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04/28/2015

Amazon's Secret Weapon: Cloud Subsidizes Retail

Joe Skorupa
Editor at Large
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By Joe Skorupa

For the first time ever Amazon separated retail revenue from cloud services during a quarterly briefing last week and guess what? Amazon is a lousy retailer. It reported a loss of $57 million on $22.7 billion in revenue. Heavy investment in Amazon Prime and fulfillment costs wiped out the profit (and a little more) from retail sales, according to Amazon execs. Retailers have always suspected this, but now they have the facts. Amazon is subsidizing its retail division from profits made from cloud services.

Amazon Web Services (AWS) will break the $6 billion mark in 2015. In Q1 alone it generated $1.6 billion. This is a hefty sum and to the surprise of many in the technology industry it means AWS is bigger than its four main cloud competitors combined, according to data from Synergy Research Group.

How could Amazon wallop the likes of Salesforce, Microsoft, Google and IBM? The answer is a highly effective tactic retailers will recognize from painful personal experience – since launching in 2006, AWS has announced 48 price decreases. Margin-killing prices are a Jeff Bezos technique to squeeze the competition, regardless of the financial distress it inflicts on his own company. You almost have to feel sorry for the biggest tech titans in the world that Bezos is running roughshod over. Almost, but not quite.

Cloud computing has come of age in the last few years and AWS is growing fast. Its revenue grew 49% in 2014. And unlike the retail division, it is also profitable – earning $680 million in 2014 on revenue of $5.2B, which is a healthy 13% operating margin. Based on these results, financial analysts predict AWS revenue will reach $15B to $20B in three years.

Jeff Bezos is on record as speculating that one day the cloud division will surpass the retail division in revenue. He may just be blowing smoke for the benefit of Wall Street investors, but it worked and Amazon's stock rallied after the recent quarterly report.

Cloud Subsidizes Retail Investments

Without the cloud services division, it is doubtful Amazon would have the resources and ability to maintain the heavy level of investment it continues to make in the retail division, which has never been profitable.

In the recent financial briefing Amazon executives were asked where all the heavy investment was going. A complete picture of cap ex investments was not provided, however two big buckets were revealed – $2.7B was invested in fulfillment (11.7% of revenue) and $2.5B in technology and content (11.1% of revenue). These figures are not annual investments. They are just for Q1.

Just about everything Amazon does in the retail division is in service of building what it calls the "Prime Platform" – which consists of an annual fee-based membership program that guarantees free 2-day shipping and much more. In recent years Amazon Prime has expanded to include free video, free music, exclusive programming and now related devices for entertainment and shopping.

Altogether, Amazon invested $3B on content in 2014 to drive membership enrollment in Amazon Prime and it worked – Prime membership was up 50% year over year, according to figures in the quarterly financial report.

Summing up Amazon's retail strategy during the analyst call, Tom Szkutak, Amazon CFO and SVP, said: "We are making some great investments for the long-term and that’s really what's reflected in the operating results that you are seeing…I talked about we're doing to support (the Amazon) Prime platform and all of those things that we mentioned, video content, original content, Prime Now, category expansion, investing on behalf of Fulfillment by Amazon (FBA), which also helps Prime devices (Amazon fire TV)…So we're feeding that and that’s what we have been doing and that’s what (is reflected) in the results that you are seeing today."

Of course this massive investment in the retail division would be not be possible if it were not for the profits coming in from the booming cloud services division. It is not clear that anyone ever uttered these words, but the sentiment has been attributed to various executives and it has been proven to be spot on: "Amazon is a technology company. We just happen to do retail."  

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