 billion transaction. Dell is among other things expected to benefit from an expansive corporate computing network that it can leverage to clear its path to enterprise cloud business, thus posing threat to AWS and others. On its part, Microsoft Corporation (NASDAQ:O:MSFT) is busy adding scale and feature to its Azure cloud platform in readiness for more intense cloud competition in the near future.
With what the competition is trying to do in the cloud, Amazon.com, Inc. (NASDAQ:AMZN) is taking nothing to chance despite its dominance of the public cloud space. That explains why the company has marked 2016 as an investment year for AWS.
Prioritizing capacity over margins
Amazon.com, Inc. (NASDAQ:AMZN) will be expanding its cloud footprint into four new regions in 2016 in a record growth for AWS given that the company added only one cloud region in the last two years.
The new AWS regions will be in the U.K., South Korea, India and Ohio (in the U.S.). If Amazon succeeds in opening four new regions in 2016, its AWS regions will jump to 15 from the current 11 regions across five countries.
Investment in new regions will increase Amazon’s cloud capacity but also push up capital expenditures, thus putting pressure on AWS operating margins and effecting profitability of the cloud business. However, that should be a necessary profitability disruption given that investment in capacity clears the way for more long-term growth and profitability in AWS.
Each AWS region is increasingly becoming important to the growth of Amazon’s cloud revenues. The average revenue from each AWS region currently stands at about $715 million, which means that more regions should bring give way for more cloud revenues. It is worth noting that average revenue per Amazon’s cloud region has more than doubled over the last two years.
Is capacity expansion necessary?
Cloud penetration is still in the early innings, with roughly 5% of the nearly $1 trillion addressable market already captured. With a larger capacity, Amazon.com, Inc. (NASDAQ:AMZN) can gain share more rapidly in the cloud and take advantage of the huge growth opportunity in market.
Although AWS is already the public cloud leader, accounting for 21.7% of revenues among the top 10 cloud vendors, its portion is only 1% of the available market. That is another reason that validates the need for capacity expansion, which Amazon plans to embark on more aggressively in the New Year.
Shift in cloud competition
The year 2016 is expected to mark a sharp shift in cloud competition whereby vendors will be more focused on attracting buyers with feature-rich offerings than price concessions.In the case of Amazon, the company learned its lessons in cloud price wars, which actually delivered a mixed bag of fortunes for the company. Investors have also grown increasingly wary of price wars in the cloud. That explains why Amazon would be more interested in innovation to add more features to its core cloud services to both differentiate AWS from the competition and also make it stickier.
The other advantage of features innovation is that Amazon is able to guard against margins erosion in a competitive environment because buyers will always be willing to pay for value.
In the past two years, Amazon has added over 1,000 new features to AWS cores such as compute, storage and content delivery. Among Amazon’s key cloud features is Snowball, which solves the problem of moving large amounts of data to AWS. Those who have been following the cloud narrative know that data transportation was one of the major obstacles in the shift to the cloud and finding a solution to it has elevated Amazon’s cloud the profile.
The various features that Amazon has rolled out have played an important role in driving the uptake of AWS, which is why Amazon isn’t ready to cool on the features innovation front. As such, as part of elevated AWS investment to add scale in 2016, Amazon will also be working to bring more features to AWS.
As much as features are set to dominate cloud competition in the coming years starting in 2016, price will always linger around as a competitive factor. Because of Moore’s Law, cloud providers will continue to find new ways to lower their cost structure and make their products/services more accessible and affordable.
More growth ahead for AWS
In the last quarter, AWS revenue rose 78% YoY to reach $8.3 billion in annualized revenue basis, marking a sharp increase from 43% growth rate in the same quarter a year earlier.
Although AWS has registered impressive growth in the past two years, that could only be the tip of the iceberg. With capacity expansion and continued feature innovation, Amazon.com, Inc. (NASDAQ:AMZN) will be able to open up more growth vectors for AWS.
As such, AWS not only has a huge growth opportunity ahead, but the robust growth will also be sustainable over the long-term as Amazon invests in scale and service differentiators.
Large customer wins
Amazon.com, Inc. (NASDAQ:AMZN) is presenting AWS as the perfect highway to the cloud for large enterprises and it is making big wins. General Electric Company (NYSE:N:GE) will be migrating close to 10,000 application workloads to AWS by the end of 2018, a move that will help the industrial giant shrink its data center count to only four from the current 34.
For Amazon, winning large enterprise customers boosts its cloud profile and also creates some kind of halo effect for AWS.
Bottom line
Looking at the growth trajectory of AWS, one gets the impression that Amazon.com, Inc. (NASDAQ:AMZN)’s cloud business could reach $10 billion in revenues twice faster than Microsoft and other legacy technology vendors in the early phase of technology adoption.
Disclaimer: The opinions and data expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisory capacity, nor is this an investment research report. The author’s opinions expressed herein address only select aspects of potential investment in securities of the company or companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.