Amazon: Will The Real AWS Margins Please Stand Up

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

Summary

There is noise around AWS margins.

Amazon's GAAP disclosure of AWS operating margins does not capture the full picture.

Incorporating stock-based compensation provides a more accurate picture of economic reality.

Apart from a recent swoon, Amazon (NASDAQ:AMZN) has seen its market capitalization soar in the past 12 months. At the beginning of 2015 shares traded at roughly $310, they are currently at about $488.

Part of the narrative fueling this has been Amazon's increased disclosure around its cloud computing segment - AWS (Amazon Web Services). The AWS segment has turned out to command higher margins than what was previously expected from the commodity like nature of its business.

Unfortunately, amid all the euphoria, it isn't quite clear exactly how profitable AWS really is. Part of the fault lies with news sources often failing to distinguish between gross, operating and net margins.

The purpose of this article is to shed some light on the actual (current) profitability of AWS. Let's start with some data (extracted from Amazon's most recent 10-K).

AWS segment results ($ amounts in millions)

  2015 2014 2013
Revenue $7,880 $4,644 $3,108
Operating expense* $6,017 $3,984 $2,435
Operating income $1,863 $660 $673
Operating margin 23.64% 14.21% 21.65%
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That would seem to be the end of the story. Unfortunately, as with almost all of Amazon's disclosed financials, there is a bit more to it. Namely, the footnote accompanying that pesky asterisk:

* - Excludes stock-based compensation and "Other operating expense (income), net," which are not allocated to segments.

I am going to ignore the other operating expense part, since I don't think it makes a material difference. However, stock-based compensation is a real expense and bound to cause a significant difference.

Consequently, to have a more accurate picture of the margins at AWS, we need to estimate stock-based compensation expense in the segment.

As a starting point, note that in Amazon's consolidated statements, most of the expenses associated with AWS fall under Technology and Content expenses. Here are the figures for the stock-based compensation component of this ($ amounts in millions):

  2015 2014 2013
Stock based comp. (tech.+cont.) $1,224 $804 $603
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All that remains to be done is estimate how much of this should be allocated to AWS. This is more or less anyone's guess. However, here are the resulting margins for AWS based on a range of, what I believe to be, reasonable guesses:

Adj. operating margin for AWS      
  2015 2014 2013
50% allocation 15.88% 5.56% 11.95%
60% allocation 14.32% 3.82% 10.01%
80% allocation 11.22% 0.36% 6.13%
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Now AWS enjoys economies of scale. Thus, one might expect margins to expand in the future. On the other hand this needs to be offset by pricing pressure - due to competition, as well as Amazon's own penchant for offering customers the lowest prices possible.

All in all, I would venture that a reasonable estimate of the pre-tax economic margins at AWS (now as well as in the future) are about 10%-12%.

Parting thoughts

Most valuations of AWS essentially involve the shortcut of taking a multiple of current segment revenue. Implicit in these multiples are estimates of two crucial factors:

  1. economic margins at AWS;
  2. revenue growth rate.

Personally, I employ a minimum of a 10% pre-tax economic earnings hurdle rate. In fact, I suggest to readers that much higher rates should be employed for businesses in which there is uncertainty about future earnings (note: extrapolating high growth rates on a straight line usually ends in tears). Consequently, given our estimate of the real margins at AWS, I would venture that an investor should value AWS today at no more than 1x their best estimate of revenues in the segment 3-4 years down the line.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.