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AWS: Forget the Revenue, Did You See the Margins?

revenue-slide

Two days ago, two analysts from UBS – Brian Pitz and Brian Fitzgerald – projected Amazon Web Services revenues at $500 million. Many were disappointed, expecting more from the widely acknowledged market leader: a half a billion dollars is approximately what Microsoft spent per datacenter pre-2010.

Those who would focus on the actual revenue figure, however, are likely to miss the more important margin numbers.

It has been long assumed that cloud computing – at least as currently practiced by the lower value add Infrastructure-as-a-Service practitioners – is a low margin business by enterprise infrastructure standards. Larger systems players such as HP and IBM have shown little appetite for the public cloud market in part because of this, depending on who you talk to. One senior executive I spoke with from a large systems vendor two years ago was blunt in his assessment of the prospects for a public cloud offering: “I don’t want to be in the hosting business.” The implication being that hosting offered insufficient margins.

Certainly nothing in Amazon’s pricing, either at launch through to today, has seemed to contradict this conventional wisdom. True, the actual cost of full-time EC2 instances exceeded competitive offerings from traditional hosts, but the dynamic consumption of AWS servers would presumably mitigate the moderate margin Amazon could realize. A half month of a $72 dollar server is worth less than a full month of a $40 server and so on.

Except that it apparently isn’t.

At the OSCON Cloud Summit, I delivered a presentation on cloud lockin. The concept as it relates to margins was simple: margins at the foundational layers were slimmer, which was spurring the development of various platform services which besides creating the potential for lock-in would theoretically provide higher margins. It’s standard technology value-add thinking: if I can charge $10 for a basic, bare bones server, I should be able charge $20 for a platform in which you don’t worry about servers, capacity planning and such any longer. That the market has largely rejected platform services in favor of more elemental infrastructure building blocks doesn’t change the basic economic assumptions being made.

My presentation was, I believe, generally well received. The reactions, both on Twitter and in person following my talk, were positive and question oriented. With one notable exception.

James Watters argued vigorously that I was underestimating, substantially, Amazon’s margins.

WOW @sogrady couldn’t have been more wrong when comparing the margins of HP to EC2; EC2 much higher than HP average 25%.

Partially the disconnect is that I hadn’t meant to imply a comparison of cloud margins to that of HP generally. The intent was rather to contrast typical cloud margins to enterprise technology businesses, where ideal margins generally begin at 40%. But as it turns out, James was right and I was wrong, irrespective of that framing error.

According to UBS, Amazon Web Services gross margins for the years 2006 through 2014 are 47%, 48%, 48%, 49%, 49%, 50%, 50.5%, 51%, 53%. Granted, this is an analyst projection. And the inherent risk of projecting four years out in a volatile market is acknowledged.

But even should we trim the figures liberally, the fact is that the margins that Amazon is realizing on basic infrastructure services are substantial. For context, look at the income statements for a Cisco, an IBM or an HP.

If this is true, most of what what we’ve believed about Amazon’s business – that it was in fact a high volume over low margin business – is wrong. And if that’s wrong, it changes the way we must evaluate the cloud industry and the attendant economic opportunities. Revenue is a function of volume and margin. The volume, with respect to the cloud, is not a concern for me. The margin always has been. If that concern can be erased through combinations of automation, efficiencies and scale, then the economics of the cloud look even brigher than they did before. The current market size may portend less upside that we’ve historically seen from technology sectors because it’s more significantly driven by volume than in years past, but I have few concerns about the market potential long term.

Which is good news for the industry as a whole, I think. Sometimes it’s good to be wrong.

Categories: Cloud, Economics.

  • http://simoncast.blogspot.com Simon Cast

    Also speaks to how much AWS can further reduce prices without a significant reduction in revenue.

    Which leads to some possibilities:
    1) AWS’s reduction in prices have come not only from volume increases but margin increases so overall impact on revenue is minimal
    2) AWS has significant scope to reduce prices should it decide to upend the hosting industry
    3) AWS has significant scope to address competitive pressures from other cloud providers

    It points to a fascinating interplay between volume and margin which I can see making AWS highly profitable and also provide a non-technological barrier to entry.

  • http://blog.gandalf-lab.com Niraj

    “Amazon’s business – that it was in fact a high volume over low margin business – is wrong.”

    This is wrong for now as Amazon is practically a monopoly in the space today. Soon, when others join in – price will go down even further and AWS margins will move towards PaaS.

    Just like kindle.

  • http://saviorodrigues.wordpress.com/ Savio Rodrigues

    Stephen,

    Doesn’t Werner’s tweet confirm that, in line with popular belief, AWS is a “high volume low margin business”?

    @dreeves1 You turned that statement on its head. At scale all components contribute to revenue, not just the network, High Volume Low Margin

    There’s nothing “low” about 40%+ gross margins!

    Maybe the UBS analysts have an incorrect gross margin estimate?

  • http://www.1060.org/blogxter/publish/5 SteveL

    -one issue is whether you view the AWS datacentres as existing capital expenses -stuff AMZN built for the Xmas rush- or new facilities. Storage cost/GB is fairly low, but their bandwidth looks nicely profitable. If you want to annoy the S3 team, create lots of 0 byte files.

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  • ashnyc

    you also need to take in consideration that amazon uses cloud computing internally. This is something integral to there business. Even if they where not renting computing power they will still need to build such an infrastructure. Q4 is where they need hugh amount of computing power, but they can rent there infrastructure at a profit during Q1-Q2-Q3

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  • Chandranshu Singh

    Amazon’s EC2 could be more of an exception than the norm; in any case one shouldn’t assume that all other IaaS vendors will do as well (in terms of margins) as Amazon has done. Two things come to mind:

    1. Amazon was a very well recognized brand before it got into the cloud business. So creating brand awareness or a name for themselves wasn’t a problem for them.

    2. Many other IaaS vendors have had to invest a lot of money for creating brand presence, and it took years for them to realise even modest margins.

    Scale in terms of installed base: (greater revenues lead to greater margins) is also closely linked to top of the mind recall of the hosting services provider.

  • http://beyondheadlines.wordpress.com Naren Chawla

    Hi Stephen:

    Rackspace (closest comparable as cited by UBS) as better reported Gross Margins (but poor profit margins) –

    RAX 2009 2008 2007
    Total Rev 187,314 178,805 169,516
    Gross Profit 125,844 121,798 116,111
    %Gross Margin 67.18% 68.12% 68.50%
    Net Income 11,198 9,812 9,035
    % Profit Margin 5.98% 5.49% 5.33%

    Also, for the record, here are CSCO numbers –

    CSCO 2009 2008 2007
    Total Rev 36,117,000 39,540,000 34,922,000
    Gross Profit 23,094,000 25,484,000 22,336,000
    %Gross Margin 63.94% 64.45% 63.96%
    Net Income 6,134,000 8,052,000 7,333,000
    % Profit Margin 16.98% 20.36% 21.00%

    I think you are pleasantly surprised that gross margins are close to approx 50%, but they are below main-line enterprise business like CSCO. If AWS gross margins were close to CSCO, then it will have nailed the argument dead-on.

  • James
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  • http://cloudscaling.com/blog Randy Bias

    I always find it amusing that folks outside the business are surprised by this. Almost every cloud provider is at 70%+ margins. Amazon actually has less margin because they are less oversubscribed. They are the most able to fall back, though. They are definitely planning around having low margins in the end game.

  • http://www.jagteshchadha.com Jagtesh Chadha

    Hi Stephen,

    This makes perfect sense.

    The aws pricing to my knowledge hasn’t changed over the last couple of years. But the cost of processing, memory and bandwidth has reduced; while they’re charging the same for it. This is what I conclude, for any additional capacity that AWS adds, their margins would continue to improve.

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