Amazon.com's AWS Is Much More Valuable Than We Thought

Summary

• AMZN's first reported financial results for AWS were way above expectations, on the bottom line.
• AWS's valuation has been estimated up to $50 billion, making the asset appear cheap compared to other cloud names such as Salesforce.com.
• After reporting financial results, AMZN has set the stage to explore its options, possibly a spin-off of AWS, leading to much larger stock gains.

Amazon (NASDAQ:AMZN) reported figures for its cloud services business, Amazon Web Services (AWS), for the first time in its history. Turns out, the company should have done it sooner, as AWS looks to be a much better-performing asset than anyone figured, and may lead to much larger gains by itself.

Up until this point, analysts have had no foolproof way to gauge AWS's operating performance. Among the most reliable methods was to use Synergy Research's estimates or to assume that Amazon's North American Other revenue was a reflection of AWS. However, what we didn't know, and couldn't know, was the asset's high profitability - which is surprising, to say the least.

AWS controls about 30% of the cloud infrastructure services market, a market that did $16 billion in revenue last year and grew 48% year-over-year. AWS's reported growth of 49% year-over-year and revenue of $1.57 billion is about what experts thought - nothing too surprising there. However, its $265 million in operating profit is shocking.

For those who haven't followed the cloud services story over the last year, the industry has undergone a series of aggressive price cuts and changes. Amazon, Microsoft (MSFT), Google (GOOG, GOOGL) and other leaders have cut prices on popular cloud services by north of 70% year-over-year. Yet, despite these cuts, revenue growth remains robust.

That said, Amazon's AWS operating profit only grew 8% in the quarter, illustrating that margins did decline in response to those price cuts. Yet, who cares? The business has an operating margin of nearly 17% - a shocking surprise to the many who figured Amazon was barely breaking even with AWS, if not unprofitable.

Now, the beauty to AWS's business model is that it is mostly recurring revenue. It is not typically seasonal, meaning that revenue has consistently grown on a quarter-to-quarter basis. AWS clients use the service for countless functions, such as a host for their applications, for storage, or to build a cloud platform service of sorts. Therefore, with most of these services being recurring or subscription based, Amazon's first-quarter results should only get better from this point forward, quarter-after-quarter.

For this reason, AWS might be even more important to the company's valuation than analysts had originally thought. Back in late 2013, Evercore assigned a seemingly ridiculous $50 billion valuation on the asset. Back then, AWS was the unquestioned leader of the cloud pack, having 1,100 product listings and five times the server capacity of its next 14 service provider competitors combined, according to Evercore. Since then, the price war has erupted, revenue growth had slowed, Microsoft has come on strong, and many thought that whatever margins AWS had created were probably evaporated.

Given these events and assumptions, it is likely that AWS's valuation relative to the company's market capitalization has seen little change. In fact, Amazon's stock has only risen 20% since that Evercore rating, and most of those gains have been due to the company's improved bottom line and cost control.

With a quarterly operating profit of $265 million and a recurring revenue business model, I will estimate that AWS is on a operating profit 12-month run rate of $1.1 billion. That means AWS trades at 45x forward operating income, assuming a valuation of $50 billion. For a business that's growing nearly 50%, led by a management team that's already said pricing will remain mostly stable, I think that's a very favorable valuation. After all, Salesforce.com (CRM) is trading at 75x forward earnings, with about half of AWS' growth rate. Given this fact, AWS might be worth closer to $85 billion in the free market, especially as a publicly traded entity of its own.

This brings up my final point, that being the possibility of Amazon finally announcing AWS's operating performance as a way to build excitement ahead of a future spin-off. While speculative, it is also very possible. AWS doesn't exactly mesh well with e-commerce, and much like eBay (EBAY) is splitting PayPal to allow different management teams to focus on different types of businesses, I think Amazon might eventually do something similar.

That said, with AWS accounting for just 7% of the company's revenue and possibly up to 50% of its market capitalization, investors should feel very good about a long-term investment in Amazon. After all, if the company were to spin off AWS, much like Yahoo (YHOO) is doing with its Alibaba (BABA) stake, then Amazon's stock no longer looks all that pricey, given the size of its e-commerce presence. The bottom line: AWS is likely more valuable than anyone thought, an indication that it'll drive Amazon's valuation higher regardless of what action the company takes.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.