Amazon Killing the Cloud Boom

Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Amazon.Com (NASDAQ: AMZN) has become a classic “category killer.”

Most investors see it as killing the category of online retail, which it absolutely dominates. It's almost five times larger than the number two in this market, according to Netonomy.

But there's a second category Amazon is killing, the cloud.

A year ago cloud companies were booming. By creating virtual operating systems, using commodity PCs instead of specialized servers, and scaling out huge data centers, cloud companies like Rackspace (NYSE: RAX) and Red Hat (NYSE: RHT) promised to revolutionize how business is done, quickly analyzing huge amounts of data for patterns or needles of opportunity, cutting costs dramatically.

But yesterday's cloud stars are today's cloud duds. And there is one reason – Amazon.Com.

Amazon.Com killing it in the cloud

Cloud has been around for a decade. Google developed many of its techniques to handle internal operations. Yahoo! developed the Hadoop software that allows “big data” to be analyzed quickly.

But Amazon was the first company to offer its cloud technology for rent. Its Elastic Computing Cloud, or EC2, was the first to be offered at an hourly rate, in 2006. While Amazon developed its technology to serve its stores, it found it had a hit with renting that infrastructure, and has been going full-bore ever since.

As with online retailing, Amazon's strategy is to put every dollar it gets back into the business, forgoing sales for growth. It barely broke even on $61 billion in sales last year, but that figure was 267% better than 2009's $24 billion, and growth investors are willing to pay a premium to be part of that. Since the market's bottom in late 2008, the value of Amazon.com shares have risen six-fold, and despite bearish articles from writers who don't like growth without profit, they're still going higher, 18.5% this year alone.

Amazon took out its first long-term debt in 2012, $3.1 billion worth, and is paying it off slowly. The money is being plowed back into infrastructure, not just for its retail operations but for its EC2 cloud. Netcraft, which does a regular automated census of Internet servers, estimated the company had 158,000 servers online last month, mostly in an immense Virginia data center. But the company is increasingly dispersed, with centers in England, Japan, Singapore and the United Kingdom.

Of greater concern to investors in cloud is its pricing. Gigaom.com this week reported what it called an “80% price cut” on some Amazon cloud services,  although it later backtracked partially, writing that cuts of 37-57% on other services were more applicable.

The company is also broadening its line. What was once base infrastructure is now available in flavors for Red Hat Enterprise Linux and Microsoft Windows as well.  Still, there is no price that's higher than $2/hour, even for the largest storage clusters, although there are up-front and reservation fees on those prices.

Amazon does not break out its cloud revenues, clustering them into something called “other,” but Macquarie Capital thinks it's worth $19 billion and that will double by 2015.  That means investors are paying a little over $2 for every $1 in Amazon retail sales – still a high figure, but with growth this fast not unreasonable.

Who Amazon is killing

Amazon is doing the most damage to companies that sought to create alternatives to its infrastructure and platform.

Rackspace, for instance, has seen its stock price cut nearly in half during 2013. The San Antonio-based company, which pioneered the development of Open Stack, an open-source cloud infrastructure, has seen its growth stop nearly dead in its tracks, growing just $10 million quarter-to-quarter. The balance sheet isn't growing, and cash flow has been cut.

Analysts who were bullish on the stock at $80/share are now calling it just a “hold,”  expecting just $0.62/share in earnings for all of 2013, and just $0.82/share next year. The company's problems are starting to impact the entire Open Stack infrastructure, which once seemed ready to take out Amazon because code is shared and can be fixed by users.

Red Hat has also been hurt by Amazon's dominance of the space, and while it's now down just 6% so far this year that understates the recent case. The price of Red Hat fell from almost $55/share in mid-May to under $46/share by early June, and has since recovered less than half that loss.

Red Hat is best known for its Enterprise Linux and JBOSS middleware. Its cloud play is called OpenShift, and is designed to bring those other products to cloud operations, making it easier to transfer workloads to cheaper infrastructure and to rewrite applications for use in the cloud. The company has reported earnings twice this year, given its fiscal year ending in February.

Sales for the February quarter were just $4 million ahead of those in the previous quarter, and they were $15 million ahead of that figure in the May quarter. Earnings Per Share (EPS) have been basically flat, at a little over $0.20/share per quarter, and margins are falling slowly.

The game is not over

It's important to note that, despite its aggressive price-cutting, Amazon has not killed the cloud market, only gotten on top of it. Microsoft has promised to match Amazon's prices on base-level infrastructure, IBM is making its cloud offerings more flexible by buying SoftLayer, and Amazon was hurt last year by a number of ill-timed service outages.

Still, its victory in a tussle with IBM over a $600 million, 10-year contract to build a private cloud for the CIA, provided another shock to the markets. It's been assumed that, while Amazon was the public cloud leader, companies would want more mainstream partners in building their own private clouds. If the CIA, assumed to be one of the largest such customers, is going with Amazon, who else might?

The Foolish bottom line

Remember, Amazon has an invisible Price/Earnings multiple, because it runs at break-even, and any fall in its sales momentum, even if that comes from retail, is going to hurt shareholders badly. Personally, I thought the price was a nosebleed high at $230/share, I sold my stake, and now I'm looking at a $300 stock, so what do I know.

The Foolish take, however, is to discount Amazon's competitors until they prove on the bottom line that they can gain traction against it. The cloud boom has become the cloud bust.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Dana Blankenhorn has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Rackspace Hosting. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus