Apple (AAPL -2.63%) and Amazon (AMZN 0.58%) weren't competitors in the past, but the two companies now have overlapping interests in app stores, streaming media, virtual assistants, smart speakers, tablets, and set-top boxes. Apple is gradually evolving into Amazon's ecosystem rival as it diversifies its business beyond the iPhone, but it's still tethered to Amazon in one major way: the cloud.
Apple reportedly pays Amazon $30 million per month to use Amazon Web Services (AWS), the largest cloud platform in the world. Apple previously stated that it uses AWS for iCloud storage, but hasn't disclosed which other services run on the platform.
This might sound like a great deal for Amazon, but Apple's dependence on Amazon is gradually waning. Let's see why Apple could eventually stop using AWS, and what that might mean for Amazon.
Down from $1 billion
In early 2016, Morgan Stanley analyst Brian Nowak estimated that Apple paid Amazon $1 billion in annual AWS fees. At $30 million per month ($360 million per year) now, that's a big fee drop from three years ago.
That annual figure probably won't drop much more. Apple reportedly signed a deal with Amazon earlier this year which guarantees that it will spend at least $1.5 billion on AWS over the next five years.
Apple reduced its AWS fees by spreading its cloud services across Microsoft's (MSFT -2.31%) Azure and Alphabet's (GOOG -1.38%) (GOOGL -1.45%) Google Cloud Platform. Apple also gradually expanded its first-party cloud infrastructure. Last January it stated that it would spend $10 billion on U.S. data centers in the next five years. In December, it stated that it would spend $4.5 billion of that total during 2019.
That aggressive spending indicates that Apple could eventually declare independence from Amazon, Microsoft, and Google, which all compete with Apple in certain markets. It would also boost the gross margins of its cloud-based services over the long term.
Cutting its long-term cloud costs
Cutting cloud costs matters because Apple is expanding its higher-margin services business to reduce its dependence on lower-margin hardware sales. Apple stated that the services unit had an impressive gross margin of 62.8% last quarter, compared to a 34.3% gross margin for its products.
However, newer services like Apple News+, Apple TV+, and Apple Arcade could initially be loss leaders due to high content costs. Morgan Stanley recently warned that Apple will likely "spend enormous sums for years" on Apple TV+ without "generating much revenue in return." The Financial Times recently reported that Apple was investing $500 million in Apple Arcade, its subscription-based gaming platform. Apple Music, which launched in mid-2015, probably still isn't generating meaningful profits.
These low-margin services could offset higher-margin services like the App Store, so cutting cloud costs by expanding the company's own infrastructure is a smart long-term strategy. This self-reliant strategy also complements Apple's approach to hardware, where it's gradually replacing third-party components with first-party ones.
What does this mean for Amazon?
Amazon's AWS revenue rose 47% to $25.7 billion, or 11% of its net sales, in 2018. Apple's annual payment of $360 million would only account for 1.4% of that total. Therefore the complete loss of Apple's business would barely impact AWS' growth.
Investors should also note that Apple's AWS payments already dropped significantly over the past three years, yet higher demand for AWS from other customers easily offset those losses. That's great news for Amazon, since AWS generates most of the company's operating profits and supports the growth of its lower-margin marketplace business and other loss-leading efforts.
Nonetheless, Apple's moves highlight three of AWS' weaknesses. First, companies that compete with Amazon in certain markets (like Apple and brick-and-mortar retailers) are likely more reluctant to use AWS. That's why many brick-and-mortar retailers use Microsoft's Azure and Google's Cloud Platform instead of AWS.
Second, large AWS customers like Apple can eventually declare independence by building their own cloud infrastructure. Facebook, Dropbox, and other companies all adopted this strategy in recent years. Lastly, these big customers can likely score better multi-year deals from Amazon, Microsoft, and Google by shopping around and spreading their services across multiple platforms.
What does the deal mean for investors?
Apple paying Amazon $30 million a month might initially sound like a big deal, but it's not a significant amount of cash for either company.
The key takeaway here is that Apple is reducing its dependence on AWS, and that long-term strategy could improve the gross margins of its growing services unit. It also highlights some issues that could throttle AWS' growth in the future. But for now, this revelation shouldn't impact either tech giant's near-term plans.