How Amazon Has Clouded Wall Street's Vision About Web Services

There is a perception among analysts, investors - and some competitors - that Amazon has finally begun to realize the profits expected of it. Their hope is that the company is now secure enough in its domination of digital commerce that it will change its historic preference for reinvesting profits rather than sharing them, especially as it moves to dominate cloud-based web services.

But as the following article suggests, that opinion is probably wrong. JL

Dan Gallagher and Miriam Gottfried report in the Wall Street Journal:

The cloud business is expected to puff up Amazon’s future profits. Analysts predict AWS will hit nearly $12 billion in annual revenue in 2016. That is plausible given the rapid pace at which corporations are shifting work to the cloud. But if history is any guide, Amazon is unlikely to rest on its profit laurels. It has long employed a strategy of investing and slashing prices to expand market share. The cloud has been no exception.
Amazon.com AMZN -0.68 % ’s day as a profit machine has finally arrived, or so many on Wall Street seem to believe.
Investing in the e-commerce giant has long been an act of faith. Over the past decade, Amazon’s annual sales have grown more than tenfold to nearly $90 billion in 2014, while earnings have been meager and sporadic. Nevertheless, investors have remained resolute in their belief of significant profits just around the corner. Amazon shares have traded at an average 110 times forward earnings over the past decade.
Now, many appear to believe the payoff is here, driving Amazon’s market value to more than double this year. Operating income for the trailing 12-month period ended Sept. 30 reached $1.7 billion, compared with just $97 million for the same period a year earlier. Wall Street expects the surge to continue, with operating income projected to hit $4.5 billion next year—more than the past five years combined.
And the just-completed holiday season offered more cheer: Amazon said Monday more than 3 million people joined its Prime two-day shipping program during the third week of December.
But there is reason to be skeptical that the age of profitably is at hand.

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The bulk of recent profits have come from Amazon’s rapidly growing cloud business, Amazon Web Services. It saw revenue surge 70% year over year to $5.5 billion for the nine-month period ended Sept. 30. AWS operating margins were 21.5% over that period, compared with 2.4% for Amazon’s retail business.
The cloud business is expected to puff up Amazon’s future profits. Analysts predict AWS will hit nearly $12 billion in annual revenue in 2016. That is plausible given the rapid pace at which corporations are shifting work to the cloud.
But if history is any guide, Amazon is unlikely to rest on its profit laurels. It has long employed a strategy of investing and slashing prices to expand market share. The cloud has been no exception.
Last year, AWS’s operating margin fell as low as 8% following a big round of price cuts. With competitors including Microsoft MSFT 0.18 % and Google pushing hard into the cloud, more price cuts at AWS seem certain.
And Amazon continues to invest heavily in its retail business, in which it aspires to deliver packages within an hour, potentially with its own trucks and drones.
Granted, Amazon investors have typically focused more on the top line than the bottom, as evidenced by the stock’s positive reaction Monday to the company’s holiday report. And Amazon’s sales should continue to grow significantly as e-commerce takes a greater share of overall retail sales. There is also a long tradition of analysts projecting rosy earnings for Amazon a few years out, only to cut them as investment spending continues. In early 2011, analysts projected Amazon’s operating income this year would be $7.9 billion, versus the current estimate of $2.4 billion.
A difference this time: The sizeable earnings jump analysts are forecasting is expected only one year from now as opposed to five years out.
Indeed, the risks underlying that assumption make Amazon’s already steep valuation look even frothier. Its shares trade at about 155 times forward earnings and about 45 times projected free cash flow, putting it well beyond other large-cap tech peers. This includes key cloud rivals Microsoft and Google parent Alphabet, both of which have much more profitable core businesses to fuel cloud ambitions.
For investors, Amazon’s ability to live up to profit expectations looks cloudy.