What Is Amazon Web Services Really Worth?

| About: Amazon.com, Inc. (AMZN)

There has been a lot of talk on Wall Street recently about Amazon.com's (NASDAQ:AMZN) cloud computing division, Amazon Web Services (AWS). The company held its first-ever AWS conference this week, and used the opportunity to promote the AWS business opportunity. In a Forbes interview, CEO Jeff Bezos explained that the business model is similar to that for the Kindle, because Amazon makes money when customers use the service. AWS charges for its various cloud computing services on an à la carte basis: The more customers who use it, the more revenue Amazon brings in.

Bullish analysts talk about AWS as an engine of growth for the company, and many investors seem to think that AWS is bound to raise Amazon's margin profile over time as a high-tech business unit. For example, Colin Sebastian of R.W. Baird recently wrote that AWS will help Amazon eventually achieve 7%-8% operating margins. A Bloomberg feature on AWS highlighted the segment's fast growth (estimates are around 60%-70% revenue growth).

However, most of the Amazon Web Services business (providing access to cloud-based storage and computing power) is fairly mundane. There are no major barriers to entry, and therefore no reason to believe that Amazon will ever be able to turn these into high margin businesses. In his keynote address this week, Andy Jassy (Amazon's senior VP for AWS) stressed AWS's scale and large customer base as key factors -- not any unique capabilities. Indeed, he made a point of highlighting how many times AWS has reduced prices since it began operations (answer = 23 times) and announced a further 24% to 27% price cut for Amazon's cloud storage product. In virtually all of its promotional materials, Amazon Web Services markets itself for being cheap, not for being unique. This is not the sign of a high-margin business.

Amazon Web Services has competed with a variety of tech companies that also offer cloud-based storage and computing capabilities, such as Rackspace (NYSE:RAX) and tech giants IBM (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ). Indeed, Jassy touted the ability of AWS to undermine these companies' more traditional business models through the "virtuous cycle" where low pricing leads to rapid growth, creating economies of scale that allow further price cuts. The problem for Amazon is that Google (NASDAQ:GOOG) recently decided to create a competing cloud computing service. While Google has had very high company margins historically, it has also shown (through its open source development of Android and the acquisition of Motorola Mobility) that it is willing to dilute margins if that will keep the company growing. Moreover, Google has an immense war chest with more than $40 billion of net cash and investments on its balance sheet to fund initial operating losses as it scales its cloud computing platform. Thus, Amazon may have finally met its match in the cloud computing world.

Amazon touted its economies of scale when announcing its most recent price cut, but the move was almost certainly a reaction to Google's announcement on Monday that it would add new features to its cloud platform and drop cloud storage prices by more than 20%. Following the Amazon price cut on Wednesday, Google announced on Thursday that it will reduce Cloud Storage prices by another 10%. Google has an incredible number of low-cost servers located worldwide (and was the original inspiration for Amazon's server farms). With this week's dual price cut, Google has shown that it is willing to go to the mat with Amazon on pricing.

I have no doubt that Amazon Web Services will continue to show strong revenue growth, even with added competition from Google, as the unaddressed market is still large. The problem for Amazon is that with Google as a competitor, it will never reach a scale where it can finally expand margins. Even if Amazon can grow the business from an estimated $1.5 billion in 2012 to $10 billion or even $15 billion in five years (a 46%-59% CAGR), margins will still be 10% or less at that time. While Rackspace, the closest comparable, had a pre-tax margin of almost 12% last year, its offerings tend to be higher value-added and thus command higher margins.

A relatively mature business with pre-tax margins of 10% or less can justify, at best, a one times revenue multiple. (That works out to a 15 times to 20 times earnings multiple) Even in the bullish scenario where AWS reaches $15 billion in sales in five years, the market would be fairly mature by then, and so the best case valuation for AWS would be $15 billion at that time. Discounting that back to present value would therefore put the maximum value of AWS today at less than $10 billion. While this is a significant number, it is a very small portion of Amazon's market cap (currently over $110 billion).

Thus, to justify the current valuation, Amazon will have to extract much higher profits from its retail business. As I have written elsewhere, revenue growth is already beginning to slow down, and I expect this trend to continue in 2013. With retail operating margins likely to be permanently low -- no more than 5%-7%, in line with best-in-class competitors like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) -- the retail business cannot justify Amazon's greater than $100 billion valuation, either. Therefore I continue to recommend shorting Amazon.

Disclosure: I am short AMZN, and long HPQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.