Amazon Web Services: Capital As A Service?

| About:, Inc. (AMZN)

"It has never been cheaper to start a company." A bold statement, but one that comes up frequently when talking to those who invest in and start new technology companies. Mostly because it is true.

One reason? The "cloud" and IaaS (Infrastructure as a Service) have been game changers.

Historically, one of the largest barriers to entry for a start-up has been spending on infrastructure. As good or not good as an idea was, you were going to need a lot of money to buy servers and equipment. But a few years ago that all changed. IaaS was born, and companies like Amazon Web Services (AWS) at Amazon (NASDAQ:AMZN) created a new industry by providing cloud based infrastructure.

And the growth has been astonishing. While Amazon does not provide any financial details about AWS in its 10-K, a division that did not exist a few short years ago is now estimated by some to have several billion in revenues. High-profile, fast growing names like Dropbox, Pinterest, and Netflix (NASDAQ:NFLX) have built incredible businesses using AWS as the backbone. Which is nothing short of amazing.

And not only have the Netflix and Pinterest benefited, but Amazon shareholders have benefited immensely as well - below is the chart of Amazon's share price since 2006 (when AWS debuted).

AMZN Chart

AMZN data by YCharts

But let's think about this for a minute. Why are so many start-ups using AWS and why is it growing so rapidly?

Looking at Netflix, an answer becomes apparent. Netflix could have gone to the capital markets, raised the money and built out its own infrastructure. But that would have been expensive for shareholders. Netflix would have either diluted equity holders by issuing stock, or taken the risk of borrowing debt. So instead, they called AWS. And AWS said "We will build your infrastructure - and you can just pay us as you use it."

The reason that AWS and IaaS can grow so rapidly is because they are buying something so that companies don't have to. One can argue that the AWS business model is, quite simply, the buying of servers and the lending of them to start-ups and growth companies. Although Amazon describes this as a "service" - the service is really just the service of providing capital. Capital as a Service. Buying things so you don't have to.

Which is really fascinating. Providing discounted capital through cheap infrastructure to new and growing companies is a great service. Because of AWS, it has never has been cheaper to start a company - or cheaper to fund your expansion. IaaS and AWS have removed a significant barrier to entry and growth by removing a risk - the risk that an investor is stuck with a bunch of expensive and soon to be antiquated infrastructure if the business fails.

That risk, of course, is now held by Amazon. Which is completely and totally acceptable - as long as Amazon is getting paid to take that risk. But because Amazon does not disclose any operating metrics for AWS, there is absolutely no way to know how much Amazon is being compensated for a risk that used to be held by venture capitalists.

That lack of disclosure poses some interesting questions for Amazon shareholders. Start-ups and growth companies are using AWS because AWS is willing to take downside risk by providing capital as infrastructure - in exchange for a recurring fee. But isn't that really just lending? Is AWS effectively making low-return unsecured loans to growth companies and start-ups? Is that why it has never been cheaper to start a company? Has Amazon Web Services simply been providing Capital as a Service?

The concern a long-term investor should have is that the answer to those questions is "Yes." Building a capital intensive server farm for a start-up and receiving a monthly fee for that service is basically lending. Amazon puts up the capital, receives a fee in return. Not much different than a bond. And judging by the lack of profits at Amazon, they are not even getting paid much "interest" to do it.

However, the even bigger concern a long term investor should have is that "Capital as a Service" has the potential to be even worse than a bond. Many of AWS' customers are early stage companies. What happens when the next "Pinterest" doesn't get its next round of funding? Amazon owns the servers, but doesn't have a customer. Big problem. At least a bondholder has recourse when the borrower stops paying.

Businesses like AWS do very well in a monetary policy environment like we have right now. QE provides liquidity that funds start-ups - and they even have a name for it: "dot.com2.0". When start-ups are getting funded, businesses like AWS grow - and grow rapidly (remember the Internet Incubators of 1999/2000?). Unfortunately, shareholders are too blinded by the growth of AWS to think critically about what Amazon is really doing: providing cheap capital to start-ups when they are already awash in it.

While AWS will continue to keep growing in the current environment, and the shares may continue to rally as a result, the long-term prospects could pose a particularly frightening scenario. It is no secret that Amazon generates the majority of operating cash flow via an operating cycle arbitrage -- borrowing "cash flow" from vendors as Accounts Payable (the "Free Pass"). But what happens when the funding environment changes? Borrowing money from vendors and using it to build server farms for start-ups that could disappear overnight is an incredibly risky proposition.

Disclosure: I am long both puts and calls in Amazon. 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.