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Summary

  • AWS' economics are starting to look like a textile operation's.
  • Indeed, they're starting to look like a textile operation's merged with a pure paper pulp maker.
  • These are horrendous economics, which will tax Amazon.com's economics even further.

Most people following Warren Buffett know that when he bought Berkshire Hathaway, Berkshire was a textile mill. Warren Buffett saw it as being cheap, from a time when he bought more on valuation than quality, and swooped in.

Thing is, the textile business was ultimately horrendous. It was permanently plunged into cut-throat competition and at the same time it required systematic capex outlays. Warren Buffett even said that seeing new, more efficient, machines coming was a dreadful sight. He'd either have to buy them and then so would everybody else, leading to no competitive benefit, or he wouldn't buy and since others would he'd be at a competitive disadvantage.

So why am I bringing this story? It happens that Amazon.com's (NASDAQ:AMZN) AWS is looking more and more like the textile business. Competition is intense and the machines keep getting improved, requiring more and more capex just to stay in the same place, competitively speaking.

Moore's law

When hyping the cloud, many have taken to describing how prices and capacity will follow Moore's law. This means as computing and networking capacity get cheaper, so will buying cloud computing and storage. This sounds good on paper, leading to the kind of chart below:

It sounds very appealing, how you can serve customers cheaper and cheaper, becoming more and more competitive against traditional in-house computing/storage.

But there are two problems:

  • First, in-house computing/storage buys the same computers and storage so it gets the same benefits;
  • And second, imagine what happens if you establish your cloud capacity at point 1, and then a competitor comes at point 2 (see chart below). Your original cloud capacity becomes instantly uncompetitive - you don't get to enjoy the benefits of Moore's law without re-buying your physical plant. And worse still, since this happens so quickly you don't get the payback on your original investment, either. That's where Amazon.com is today regarding its past cloud investments and the recent price cut. Amazon.com is not going to recoup the massive past investments in AWS, as the equipment is running at a loss now and will quickly be obsolesced as well.

So this is all strikingly similar to textiles. Amazon.com has to keep on spending massive amounts on capex, and such investments only keep it in the same place competitively speaking. And over time, with the massive ongoing improvements in equipment, the past investments won't have time to be paid back and will become obsolete quickly.

It gets worse. The business is also similar to a pure paper pulp maker

Providing cloud capacity can be even worse than a textile business. Here, I'll introduce pure paper pulp makers. There were several of these for many years, including Aracruz in Brazil. These producers were not integrated: they produced paper pulp but not paper. Most of the paper production worldwide, however, was integrated, in the sense that paper markets mostly also had pulp operations.

This meant that making paper pulp was a deeply cyclical business - when demand for paper diminished a little, demand for paper pulp diminished a lot, since integrated paper makers first cut outside supplies unless the price was very low.

So how is the cloud becoming similar? It is becoming similar with the emergence of hybrid clouds, where customers run part of the necessary capacity themselves and buy capacity from public clouds for peaking needs. I have explained this phenomenon in my previous article "How Amazon's AWS Can Attract Ugly Economics".

This is already happening with AWS' largest customers, including Zynga, Dropbox and Netflix. At the same time, since AWS needs to compete with baseload capacity, its prices cannot be the "peaking" prices which such usage would demand. Furthermore, the peaks can be large and AWS needs to have the capacity to serve them.

All in all, on top of behaving like a textile business, selling public cloud capacity will also behave as a pure paper pulping operation. Mind you, the economics on these pure paper pulp makers were so hideous that when they had profits, they'd usually trade for a low single digit Price/Earnings.

Conclusion

Public cloud provisioning is taking on characteristics of two lousy businesses: textiles and pure paper pulp making. Neither bodes well for the economics of the business.

Amazon.com remains fantastically overvalued and its economic prospects keep getting worse. Salvation is not going to come from AWS.

Disclosure: The author is short AMZN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: How Do You Like Them Textiles?