The cost of cloud computing is rapidly declining, and for the past few years, Amazon (NASDAQ:AMZN) has been dictating the pace of this decline. Microsoft (NASDAQ:MSFT) has been matching the price cuts of Amazon, ensuring that its Azure cloud is competitive, but Amazon has always led the way. With Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) recent slashing of its own cloud computing prices, Amazon was forced on the defensive, cutting prices reactively instead of proactively. This marks an important shift, and the cloud computing price war now ensuing will certainly lower the margins of all companies involved. Smaller companies like Rackspace (NYSE:RAX) will be hit the hardest, but of the big three, Amazon will be hurt more than the rest.
An expensive game to play
Building out the massive data centers required to offer cloud computing services is an extremely capital intensive proposition, and this can be seen by looking at the capital expenditures of the largest cloud computing players. Amazon has ramped up spending dramatically over the past five years, spending more than $3.4 billion on capital expenditures in 2013. This compares to just a few hundred million dollars in 2009.
Capital expenditures have also increased at Microsoft, Google, and Rackspace over the past five years, but directly comparing spending between the companies isn't very useful. Instead, here is a chart of the percentage of operating cash flow spent on capital expenditures for these four cloud computing companies over the past five years:
It's clear from this chart why Rackspace is going to have a difficult, if not impossible, time competing with the big three. In 2013, Rackspace spent more than 100% of its operating cash flow on capital expenditures, meaning the company is burning through cash just trying to keep up. Faced with a price war, Rackspace simply has no room to absorb any serious price cutting.
The big difference between Amazon and the other two companies, Microsoft and Google, is that Amazon doesn't have a reliable cash cow that spits out tens of billions of dollars per year in profit. Microsoft has Windows and Office, and Google has its vast advertising empire.
In fiscal 2013, Microsoft recorded an operating cash flow of $28.8 billion, spending just $4.3 billion on capital expenditures. Google recorded an operating cash flow of $18.7 billion and spent $7.4 billion on capital expenditures. Both companies have room to not only continue to invest in building out their respective cloud infrastructures, but to absorb losses as they fight for market share.
Amazon has a far more limited ability to do this, considering its main business is low-margin retail. And given that Amazon is no longer dictating the pace of cloud price cuts, with Google pre-empting the company, Amazon's leadership in the cloud is now under serious threat.
The bottom line
Amazon became the leader in the cloud by being aggressive with pricing, but now its competitors are using the same tactic against it. With Microsoft matching all of Amazon's price cuts, and Google forcing Amazon to react instead of lead, I seriously doubt Amazon will remain the market leader in the long term. Amazon simply doesn't have the same resources that Google and Microsoft have, and both companies have a far greater ability to absorb short-term losses in an effort to win market share.
Timothy Green owns shares of Microsoft. The Motley Fool recommends Amazon.com, Google (C shares), and Rackspace Hosting. The Motley Fool owns shares of Amazon.com, Google (C shares), and Microsoft. 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.