Why Big Discounts to Cloud Customers Is Really, Really Bad News for Amazon

07/25/2014 12:01 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

If the price war with Google keeps driving cloud prices lower, investors can forget about Amazon's promise of "profits someday," says MoneyShow's Jim Jubak.

"We lose money on every sale but make it up on volume. Honest. Someday."

That has long been Amazon.com's (AMZN) mantra and investors have been willing to be patient with the story. That patience got a severe test with the second quarter earnings and revenue numbers reported after the close on July 24. Revenue grew by 23.2% year over year to $19.34 billion versus the $19.32 billion consensus but earnings missed badly with the company reporting a loss of 27 cents a share, 12 cents a share worse than the Wall Street consensus.

As of 12:00PM New York time today, July 25, Amazon's shares were down almost 11% to $319.32. At that price, the stock is trading at a seven-week low and is testing support near $320.

I think analysts and investors will get over today's disappointment. I've noticed that while lots and lots of analysts are cutting their target price for the stock, most of them are cutting their target prices to levels above-say, $350-or well above-say, $415-today's price levels. In an economy and stock market where revenue growth is hard to come by, it will be difficult not to be seduced by that 23% revenue growth number.

But I think that yesterday's earnings report flags a problem that the "profits someday" crowd needs to work into their analysis. And that's the story of what's going on in Amazon's cloud services business, known as AWS (Amazon Web Services). This unit, which sells cloud-based web and mobile applications, storage, and archiving, data processing, and warehousing, and deployment services, saw usage rates grow by 90% year over year. Amazon doesn't break out much about AWS (and what it does break out is often confusing-for example, AWS shows gross margins of 100% since its costs are attributed to a line called Technology and Content) but, in the earnings conference call, management noted that Amazon's cloud business was in a price-cutting dogfight with Google (GOOG) as that company tried to close the gap with segment leader Amazon. That resulted in price reductions to customers of 28% to 51% starting in the quarter.

That's really important for any investor hoping to see profits from Amazon in his/her lifetime. Cloud services have the highest potential margin for any of Amazon's recent investments. The potential gross margins in cloud services is an estimated 70%, currently. Amazon needs that gross margin from cloud services since it persists in investing in low margin businesses such as hardware and online grocery delivery. Sure, Amazon continues to cut operating costs in its core business by building more warehouses to make delivery more efficient and it is getting high margin revenue from memberships, but-of the company's new big investment areas-only cloud services carries potentially high margins.

But the exact size of those margins in cloud services-whether or not a company gets that potential 70%-depends on the mix of products and services that a cloud business offers. Services and products such as storage and archiving are commodities. Margins there aren't very high and they're subject to intense competition from Google, Microsoft (MSFT) and soon Alibaba (which has announced that it is getting into the cloud business.) IBM (IBM), on the other hand, with its own extensive software services business and experience (and with its new applications partnership with Apple (AAPL)) has targeted the higher margin end of the cloud where clients pay up for customized solutions, customized data crunching, and customized applications.

The price war at the commodity end of the cloud sector will, of course, drive down prices even for companies in the customized end of the sector, but the biggest damage will be inflicted at the commodity end of the sector.

Every company in the cloud sector knows this-and every company in the sector is trying to position itself in the higher margin customized-end of the sector.

Who will succeed?

We'll know by watching the gross margins that cloud companies manage to achieve. So far, however, the big drop in prices that Amazon acknowledged this quarter thanks to competition from Google argues that-at best-moving up to the high margin end of the cloud is still a work in progress for Amazon.

Given the relatively low margins for many of Amazon's other new businesses, that's not good news.

And that margin pressure is about to get worse for Amazon across its business from e-commerce to cloud services with Alibaba's entry into the US market after what now looks like a September IPO.

The biggest danger that China's Alibaba poses to Amazon, however, comes from that IPO itself. At this point, pre-IPO, if you want to buy a piece of the huge growth in e-commerce revenue, Amazon-despite its lack of profits-is the odds on buy. After the Alibaba IPO, investors will have a second choice, one with a business model that produces higher margins than Amazon's does.

There will be some bleeding from Amazon's shareholder base. How much? It will depend on Amazon's ability to put a date on that promise of profits someday. And a good bit of that answer will depend on the company's ability to show a climbing gross margin in its cloud unit.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I managed, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund shut its doors at the end of May and my personal portfolio is now in cash. I anticipate putting those funds to work in the market over the next few months and when I do I'll disclose my positions here.

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