Is Amazon's AWS Too Profitable?

By Markets Fool.com

SOURCE: AMAZON.com.

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For a company that went two decades with minuscule profit margins, Amazon.com has enjoyed a streak of profitability that's been a welcome relief for longtime stockholders. The driving force behind Amazon's profit over the past year is Amazon Web Services, the company's cloud computing division. Last year, it brought in $7.9 billion in revenue at an operating margin of 24%. Amazon's retail operations produced an operating margin of less than 3% by comparison.

While investors have cheered the profits driven by AWS, competitors Microsoft and Google, the Alphabet subsidiary, are aggressively going after the market. Google recently announced a slew of new customers, including Spotify, Disney, and Home Depot, while reports indicate that Apple recently came on board as well. With high-profile (and high-revenue) customers heading toward the competition, does Amazon need to consider the weird idea that AWS profits may be too high?

Another price war
While it's not explicitly clear how Google is attracting such big customers, the likeliest case is that it's simply undercutting Amazon's pricing. This is a tactic both Google and Microsoft have taken before to attract new customers. In late 2013, all three cloud companies started slashing prices considerably. Google committed to pricing that follows Moore's Law, implying the cost will be cut 20% to 30% every year.

From October 2013 to June 2014, Amazon cut prices 36%, according to RBC's Mark Mahaney. Google cut its prices 35%, and Microsoft trimmed 24% off its prices in the same period. As a result of the price cuts, Amazon's AWS operating profit actually fell year over year in 2014.

It certainly bounced back in 2015, nearly tripling year over year, but another price war could be just as costly for Amazon. Analysts expect Amazon's profits to continue expanding this year and next. Analysts' consensus for Amazon's EPS come to $4.69 for 2016 and $8.64 in 2017, up from $1.25 last year. Considering most of Amazon's profits are driven by AWS, a drop in operating income like in 2014 would be devastating for Amazon's stock price.

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And Google and Microsoft are serious
Google recently announced plans to add 12 new regions in the next 18 months to its Cloud Platform to provide it the global scale to take on Amazon and Microsoft. It's starting with covering the Western U.S. with a data center in Oregon and East Asia with a data center in Japan. The move will quadruple its existing reach and bring it in line with Amazon, which currently operates 12 regions, with a further five planned.

Google's head of cloud computing, Diane Greene, is also hiring across the board in an effort to work more closely with its enterprise customers. She wants to make sure their needs are met, whereas before it was focused on building advanced cloud system. It eschewed basic services like compatibility, compliance, and security, which are of the highest importance for enterprise customers, and a reason Amazon's more basic services drew more customers.

Microsoft, meanwhile, just announced that Azure, its cloud platform, is drawing in 120,000 new customers every month, accelerating from 100,000 at this time last year. It also released an Internet of Things platform, which has seen strong adoption, processing over 2 trillion messages every week.

Should Amazon investors be scared?
While Google and Microsoft have gotten more aggressive with their products and pricing lately, Amazon has maintained a sizable lead over the competition. While Google has made some high-profile announcements, Amazon hasn't lost any major business because of it. With the market for cloud platform and infrastructure expected to grow 35%, according to Gartner, Amazon can afford to cut prices a certain degree to stem any losses to Google or Microsoft.

So, while the announcements indicate the competition is heating up, Amazon is still in the catbird seat.

The article Is Amazon's AWS Too Profitable? originally appeared on Fool.com.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy owns shares of Amazon.com and Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Apple, and Walt Disney. The Motley Fool recommends Home Depot and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.