Amazon (NASDAQ:AMZN) provides access to technology infrastructure to developers and enterprises through Amazon Web Services (AWS). We estimate that this business constitutes roughly 10% to the company’s value.
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However, there is more to it than meets the eye. The global demand for web services is growing rapidly due to enterprises moving their IT infrastructure to cloud, rising Internet usage and growing e-commerce volumes. Amazon is leveraging this trend by diversifying its business outside of online retailing where its margins are razor thin, and any change in tax regimes or competitive environment can have a significant impact. Aside from reducing the business risk, the web services segment is also supporting the retailer’s margins which is one of the reasons why the company saw its overall EBITDA (earnings before interest, taxes, depreciation and amortization) margins jump by more than 1% in 2012. There is also an opportunity for Amazon to leverage its relationship with the companies that use its web services, and sell office specific goods to them.
Amazon’s web services include infrastructure & cloud services, payments and billing services, merchant services and on-demand workforce. The company competes with Microsoft’s (NASDAQ:MSFT) SQL server data services and Google’s (NASDAQ:GOOG) app engine in this business.
The Demand For Web Services Is Growing
Cloud computing, which is one of the main web services offered by Amazon, has seen rapid growth in recent years. We expect this to continue as enterprises look to cut their IT infrastructure costs. Although the economy in the U.S. is improving, Europe is still facing economic headwinds and GDP growth in some of the emerging markets such as India and Brazil has slowed dramatically. Many businesses can leverage Amazon’s cloud computing business to lower their IT costs in order to create more room for interest payments. Besides being cost efficient, cloud computing’s advantages include the availability of virtually infinite computation resources as well as scalability, faster deployment and implementation.
Research firm Global Industry Analytics Inc. estimates that the cloud computing market will reach $286 million by 2018.  This plays right into Amazon’s hands. Due to its reliability, global reach and well recognized brand, the company can be at the forefront of this growth. Despite the growing competition from Google and Microsoft, Amazon’s solutions remain well ahead in terms of their support for all languages and the provision of unlimited capacity. If the company grabs even 10% of this market in the next 6-7 years, there can be 5-10% upside to our price estimate.
Web Services Business Has Higher Margins
In the first quarter of 2013, Amazon registered growth of 22% which was primarily driven by its services segment that saw its sales jump by 45%. The story continued in the second quarter also as enterprises continued to flock to Amazon. Besides helping big businesses, the company’s cost efficient web services are useful for young startups that may have cash restrictions. The aggressive ongoing price war between Google, Microsoft and Amazon suggests that the company enjoys considerable margins on these services. We believe that the growing popularity of these services will mitigate the negative impact of the costs associated with fulfillment centers that Amazon is opening to speed up the delivery of physical goods to customers.
The company is spending a substantial amount on improving its supply chain to keep up with the rapid growth in the e-commerce industry. Market research firm Forrester expects U.S. online retail sales to grow rapidly and take market share away from physical stores. This is clearly evident from the comparison of Amazon’s growth with that of traditional brick-and-mortar retailers such as Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), Target (NYSE:TGT) and Best Buy (NYSE:BBY). Forrester further predicts that the U.S. online retail market will reach $262 billion in 2013, registering 13% growth over 2012.  Although the online channel still accounts for just 8% of total retail sales in the U.S., the future growth potential is huge and Amazon will help lead the way. Another market research firm eMarketer forecasts U.S. retail sales to grow at a CAGR of 14% over the next few years, increasing from an estimated $225 billion in 2012 to close to $434 billion in 2017.  While the U.S. growth outlook certainly looks promising, international markets can offer even higher potential in the long term.
As more online retailers spring up and traditional giants ramp up their online efforts, Amazon will have to make additional investments and may face risk of profit decline as its margins are already very low. Expanding web services can help mitigate this risk to a certain extent.
Our price estimate for Amazon stands at $280, implying a slight discount to the market.Notes:
- Growing Focus on Cost Mitigation Spurs Demand for Cloud Computing Services, According to New Report by Global Industry Analysts, Inc., PRWeb, Aug 19 2013 [↩]
- US Online Retail Forecast, 2012 To 2017, Forrester Research, March 13 2013 [↩]
- US Retail Ecommerce Outlook—What’s Driving Growth?, eMarketer, Apr 18 2013 [↩]