Amazon's Cloud Isn't As Profitable As You Might Think

When Amazon.com (AMZN 1.30%) reported its first-quarter results last month, the big news was that the company's cloud computing business, Amazon Web Services, appeared to be extremely profitable. The first quarter was the first time Amazon broke out AWS as a separate segment, and the results sent shares soaring the following day.

There are a couple of things, though, that Amazon investors are ignoring. First, as fellow Fool Adam Levine-Weinberg pointed out, the operating-income numbers Amazon reported for its AWS segment don't include a major expense: stock-based compensation. Second, the economics of Amazon's cloud business are degrading rapidly.

While investors and analysts seem smitten with Amazon's results, the company's cloud business isn't nearly as attractive as it appears.

How about we include all of the expenses?
Amazon reported AWS revenue of $1.566 billion during the first quarter, along with operating income of $265 million, good for a 17% operating margin. These are non-GAAP numbers, though, since they exclude both stock-based compensation and some other expenses that Amazon leaves out.

The company didn't disclose how much stock-based compensation AWS was responsible for. Instead, Amazon simply reported the total stock-based compensation, which was $407 million for the quarter. In the company's 10-Q, it split the stock-based compensation expense between its expense categories -- fulfillment, marketing, technology and content, and general and administrative -- but not between the actual segments.

This makes it impossible to determine the real profitability of AWS. We do know a few things, though. Since essentially all of AWS's expenses are part of the technology and content expense category, we can put an upper limit on AWS's contribution to stock-based compensation. For the first quarter, that would be $233 million.

What fraction of this came from AWS? Total technology and content spending, minus stock-based compensation, was $2.521 billion in the first quarter. We know that AWS accounted for $1.301 billion of these non-GAAP operating expenses, or a little more than half. If we assume that stock-based compensation is split in the same way, AWS's stock-based compensation would be about $120 million.

That knocks the 17% non-GAAP operating margin down to about 9.25%, if my assumptions are correct. This still doesn't include any interest from the capital leases that Amazon uses to fund AWS. And if you were looking to value AWS as a separate business, taxes would knock this number down even further.

You could argue that, since stock-based compensation isn't a cash expense, it can safely be ignored. You could make the same argument about depreciation, but in both cases you would be wrong. A company giving its employees something of value, cash or non-cash, is a real expense, and it needs to be accounted for. If Amazon didn't hand out stock-based compensation to its employees, it would need to pay them more in cash. From Amazon's Q1 10-Q:

Operating expenses without stock-based compensation has limitations since it does not include all expenses primarily related to our workforce. More specifically, if we did not pay out a portion of our compensation in the form of stock-based compensation, our cash salary expense included in the "Fulfillment," "Marketing," "Technology and content," and "General and administrative" line items would be higher.

The 17% profit margin for AWS? It's not real. The real number is probably far lower, and while AWS probably still has a higher operating margin than the retail business, it's far from a cash cow for Amazon.

Things are getting worse
Along with Amazon's inflated profit numbers for AWS, the economics of the business are degrading. Here's the revenue and non-GAAP operating income for AWS for 2013 and 2014:

Source: Amazon Q1 earnings release.

While revenue grew by about 50% in 2014, operating income declined, sending margins plummeting.

This isn't the only sign of problems for AWS. While revenue grew by 50% in 2014, property and equipment attributed to AWS, mainly all of the servers and networking equipment, nearly doubled. In 2013, every dollar of AWS property and equipment produced about $0.96 of revenue annually. In 2014, this number fell to $0.77.

AWS is an extremely capital-intensive business, with servers having a useful lifetime of only a few years. In 2014, Amazon poured $4.295 billion into AWS in the form of capital expenditures and capital leases. The additional deprecation from these investments, along with lower revenue per dollar of assets, led margins to decline.

As AWS gets bigger, and as Amazon adds more high-value services, one would expect the business to become more efficient, with a higher asset turnover. At the very least, AWS shouldn't be getting less efficient. But it is, and that's a problem.

A good comparison is Rackspace (RAX), a cloud hosting and cloud computing company. Rackspace isn't as big as AWS, and it's not growing as fast, but its business is very similar. Here's how Rackspace's operating margins and property and equipment turnover have evolved over the past five years, as revenue has more than doubled:

Source: Rackspace. Operating margins are not comparable to AWS, since AWS numbers are non-GAAP.

As Rackspace has grown, its operating margin has shrunk a bit, but its revenue per dollar of property and equipment has expanded, exactly what should be happening as the benefit of scale makes the company more efficient. Rackspace generates far more revenue for each dollar of equipment compared to Amazon.

AWS is far less profitable than Amazon's reported numbers suggest, and the business is getting less efficient as it grows, with Amazon generating less revenue for each dollar it throws into AWS as time goes on. AWS doesn't seem to be benefiting from scale at all, and that should be a major concern for investors.