For years, Amazon's (AMZN 0.29%) cloud computing division, Amazon Web Services (AWS), has been the company's No. 1 cash cow, driving the majority of its profits.
The company is best known to consumers for its huge e-commerce business, but savvy investors know that AWS has been the real story here. At one point, some prominent investors argued that based on a sum-of-the-parts analysis, investors were getting the e-commerce business for free since AWS could account for the entire valuation of the stock on its own.
However, these days, the shine may be coming off AWS. Amazon stock tumbled on its second-quarter earnings report last week, falling 8% even though it beat estimates on the top and bottom lines.
Instead, the sell-off seemed to be driven by weakness in the cloud-computing unit. Revenue at AWS rose 17.5% to $30.9 billion, which was slightly better than expectations at $30.77 billion. But that growth rate was much worse than what was reported by chief rivals Microsoft Azure and Alphabet's Google Cloud at 39% and 32%, respectively.
Also, AWS profit margins contracted in the quarter, falling from 35.5% in the quarter a year ago to 32.9%, its lowest level since the fourth quarter of 2023, and operating income at AWS rose less than 10%, going from $9.3 billion to $10.2 billion.
Improvements at the e-commerce business helped offset that weakness, but slowing growth from AWS could be a red flag for a stock that has soared to a valuation north of $2 trillion in large part because of the success of that segment, which is still the leading cloud computing business.
Image source: Amazon.
Why Microsoft and Google are outgrowing AWS
The biggest concern for Amazon investors right now is that while AWS remains the largest cloud infrastructure platform, its smaller rivals are growing much faster than it is, showing they may be beating it in the artificial intelligence (AI) race. For example, Azure's growth rate was more than double that of AWS in the June quarter.
Although 17% growth isn't shabby for a business the size of AWS, given the conditions in the industry -- with AI spending surging and its rivals growing faster than 30% -- investors have to ask what happens to AWS in a weaker macroeconomic environment or if the AI boom fizzles. Given its current underperformance, it seems likely that its growth would fall to single digits or potentially turn negative.
Gil Luria, an analyst at D.A. Davidson, called the AWS results "very disappointing" and said that Azure could surpass AWS as the top cloud infrastructure business by the end of the year.
On its earnings call, Amazon noted that demand is outpacing capacity at AWS. That should be good news and could explain the slower growth. But even with that dynamic, the company saw margins compress, indicating it could be losing higher-value business to Alphabet and Microsoft, both of which have been at the forefront of the AI race while Amazon arguably got off a slow start.
Amazon is stepping up its capital expenditures in the second half of the year in order to provide more capacity, and free cash flow has been negative for the first half of the year, showing that the company has already accelerated infrastructure spending to add new data centers to support cloud growth.
What it means for Amazon
There's no single reason Amazon is losing market share in cloud computing to Google and Microsoft, a trend that has now gone on for several quarters, but there are a number of factors at play here.
First, Amazon invented and pioneered cloud infrastructure services, and it had a seven-year head start, according to company founder Jeff Bezos. Naturally, as Amazon has shown the massive market for cloud computing, Alphabet and Microsoft have hustled to close the gap.
Those two competitors also have their own advantages in the industry. Microsoft is the leading enterprise software company. And for businesses that are already using Microsoft for services from Windows to Office to Dynamics ERP, keeping your data in Azure rather than AWS might make more sense. Google Cloud, meanwhile, is a leader in AI and analytics, and it's also known for its open-source and developer-centric approach.
Both challengers have also become more price-competitive with Amazon over the years.
Overall, AWS, which generated more than $10 billion in operating income in the second quarter, remains a golden goose for the company, and its relatively slow growth isn't a reason to sell Amazon stock.
Nonetheless, investors should pay attention to its performance over the coming quarters. If its growth slows further or the gap widens with its rivals, that could weigh further on the stock. On the other hand, based on management's statement that demand is outstripping supply, investors should expect AWS' growth to accelerate in the coming quarter as it moves through its capital expenditure cycle.
The next few quarters of results should be telling for the future of AWS. If the cloud business continues to disappoint, expect Amazon stock to head lower.
