Amazon: Clouds on the Horizon a Good Sign?

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

When Amazon (NASDAQ: AMZN) Web Services (AWS) goes down, it seems to take half the web with it. Giants such as Netflix, Reddit, and Quora all use Amazon  AWS for their web servers and database needs. Let's take a more in-depth look at Amazon Web Services.

The product

AWS offers startups and big business alike a virtual data center that can scale up and down in mere minutes and that can be controlled from a computer anywhere. With AWS, businesses have the ability to build applications and websites, store data, and analyze data on Amazon's proven infrastructure. Start-ups and enterprises love AWS because it saves them the hassle of managing and scaling their own data centers, which can be very expensive and time consuming.

The business model

Amazon Web Services is sticky. Once a company uses AWS, it is hard for the business to switch to another service provider because any switch would mean server downtime, database migrations, and loss of focus on the product. 

In terms of profits, Amazon benefits from the fact that computing power and storage improves every year, while the price for those components stays the same. So as time goes on, even though Amazon may be charging the slightly lower rates for a computing hour or gigabyte of storage, Amazon's profitability goes up because its costs go down much more.

The potential

Big business has a lot of data and needs to mine that data to extract profitable insights. That data is growing very quickly over time, and Amazon Web Services, as the tool of choice for businesses to mine that data, will grow with it.

While Amazon does not state AWS revenue or margins in any of its filings, analysts speculate that AWS generated $1.5 billion in revenue in 2012. Joyent CTO Jason Hoffman believes that AWS' upper margins may be around 40-50%, and Macquarie analyst Benjamin Schachter believes that the cloud market will reach $71 billion in 2015 with AWS potentially capturing $38 billion, or 53 percent of that market.  

Using more conservative numbers of $20 billion revenue and 25% margin, Amazon Web Services could make $5 billion in gross income by 2015.

Other cloud providers

Rackspace Hosting (NYSE: RAX) is known for providing services and support for OpenStack, an open source cloud infrastructure project. Many thought OpenStack would win the $6 billion private cloud market because businesses could control it better. Those people underestimated Amazon's strength. On March 2013, the CIA awarded a $600 million, 10-year private cloud contract to AWS rather than IBM. The deal showed everyone that Amazon could also compete in the private cloud market as well.

Because of the fierce competition with Amazon, Rackspace Hosting shares are down 37% year to date. The shares trade at a nosebleed 55 times next year's earnings, and the company is projected by analysts to only grow at a 22% annual clip for the next five years. 

Another tech company that has had to deal with the rise of Amazon cloud is IBM (NYSE: IBM) . Just recently, IBM asked the majority of its US hardware workers to take a week off with lower pay, to cut expenses because of weakness in its hardware division. The company's hardware sales weakness can be attributed to the shift in IT hardware spending to cloud services that mainly use private label commodity gear versus IBM's brand-name hardware. The hardware division made up 16% of IBM's revenue in 2012, and its sales were down 12% year over year in Q2, and 17% in Q1. 

In response to the hardware division's weakness, IBM management has taken a $1 billion restructuring charge and is reportedly trying to sell its x86 server business to Lenovo.  

Conclusion

With secular growth trends such as the rise of big data and increasing acceptance of cloud computing, Amazon Web Services stands to benefit greatly. Using conservative estimates, Amazon Web Services could generate more than $5 billion a year in profit by 2015, making Amazon stock a buy.  
 

It's incredible to think just how much of our digital and technological lives are almost entirely shaped by just a handful of companies. Find out "Who Will Win the War Between the 5 Biggest Tech Stocks?" in The Motley Fool's latest free report, which details the knock-down, drag-out battle being waged by the five kings of tech. Click here to keep reading.


Jason Bond has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Rackspace Hosting. The Motley Fool owns shares of Amazon.com and International Business Machines.. 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!

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