28 November 2012 Posted by Paul Burns
Today at the AWS re: Invent show in Las Vegas, Andy Jassy, Senior Vice President, Amazon Web Services (AWS) had a lot to say about how low gross margins for AWS are fundamentally disrupting the IT industry. Jassy was in the process of slamming “old-guard technology companies” as well as the value of private clouds. He said:
“So, if you ask yourself: Why are these old-guard technology companies so desperately trying to get you to buy the private cloud? Why? And I think the answer is the economics of what we are doing are extremely disruptive for old-guard technology companies. These are companies that have lived on 60 to 80 percent gross margins, for many, many years.”
Frankly, 60 to 80 percent gross margins sounded a bit high to me. So I took a look at some decidedly old guard players that have private cloud offerings:
- HP: 23.2% (fiscal year ended Oct 31, 2012)
- IBM: 46.9% (fiscal year ended Dec 31, 2011)
Well, maybe Jassy is younger than I and has a different perspective on “old.” So, I checked out these other players with private cloud offerings that he may consider “old guard”:
- Cisco: 61.2% (fiscal year ended July 27, 2012)
- EMC: 60.8% (fiscal year ended Dec 30, 2012)
- Oracle: 78.8% (fiscal year ended May 30, 2012)
OK, so then I could see the 60 to 80 percent numbers he referenced. Yet, this gross margin business still wasn’t doing it for me. After all, Amazon doesn’t even share its AWS revenues publicly, let alone it cost of sales and resulting gross margins. So, all this jibber jabber about disruption through low gross margins still just didn’t sound right. Not that Amazon isn’t disrupting the IT industry… they clearly are, along with a number of other leaders in the cloud-computing segment. And, not that Amazon isn’t applying downward pressure on pricing… again, they keep prices fairly low and keep lowering them. In fact, as far back as three years ago, I’ve written on AWS’s low cost strategy here.
I guess my primary issue was with Jassy’s focus on gross margins, rather than price (relative to competitors, relative to in-house IT, etc.) and rather than net margins (pre-tax or even post-tax earnings). You see, he was bragging about the combined value of high volume AND low gross margin – claiming AWS dominance in what it has to pay in order to deliver ever increasing volumes of it services (e.g. power, cooling, labor etc.).
Yes, there are certainly scale advantages to be found in the infrastructure-as-a-service (IaaS) model. And I suspect AWS does better with economies of scale than most if not all of its competitors. But I don’t think that is what is driving the “disruptive gross margins” Jassy claims for AWS.
First, one of these years AWS really must come clean and share its revenues as well as a breakdown on cost of sales and operating expenses. That will give far better insight to what is really happening. What we’ll see is something like the following simplified income statement:
Here is what the above income statement looks like for AWS competitor, and publicly traded company, Rackspace (RAX) (Note: these are actual results for fiscal year ended Dec 31, 2011; in millions):
From the above we can see the gross margin and operating margin for Rackspace:
- 69.8% gross margin (= 716/1025)
- 12.0% operating margin (= 123/1025)
But wait… Rackspace isn’t an old-guard technology company is it? Heck no. Yet, they have higher gross margins than most technology companies!
But, but… Jassy claims economies of scale are leading to DISRUPTIVE gross margins for AWS. But, just look at the Rackspace income statement. If they were to improve their economies of scale, their cost of sales would DECREASE and lead to HIGHER gross margins, not lower. Even if you assume AWS simply has average economies of scale, lowering cost of sales means higher – not lower – gross margins. Remember, Jassy was focused on gross margins.
Now, even if we apply his same logic to the next lines down in the income statement, you can see that economies of scale mean LOWER operating expenses and thus HIGHER operating income. So, this “our superior scale is leading to disruptive gross margins” really is jibber jabber – an Amazon distortion field emanating from Seattle, WA (as opposed to the “classic” distortion field emanating from Applie in Cupertino, CA).
So, what up AWS? Do you even have disruptive gross margins? I think the answer is a fairly solid yes. However, it comes from a simple choice rather than some mysterious economies of scale, unachievable by anyone else. By lowering prices, Amazon gets to lower gross margins. Interestingly, they brag about the low gross margins. Most companies cry about it. High gross margins are often helpful for profits!
On the other hand, there are many strategies for an IaaS provider to follow… Amazon is clearly going for lower prices and higher volume. That is a growth strategy, not a profit strategy (note that overall Amazon is traditionally quite good at growth and horrific at profit). This will have impacts – yes, even disruptive impacts – to the industry. Longer term it even has the potential to harm the industry! That will have to be discussed at a later time. But, simply put, when you have a company that is willing to sell at cost, there can be long term harm. I don’t believe AWS is selling anywhere close to cost… but Amazon does all the time! (& Jassy emphasizes they have the same DNA).
So what is the conclusion here? Am I trying to catch the obviously brilliant and talented Mr. Jassy on an accounting technicality? Not at all. Instead, I think it is important for the industry (IaaS customers, competitors and others) to understand the real underlying dynamics and economics for AWS and others. Cloud computing, particularly IaaS, is not currently a low gross margin game. Just look at Rackspace. However, Amazon is intent on making it that way.
Yet, contrary to what Jassy has said, I do not believe that AWS scale and related economies (which are likely real at least to some degree, and perhaps even significant) are driving what they claim as low gross margins. Their gross margins – whatever they are – represent a simple DECISION by AWS. A simple STRATEGIC decision! OK, I’m getting carried away with all the caps… but the passion is flowing! It is a decision to grow quickly at the cost of short-term profits. [and it sets up some interesting issues related to their long-term profits as well; more fodder for later…]
Will AWS drive the profits out of the IaaS industry? They are certainly adding to pricing pressure and raising barriers to entry. And there is absolutely an element of volume or scale that competitors must achieve to make a ton of money. But right now, we are a ways from an overall low gross margin or low profit industry within the IaaS industry. And there are plenty of innovators — such as ProfitBricks (InfiniBand, SDN), Cloud Provider USA (solid state drives) and SoftLayer (automated physical and virtual infrastructure) with competing strategies that enable higher gross margins and, longer term, a healthier industry. These providers and others are also having a major impact on the direction and outcome of the IaaS industry.
Whatever margins AWS is achieving — both gross and operating — I believe they are currently driven by a strategic decision, not by unmatched economies of scale.
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