Amazon.com's AWS Unit Is Starting to Enjoy Operating Leverage

By Markets Fool.com

Image source: Getty Images.

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This should come as no surprise, since cloud infrastructure businesses are fundamentally scalable once upfront investments are made, but Amazon.com's (NASDAQ: AMZN) all-important Amazon Web Services (AWS) segment is starting to enjoy the benefits of operating leverage. The e-commerce giant reported third-quarter earnings last month, and AWS continues to steal the show in terms of profitability.

AWS revenue jumped 55% last quarter to $3.2 billion, while AWS operating income doubled to $861 million. That actually accounted for more than 100% of Amazon's consolidated operating income; international e-commerce operating losses of $541 million more than consumed all of North America's e-commerce operating income of $255 million and AWS was able to bring Amazon to an overall operating profit. Within the segment, operating margin (excluding stock-based compensation) has now hit an impressive 32%.

Data source: SEC filings and author's calculations. Chart by author. SBC = stock-based compensation.

This performance is even more impressive when you acknowledge that AWS is engaged in an ongoing pricing war with other major cloud infrastructure providers. Amazon is constantly and aggressively cutting prices to remain competitive, yet is still able to grow the top line while also expanding profitability. Most of the time when an industry is engaged in a price war, everyone loses in the form of margin contraction. Not so with AWS.

That's what he said

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On the earnings call, CFO Brian T. Olsavsky expressed confidence in AWS' competitive position:

The thing I can tell you about pricing is that our pricing is, price reductions are a core part of our philosophy, of course. We had a price decrease in Q3, and that was our 52nd since we started this business. So we are comfortable with price decreases. Not only did we lower the prices of our products but we also create new services that are cheaper that customers can switch to. So they can also benefit from that as well.

So if you step back and say why do people choose AWS, I'll give you the points I said last quarter. Basically what we hear are the functionality and pace of innovation is greater than our competition. We have added more new significant features and services this year already than we had all of last year when we added 722. We have a partner and customer ecosystem. You've read about the VMware deal that we signed this quarter. So we continue to extend with partners and build ecosystems that better can support customers. And finally experience. We've been in this business a long time, longer than anyone else, and we've used that time to make our products and services better. So there was going to be a lot of winners in this space as we said, but we are very happy with our position and the customer reception to our products.

Amazon is also doing some hand-holding in terms of helping customers transition their IT needs from on-premises solutions to the AWS cloud, assisting with things like database migration. Making it easy to migrate to AWS is a key initiative at Amazon. Amazon continues to expand its AWS team, and has been aggressively hiring there. That will put upward pressure on stock-based compensation expenses within AWS (which are excluded from the chart above), which were $160 million last quarter. Still, Amazon has established itself as the leader in cloud infrastructure, and it's going to play major defense.

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Evan Niu, CFA has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. The Motley Fool recommends VMware. 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.