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How the cloud could boost Amazon’s slow-moving margins

According to analysts at Morgan Stanley (s ms), Amazon’s (s amzn) cloud computing division could be a shining star (even if not too bright) on the company’s long road toward increased profit margins. However, while their forecast isn’t glowing, it also doesn’t account for the evolution of Amazon’s cloud business from pure infrastructure-as-a-service into higher-level (and higher-margin) services.

In the new research report published Monday morning, analysts Scott Devitt, Andrew Ruud and Nishant Verma come to a possibly disconcerting conclusion for any investors banking on Amazon (s amzn) for short-term returns. The report’s gist: “After analyzing’s cost structure in detail and by segment, we conclude that there are far more variable costs than investors believe, leading to an overly optimistic timeline for margin expansion.” But Amazon Web Services is an opportunity Amazon might be able to exploit.

The report estimates that AWS was responsible for $1.19 billion in revenue in 2011 (I predicted in October the business was on a billion-dollar run rate), of which $108 million (or about 9 percent) was sheer profit. It’s able to maintain this margin while constantly dropping prices on its cloud services, the report contends, because AWS uses a cost-plus pricing model. That is, it just adds a premium (about 10 percent) on top of the cost of delivering those services, which continue to drop as Amazon leverages its economies of scale to buy and operate more gear and bandwidth at lower prices.

Although AWS margins remain flat, the report notes that AWS also comprises a significant portion of Amazon’s overall technology spending, so being able to drive steady, predictable profit from it is a good thing. Non-AWS technology spending, the authors estimate, is about 4 percent of net sales — “represent[ing] the largest opportunity for operating margin expansion in the near-term.” Keeping those cost down means a greater percentage of revenue goes toward profit.

However, the Morgan Stanley report doesn’t address the possibility that AWS margins actually could start rising as the company expands its services beyond sheer infrastructure and into managed services. Its NoSQL DynamoDB database service, for example, is a service for which Amazon adds value (and cost) beyond just the delivery of cloud-based infrastructure, and there are lingering rumors of a big data analytics service that will provide higher-level services than AWS’s existing Elastic MapReduce offering.

We shouldn’t overlook the possibility of AWS expanding its licensing activities, either. As it becomes more entrenched as the de facto cloud computing platforms for many companies, providers of other services and software are keen to get on board. Already, private-cloud pioneer startup Eucalyptus has licensed the AWS API, and Citrix (s ctxs) wants to do the same for its CloudStack software. If it’s feeling greedy, Amazon could look to capitalize even further by charging others to integrate directly with its business.

Or it could just give that cost-plus dial about a quarter turn.

Image courtesy of Flickr user comedy_nose.

12 Responses to “How the cloud could boost Amazon’s slow-moving margins”

  1. and for God’s sake, NOBODY HAS LICENSED THE AWS API. That. Can’t. Happen. Its an API. I can’t license the three tined salad fork next time I open a restaurant, criminy.

    • Derrick Harris

      I appreciate your enthusiasm. But here’s the thing: Morgan Stanley did, in fact, base its margin projections and cost-plus conclusion on AWS operating primarily as a cloud-computing service.

      As for the AWS API, you can totally license an API and control how people (or companies) use it. Maybe you saw the stink developers raised when Twitter changed its API terms. Gartner’s Lydia Leong actually has a good analysis of the AWS-Eucalyptus deal:

      • Oh for heaven’s sake… from your own article: “Non-AWS technology spending, the authors estimate, is about 4 percent of net sales — “represent[ing] the largest opportunity for operating margin expansion in the near-term.” ” That ‘largest opportunity’ is from as a whole, a $30B+ business, not AWS, a $1.19B segment of that. The report also notes, which you have left out, that AWS (including fulfillment, which MS estimates margins of 50%), with 9% margins, is the same as most other hosting businesses, and (from the research)”The bottom line is that the two fastest growing business segments contribute the lowest margins after allocating variable costs into cost of sales”. The whole point of the MS note was that the way Amazon reports margins is messed up, and doesn’t reflect reality. AWS can’t drive margins up more than a fraction of a percent, do the math.

        APIs… Amazon does not license its IaaS APIs Eucalyptus has copied these APIs from day one, and this deal formalizes that, and lets them into a technical partnership to keep Eucalyptus and AWS on the same pace in updating and releasing new APIs. Your statement that AWS has licensed its APIs is flat wrong, or at least, should be sourced to Lydia, since she’s the only one who’s said that. Today, You, I, the neighbor’s dog, can make free use of any form of the AWS IaaS APIs for any reason, and Amazon won’t say boo. The only API Aamazon licenses is its Product Advertisement API, which lets you pull free stuff from their main site to put in your application, exactly like the Twitter, Bing, Google, et al APIs. These licenses reflect terms of use for consuming their stuff, since they want to make money from it. AWS only lets you into their Customer Agreement for AWS as a whole. There is no license for the APIs. OpenStack/CloudStack/Citrix/anyone else did not and does not have to “strike a deal” to copy the AWS APIs.

        • Derrick Harris

          My point about AWS is this: If it is indeed a cost-plus business, then AWS could help spur margin growth. That aspect makes it similar to other web-hosting companies, but AWS has (I presume) better economies of scale that could let it ramp up the premium a point or two and still drop prices, and — more importantly — the ability to offer value-added services. That might not result in huge margin growth, but it will be growth that’s just icing on top of the cost-plus profit.

          Regarding APIs, you’re just arguing semantics. Copying or making products compatible is one thing but, you can’t literally use someone else’s APIs without a license to do so, which is what AWS appears to have allowed with Euca, and then some. The same way I can grant you a license to use copyrighted works (which the code underlying the APIs is) or patents in a limited manner. Just because Amazon’s APIs are publicly available that doesn’t make them open source.

      • Here is a post that adequately discusses the Morgan Stanley note to bring some more depth:

        “Regarding APIs, you’re just arguing semantics. Copying or making products compatible is one thing but, you can’t literally use someone else’s APIs without a license to do so, which is what AWS appears to have allowed with Euca, and then some.”

        ‘Copying or making compatible’ is exactly what Eucalyptus has done for the last 4 years. They do that by copying the AWS APIs and their functionality, in their software. That is what OpenStack, CloudStack and etc will do to implement AWS APIs. They will copy them into their software. Nothing in this deal has changed that in any way.

        There is not a license agreement with AWS needed to do that, nor is there one to “literally use” the APIs. Service provider/channel partners like RightScale or others do not enter into license agreements to deliver AWS services to their customers. They just do it. No licensing around the APIs. Amazon does not protect its APIs in this way.

    • Scott Bonagofsky

      Can’t license an API? Better call Oracle and tell them that about the Java API. Tell ebay too. In fact, tell all of the hundreds of companies that license their APIs.

      • I was hasty. I am aware that APIs are licensed all over the place. This particular kind of API is not licensed. full stop. Here’s Rackspace’s API agreement, another similar case. Want to copy it when you build your cloud? Heave away. Want to copy Oracle’s ExaLogic APis? maybe run that past legal.

        • Derrick Harris

          Yeah, Rackspace is working on its OpenStack migration, so it makes sense for it to open source its APIs regardless. But it was never as proprietary as AWS is.

  2. You fail to mention that AWS revenues are not exclusive to EC2 and S3, but include facilitation(S&H for sellers) credit services ala paypal for processing transactions, and many other parts of the “Web Services” offers, which grow as the online retail business grows, nothing to do with EC2/S3. Any commentary about margins is thus basically worthless, since you haven’t made any effort to understand which parts of what revenue have what margin available. Morgan Stanley’s little worker bees clearly have, since they understand cloud doesn’t mean shit to’s metrics.

    Let me end by saying that if you seriously think hosting infrastructure is a cost plus business for Amazon, please contact me immediately about a business opportunity I have for you to process checks. It is a $500 per week opportunity!