The Strategy Behind Amazon Web Services' Growing Margins

A solid strategy need not be complicated, as AWS shows

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Dec 07, 2016
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Amazon Web Services has been cutting prices whenever it gets a chance. Amazon EC2, its on-demand reserve instances, has gone through 53 price cuts since launching in 2006 while S3, its store service which cost 15 cents per GB in 2006, now costs 80% less. To call Amazon (AMZN, Financial) relentless in its pursuit to reduce prices would be an understatement, but with such aggressive cuts, it’s a wonder how the company managed to push its margins upward with each quarter.

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Between second-quarter 2015 and third-quarter 2016 Amazon AWS’s margin has moved from 21.4% to 31.6%. In fact, the slew of price cuts has had the exact opposite effect on Amazon’s margin as one might have expected. Admittedly, with margins already around the 30% level it will be difficult to keep moving the needle northward, but how was Amazon able to achieve the seemingly difficult feat of cutting costs while increasing margins?

The answer to that lies in the way Amazon looks at its operations. Amazon relentlessly keeps expanding the depth of the services and the features it offers its cloud customers.

“There are only 24 hours in the day. There is so much that we’re doing simultaneously. We’re going to launch 1,000 significant services or features this year,” said Andy Jassy, Amazon Web Services CEO in an interview with Seattle Times.

While reducing prices on 10 services, Amazon would have possibly added 10 or 20 more services to its list. The cost of a particular service keeps coming down for the customer while the overall revenue per customer keeps increasing due to the launch of new services. In the bargain, Amazon benefits from customers including add-ons – but they're worth the money from the customer’s viewpoint, leading to higher margins.

For Amazon, it’s a trade-off between initial higher pricing and higher purchase volumes, but this model on which AWS operates exerts a tremendous amount of pressure on the competition because it needs to quickly launch a competing service while also immediately moving to price-match Amazon on existing services. Established players like Microsoft (MSFT, Financial) will be in a position to play catch-up, but it puts newcomers like Google and Oracle (ORCL, Financial) under enormous strain.

Looking at it from the customer’s perspective, by continually launching service after service and cutting prices at the same time, Amazon gives customers hardly any reason to look outside. And the more they stay within the "web of Amazon services," the harder it will be for them to move out. For potential customers, Amazon clearly stands out because it has more services under its belt than others.

This strategy has served the company well, and it will continue to do so in the bargain making sure that the company stays at the top of the pile. As long as Amazon holds on to the market perception that it is the undisputed leader when it comes to innovation, it will remain the leader of the cloud race and will make everybody else play catch-up.

Disclosure: I have no positions in the stock mentioned above and no intention to initiate a position in the next 72 hours.

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