Just because a market is enormous, it doesn't mean it's profitable. In the short run investors may be excited by top line growth — but at some point, if it doesn't produce profit, they get impatient. And Amazon's latest quarterly results are a case in point.
What those results reveal is that cloud services — the business of renting data storage and computing power to other companies – looks like a cloud that's poised to burst — spilling red ink into investors' portfolios.
Before getting into this unpleasant future, let's look at those Amazon results. On July 25, Amazon shares fell 11% after it missed expectations — reporting a $126 million loss that was more than twice what analysts had predicted. While its sales soared 23% to $19.3 billion its expenses were up more — 24% to $19.4 billion.
English: Cloud Computing (Photo credit: Wikipedia)
Amazon cut prices for its Amazon Web Services unit in 2014. In a conference call, Amazon CFO Tom Szkutak said, "We had very substantial price reductions." Unfortunately. Amazon does not disclose its AWS revenues — but analysts "generally expect the business to generate between $5 billion and $6 billion in annual revenue by next year," according to the Wall Street Journal.
This brings to mind an idea that HBS strategy guru, Michael Porter, introduced in his 1980 book, Competitive Strategy — the five forces that shape an industry's profit potential. As I observed when working for Porter, those forces — rivalry among existing competitors, threat of new entrants, bargaining power of buyers and suppliers, and the threat of substitutes — can turn an industry that looks attractive on the surface into a minefield of profitless prosperity.
An example of this is the personal computer industry in the 1990s. This was a large and rapidly growing industry that reserved most of the profits for suppliers — like Microsoft Microsoft and Intel Intel which teamed up to gain a near monopoly position in supplying PC brains.
Companies that made PCs competed fiercely on price and the buyers — consisting largely of big companies — used their enormous bargaining power to put downward pressure on prices. Moreover, the barriers to entry into the industry were low so startups got into the business and cut prices to take market share.
Similar forces are at work in the $100 billion cloud computing industry. IDC predicted 25% growth in 2014 which makes the industry sound superficially attractive — after all it's big and growing fast. But there is significant rivalry from Microsoft's Azure and Google's Google's web services.
Moreover, new entrants — deep-pocketed and startups — are coming into the market. New corporate rivals include Verizon Communications Verizon Communications, Cisco Systems Cisco Systems IBM, and VMware. And startups Digital Ocean, Joyent and Contegix are focusing on niches through innovation, according to the Journal.
Amazon has been slashing prices — between 28% and 51%, reported the Journal. Google's Compute Engine service cut its prices — slashing by 60% per Gigabyte the price of Persistent Disk according to Cloud Times. And the Journal suggests that lower prices are cutting into AWS's margins that were believed to be higher than those in Amazon's core business of e-commerce.
And that's because Amazon enjoyed a huge market share lead that is probably eroding. In 2003, Evercore estimated that Amazon controlled 37% of the $9 billion infrastructure as a service market — way ahead of Microsoft (11%), Google (10%), and Rackspace (4%).
But in 2014, Microsoft has been catching up fast. According to Gartner, Microsoft is giving market leader AWS "a run for its money. Microsoft's vision of infrastructure and services platform allows customers to offer not only standalone offerings, but also to extend and interact seamlessly with Microsoft infrastructure and on-site applications."
Companies can play these rivals against each other to put downward pressure on prices. And given the risks of outsourcing their operations to a company that might be subject to security breaches or service interruptions, companies are likely to remain skittish about the cloud.
Finally, the investment required by cloud services providers to keep up with rapid growth and changing technologies is likely to yield a squeeze on costs even as new entrants jump in and cut price to grab new customers.
Rackspace is the only pure play in this industry and its financial picture is not pretty. In the last 12 months its revenues rose 17% but its net income fell about the same percent and its net margin is a skimpy 5%.
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