Insights on cloud growth from AWS and Microsoft latest earnings

Earnings announcements from both Microsoft and AWS amply demonstrate that cloud services are both growing at a healthy clip and proving to be profitable.  In Amazon's case, AWS accounts for a whopping 59% of Amazon's total operating income while generating 29% margins in an expanding, capital-intensive business.

It’s harder to extract cloud revenue at Microsoft since it spreads Azure, Office 365 and Dynamics 365 across two business units that each include on-premises software products, but each segment is extremely profitable. There are headwinds from slowing economic growth in China and Europe and somewhat slower growth in overall IT spending. However, we are still in the early stages of a generational shift of IT infrastructure from artisanal installations to global-scale utilities where the likes of Amazon, Microsoft, Google, Alibaba, and a few others are competing to be part of the infrastructure oligarchy.

AWS steady growth

The first time Amazon broke out AWS earnings, less than four years ago, people were stunned that it was booking revenue of billion dollars a quarter and astounded that AWS was profitable to the tune of $660 million in 2014.

AWS demonstrates the power of compound growth because, in Amazon's Q4 2018 report, the company has mushroomed to almost $7.5 billion in sales. It is on pace to be a $30 billion business this year. Although still a relatively small part of the $200+ billion retail giant, AWS is the company's most profitable division, and by some distance. The importance of AWS to the company is evidenced by the fact that fully half of the bulleted highlights in Amazon’s earnings release were devoted to new or enhanced AWS services.

If enterprises are planning some sort of cloud backlash or infrastructure repatriation, there's no sign of it in AWS's numbers. Its revenue growth rate has stabilized at about 45 percent (down from 70 percent a few years ago), which suggests that AWS revenue tops $50 billion in a couple of years.

Source: Amazon Q4 2018 earnings slide presentation

Amazon’s post-earnings conference call showed a company providing the resources required to ensure continued growth in its cloud services.

According to Dave Fildes, Amazon’s Director of Investor Relations, in the quarter it increased headcount “only” 14 percent year-over-year, but one focus area was “AWS, especially sales and marketing.” Amazon CFO Brian Olsavsky added that, “there were groups that were growing considerably higher than that 14 percent,” which given Fildes’ comments likely means AWS. Amazon understands that it can’t become a strategic part of enterprise IT by coming in the back door and relying on organic growth. Instead, it needs a sales and marketing staff that is skilled in the ways of navigating bureaucratic bidding and purchasing processes while also addressing the technical questions of IT engineers and developers.

Wall Street regularly dings Amazon for its profligate capital spending as the company has a history of aggressively expanding its distribution, logistics and data center footprint at the expense of operating profits. However, 2018 appeared to be a year of capital consolidation for AWS. According to Olsavsky,

If you use the capital lease line as maybe an indicator for what we have invested into our AWS business to support infrastructure and global expansion. That number grew 10% last year when it had grown 69% in 2017.

However, don’t expect that low rate to continue, since Olsavsky also noted (emphasis added)

Total capex that grew 33% in Q1, 1% in Q2, -1% in Q3, and then +17% in Q4, just the quarter itself. So, there was, as you say, a bit of investment in Q4 relative to Q2 and Q3. I still think the 17% is a low number for us when you talk about the supporting the AWS business that's still growing in a very high clip and a very strong and healthy growth in FBA [Fulfillment by Amazon] and customer demand and our expansion into new countries, both with AWS and also with our core consumer business.

Continuing to provide the capital and personnel required to feed a business expanding at 45 percent annually shows that Amazon refuses to give competitors an opening to easily take cloud market share. Amazon’s executives understand that AWS is the beneficiary of years of inaction by competitors and they aren’t about to fritter away their lead by coasting.

Here’s what CEO Jeff Bezos had to say about the seven year first mover advantage AWS enjoys in an interview last fall (as quoted by Loup Ventures) (emphasis added),

And then something – then a business miracle happened. This never happens. This is, like, the greatest piece of business luck in the history of business, so far as I know. We faced no like-minded competition for seven years. It’s unbelievable. … When I launched Amazon.com in 1995, Barnes & Noble launched Barnesandnoble.com in 1997, two years. That’s very – that’s very typical if you invent something new. We launched Kindle; Barnes & Noble launched Nook two years later. We launched Echo; Google launched Google Home two years later. When you pioneer, if you’re lucky, you get a two-year head start. Nobody gets a seven-year head start.

As Microsoft, Google, IBM, and Oracle struggle to keep up and fight for second and third place in the cloud market and VMware is forced to admit defeat and partner with AWS to establish a viable public cloud service, they have no one but themselves to blame.

Source: @jordannovet, Twitter

Microsoft, the delicate shift from software to services

Microsoft’s shift from software to cloud services has been one of the hallmarks of CEO Satya Nadella’s reign. However, it’s difficult to precisely measure the success of its cloud businesses since they are spread across two reporting segments, Productivity and Business Processes (Office 365, Dynamics 365 and LinkedIn) and Intelligent Cloud (Azure IaaS and PaaS and GitHub), that each has significant non-cloud components. Nevertheless, in its earnings release, Microsoft noted the following:

• Azure revenue increased by 76%
• Office 365 Commercial revenue growth of 34%
• Dynamics 365 revenue up 51%
• LinkedIn revenue increased by 29%

Source: Microsoft Investor Relations charts of key metrics

In the context of a year-over-year revenue increase of 12%, these results show how aggressively Microsoft’s customers are shifting existing and new consumption to cloud services and that these services are solely responsible for Microsoft’s overall growth. Microsoft CFO Amy Hood said on the earnings conference call with analysts that "most of the Azure growth is really driven by consumption," which has, in turn, led to larger customer commitments, presumably in the form of Azure Reservations for VM instances and SQL capacity.

Two trends are noteworthy factors in Microsoft's cloud growth:

1. Users are shifting from self-managed packaged software to the equivalent cloud service.
2. A reluctance by companies in retailing and other industries where Amazon competes to do business with AWS.

Prime evidence of the SaaS shift comes from the results for Office Commercial products and cloud services revenue which overall increased 11% amidst 34% growth in subcomponent Office 365 even as Office Commercial product revenue declined by 21 percent (slide 9 of earnings presentation). Similarly, Hood noted in the earnings call that, "This quarter, more than nine out of every 10 new Dynamics CRM customers chose our cloud offering."

Source: Microsoft Investor Relations charts of key metrics

The preference of retail companies for Azure over AWS was also the topic of questions during the earnings call after Microsoft unveiled a significant new commitment from the Albertsons grocery chain. Nadella noted some retail successes on the call,

In retail, Azure was front and center at the NRF. (National Retail Federation conference) Kroger is partnering with us to redefine customer experience in stores and provide employees with AI-driven insights, while the GAP chose our cloud to accelerate the digital transformation. And just this week, Albertsons chose Azure as its preferred cloud.

The most significant example of competitive tension working to Microsoft's benefit at the expense of AWS is Microsoft's "strategic partnership" with Walmart. The five-year agreement, announced last summer, makes Azure Walmart's strategic cloud provider and has recently spawned the creation of a "cloud factory" at Walmart's Austin technology center to migrate internal Walmart applications to Azure, develop cloud-native applications and business processes, and lower IT operational costs.

Nadella later addressed the motivation for retailers by obliquely noting conflicting commercial interests at AWS and Microsoft's clarity of purpose and business model (emphasis added),

It's clear that we also have a fantastic alignment of our business model with the interest of our customers. In other words, we want to make sure that we are, in fact, making our customers fully capable digital companies in their own right, whether they're in retail, whether they're in oil and gas, whether they're in healthcare because that's really what's in our long-term interest, which is to ensure that they have full digital capability, and then they'd use the subscriptions and the consumption capabilities of our cloud. And of course, that means we have a trusted relationship, which is a competitive advantage in a world where some of our competitors have more complex business models, where in some cases they give them platforms, in other cases where they compete with them or tax them. That's definitely something that I'm sure our customers pay attention to. But we are very focused on making sure that we have the right product that's competitive in the marketplace and then our business model that's long-term aligned with the interest of our customers.

My take

Unfortunately, Wall Street and other nattering nabobs of negativism in the tech media gravitate to glass-half-empty narratives when everything doesn’t go according to their expectations.

Fast-growing cloud services at Amazon and Microsoft are convenient targets since the increasing difficulty of growing a multi-billion dollar business at triple-digit rates means that the relative growth is destined to slow, even as absolute revenues continue to increase non-linearly.

Many naysayers also seem to have a problem with math, since they often confuse growing growth, i.e. acceleration, with growth. We see this phenomenon almost every quarter when Amazon and Microsoft break out their cloud business results in their quarterly earnings report. The kneejerk narrative is often one of disappointment at the slowing growth.

Memo to the math-challenged: slowing growth is still growth, and at rates of 45 -76%, as AWS and Azure just reported, imply that revenue is doubling every 11 to 18 months. While that's down from the triple-digit growth of a couple of years ago, it's impressive for an organization like AWS that would rank in the low-100s, i.e. about the size of Northrop Grumman or Raytheon, on the Fortune 500 as a standalone company.

Amazon AWS and Microsoft's SaaS and IaaS cloud businesses are pivotal to their company's success and by most measures, each had a stellar quarter. Although AWS has what seems like an insurmountable lead in infrastructure and PaaS services, Microsoft's broader mix of cloud services put it in an equally strong position. Today, the cloud market is too fragmented to declare the pair a duopoly just yet. However, given their strength of products and execution, competitors will likely be fighting for niche markets or foreign, notably Chinese, markets with a preference for local providers.