Last December, investment firm Edge Consulting Group predicted that Amazon (NASDAQ:AMZN) would eventually spin off Amazon Web Services (AWS), its cloud computing business. When Amazon started disclosing AWS's growth figures earlier this year, discussions about a spinoff escalated. Let's take a closer look at AWS, how it complements Amazon's core business, and the pros and cons of a potential spinoff.
How much money does AWS make?
AWS is a versatile cloud platform that hosts enterprise data, cloud-based computing, data processing, machine learning, Internet of Things messaging, and other services. AWS's top customers include Netflix, Expedia, the CDC, and NASA.
AWS has an annual run rate of $7.3 billion, making it a dominant player in the "cloud as a service" market that also includes IBM's (NYSE:IBM) Bluemix and Microsoft's (NASDAQ:MSFT) Azure. IBM reported an annual run rate of $4.5 billion in "cloud as a service" revenue during its second quarter. Microsoft's "commercial cloud" revenue, which includes Azure, Office 365, and Dynamics CRM, had an annual run rate of over $8 billion last quarter. But Azure, which directly competes against AWS, reportedly generated only $1.2 billion in revenue last year.
According to Synergy Research, AWS controls 29% of the global public cloud market. Microsoft and IBM control 25% and 12%. On its own, AWS has delivered solid sales growth and surprising profitability. In the first half of fiscal 2015, AWS revenue rose 65% annually to $3.4 billion and accounted for 7% of Amazon's top line. Operating income more than doubled to $655 million, or 37% of Amazon's operating profits.
The benefits of a spinoff
Edge Consulting believes that a stand-alone AWS would attract lots of investor interest, boosting its potential market valuation to $38 billion. An IPO would generate plenty of cash for Amazon, which could maintain a majority stake in the new company.
For now, AWS's revenue and operating income growth are both outpacing its operating expenses, which rose 58% annually in the first half of 2015. But as Amazon sinks more money into expanding the unit, expenses could spike. For example, Amazon recently agreed to build a new solar farm and wind farm in the U.S. to support its AWS data centers. As a stand-alone company, AWS could use its own cash on projects like these, while acquiring smaller cloud players with cash and stock to expand its business.
AWS and Amazon's core businesses are connected by infrastructure, but they don't have strong shared interests. As two separate companies, they could focus more on their respective markets instead of balancing out growth between the two. Amazon is AWS's largest customer, but it could simply retain a preferred customer status after the spinoff.
The drawbacks of a spinoff
Speaking to CNBC, AWS chief Andy Jassy said that CEO Jeff Bezos had no plans to spin off the unit, since the two business complement each other. Forrester Research analyst Jeffrey Hammond also told CNBC that a spinoff wouldn't make sense, since many synergies between AWS and Amazon's core business are just being realized.
Hammond notes that AWS is the backend for Amazon's expanding ecosystem of digital content and other e-commerce services. In the near future, more drones, Dash Buttons, and Alexa-powered devices will join that ecosystem. Hammond claims that Amazon needs the in-house ability to beef up its backend to meet those demands, so it doesn't make sense to rely on another company's cloud infrastructure. Hammond also believes that AWS could become Amazon's most profitable business unit, so it would be silly to "sell off the goose capable of laying golden eggs."
There are also unanswered questions about the AWS unit's profitability. AWS had an operating margin of 19% for the first half of 2015, but that's a non-GAAP figure that excludes stock-based compensation. Since Amazon doesn't disclose stock-based compensation by business unit, we don't know exactly how profitable AWS is on a GAAP basis. Amazon must reveal those figures if it spins off AWS in an IPO, which might disappoint potential investors.
The verdict: Amazon should keep AWS
In my opinion, it makes much more sense to keep AWS than to spin it off. Amazon's e-commerce and digital ecosystem is expanding rapidly, and it needs a first-party backend to support that growth. Amazon isn't shy about investing lots of cash into future growth, so AWS could grow faster as an Amazon unit than as a stand-alone company.
Therefore, spinning off AWS is a short-term thesis focused on boosting cash flows instead of ecosystem growth. Amazon investors should be well aware by now that the company cares much more about the latter than the former.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com and Netflix. The Motley Fool owns shares of 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.