Ever since Amazon (AMZN 1.42%) started breaking out Amazon Web Services' (AWS) revenue and operating profits in 2015, a growing number of analysts have called for the tech giant to spin off the expanding cloud business.
As a longtime Amazon investor, I've repeatedly opposed that idea, for a simple reason. AWS generates higher-margin revenue than Amazon's retail business, so it actually drives most of Amazon's profit growth, while supporting the expansion of its retail ecosystem with deep discounts, cheap hardware devices, brick-and-mortar stores, and other loss-leading strategies.
But over the past year, I've gradually warmed up to the idea of Amazon spinning off AWS. Let's take a look at three reasons Amazon should consider a spin-off -- and whether or not it could actually happen.
Image source: Getty Images.
1. Amazon has a hidden growth engine
Amazon is actually the third-largest online advertising platform in the U.S. after Alphabet's (GOOG 0.80%) (GOOGL 0.72%) Google and Facebook (FB 1.69%), according to eMarketer, but it hasn't started to break out its advertising revenue or operating profits separately yet.
Instead, Amazon's advertising business accounts for the lion's share of its "others" segment, which grew its revenue 82% year over year to $14.8 billion in the first half of 2021 and accounted for 7% of Amazon's top line. By comparison, AWS' revenue increased 35% year over year to $28.3 billion in the first half of 2021 and accounted for 13% of Amazon's top line.
Amazon doesn't break out the "others" segment's operating profits yet, but market-leading advertising platforms usually generate higher-margin revenue than cloud infrastructure platforms.
For example, Facebook -- which generates nearly all of its revenue from ads -- ended last quarter with an operating margin of 43%. AWS, the only major public cloud infrastructure platform that generates consistent profits, ended last quarter with an operating margin of 28%.
Therefore, Amazon's advertising business likely operates at higher margins than AWS, and it's generating much stronger sales growth. Meanwhile, AWS faces intense competition from Microsoft's (MSFT 1.07%) Azure and Google Cloud, and it could be forced to match their recent price cuts for their third-party cloud marketplace fees (3% for both platforms, compared to AWS' 5%).
Based on these facts, it makes sense for Amazon to spin off AWS while it's still growing and rely more on its booming advertising business for its future earnings growth.
2. It could appease the antitrust regulators
AWS gives Amazon a killer advantage against most other retailers, since its higher-margin revenue supports the expansion of its Prime ecosystem with lower-margin strategies. That's why many big brick-and-mortar retailers prefer to use Microsoft's Azure or Google Cloud instead of supporting the growth of Amazon's biggest profit engine.
Amazon also faces constant pressure from antitrust regulators in the U.S. and overseas regarding the dominance of its e-commerce marketplaces. AWS, which Canalys estimates controls 31% of the global cloud infrastructure market, is also being scrutinized by regulators, and it could face probes if more retailers complain about the profit-generating synergies between Amazon's retail business and AWS.
Proactively spinning off AWS might appease the regulators, make AWS more appealing for Amazon's retail competitors, and give Amazon more breathing room to expand its advertising business.
3. AWS wouldn't need to support the retail business anymore
AWS supports Amazon's profit growth, but Amazon's retail business is also preventing AWS from achieving its true growth potential. Spinning off AWS would enable the cloud company to invest in its own future growth without the burden of supporting Amazon's lower-margin marketplaces and stores.
That separation would be comparable to eBay's (EBAY 1.71%) spin-off of PayPal (PYPL 1.36%) in 2015. In that divestment, each eBay shareholder received one new share of PayPal for each eBay share they owned. Here's what happened to both stocks after the split:
Source: YCharts.
That spin-off unlocked PayPal's growth potential as a stand-alone company, and investors who kept their shares of both companies have netted big multibagger gains in just over six years. We could see Amazon and AWS generate similar gains as separate companies in just a few years.
But will a spin-off ever happen?
Amazon CEO Andy Jassy, who previously led AWS before succeeding Jeff Bezos in July, previously rejected calls to spin off AWS. However, a spin-off makes more sense every quarter as Amazon's advertising business expands and the company faces more antitrust headwinds. Therefore, I still believe Amazon could still spin off AWS in the near future -- and investors should applaud the move.
