One of the technology industry’s biggest and most important IPOs occurred late last month, with a valuation of $25.6 billion dollars. That’s more than Google, which IPO’d at a valuation of $24.6 billion, and certainly a lot more than Amazon, which finished its first day on the public markets with a valuation of $438 million. 1 Don’t feel too bad for the latter, though: the “IPO” I’m talking about was Amazon Web Services, and it just so happens to still be owned by the same e-commerce company that went public nearly 20 years ago.

I’m obviously being facetious; there was no actual IPO for AWS, just an additional line item on Amazon’s financial reports finally breaking out the cloud computing service Amazon pioneered nine years ago. That line item, though, was almost certainly the primary factor in driving an overnight increase in Amazon’s market capitalization from $182 billion on April 23 to $207 billion on April 24. 2 It’s not only that AWS is a strong offering in a growing market with impressive economics, it also may, in the end, be the key to realizing the potential of Amazon.com itself.

Understanding Amazon, Part 1

Much of the analysis of Amazon tends to fall in two diametrically opposed camps that are strangely united in their lack of rigor and in-depth appreciation of the economics driving Amazon’s business. On one hand are the ardent skeptics, who see Amazon’s lack of paper profits as prima facie evidence that the company is dramatically over-valued by the stock market; on the other are the true believers who point to Amazon’s ever-increasing revenue numbers as equally obvious evidence that the company is undervalued and primed for ever bigger and better things.

A more nuanced approach considers the fact that Amazon is not a monolithic operation, but rather a collection of businesses sharing resources, including a channel (Amazon.com), logistics, and a common technological foundation. These businesses range from bookshops to video game stores to home furniture to clothes to shoes to consumer electronics to auto accessories…the list is quite extensive at this point! True, consumers experience all of these different businesses as a unified Amazon.com, but inside the company some of these businesses are mature and (theoretically) throwing off cash, while others are reliant on investment as they work to get off the ground.

This view is a more sophisticated take on the aforementioned bull argument: it’s not that Amazon is not making money, it’s that the company is reinvesting every dollar it makes into growing new businesses; were the company to stop investing, it would start throwing off cash. This is exactly how Jeff Bezos has represented the company — except for the stop investing and throw off cash part, of course.

Why Amazon Started with Books

In The Everything Store , Brad Stone explains that while Jeff Bezos had always planned to build a site that sold, well, everything, he started with books for a very particular reason:

Bezos concluded that a true everything store would be impractical — at least at the beginning. He made a list of twenty possible product categories, including computer software, office supplies, apparel, and music. The category that eventually jumped out at him as the best option was books. They were pure commodities; a copy of a book in one store was identical to the same book carried in another, so buyers always knew what they were getting. There were two primary distributors of books at that time, Ingram and Baker and Taylor, so a new retailer wouldn’t have to approach each of the thousands of book publishers individually. And, most important, there were three million books in print worldwide, far more than a Barnes & Noble or a Borders superstore could ever stock.

If he couldn’t build a true everything store right away, he could capture its essence — unlimited selection — in at least one important product category. “With that huge diversity of products you could build a store online that simply could not exist in any other way,” Bezos said. “You could build a true superstore with exhaustive selection, and customers value selection.”

There was one more critical factor, though, that Stone only mentioned in passing a few chapters later: despite the fact that books were a commodity, they were exceptionally high-priced. The list price of a new book contained a 50 percent markup for the retailer, which meant Bezos — who a few years later would coin the famous phrase, “Your margin is my opportunity” — could sell books at a significant discount while still making money on each transaction (and over time, Amazon would not only bypass the wholesalers but eventually become large enough to dictate terms to publishers).

Moreover, the nature of Amazon’s business — customers paid for books with credit cards immediately, while Amazon paid book wholesaler invoices months after delivery — resulted in a negative cash conversion cycle that freed up much more cash for investment than would otherwise be warranted by Amazon’s margins, an effect that was greatly magnified by Amazon’s growth rate.

This made books, over the long-run, a truly profitable business for Amazon, and the company repeated the trick for many of the exact same reasons in CDs, DVDs, and video games: commodity products with massive selections traditionally sold at a significant markup and paid for 90 days later allowed Amazon to have a superior selection and lower prices and make money to boot. 3

Understanding Amazon, Part 2

The problem with the bull case for Amazon is the assumption that all of Amazon’s different businesses are essentially the same: selling books is like selling DVDs is like selling clothes is like selling TVs, etc. However, while that may be true from an infrastructure perspective (same channel, logistics network, and technology stack), it’s absolutely not the case from an economic one.

Consider books versus TVs: there are an effectively infinite number of books, but a relatively small number of TVs, which means it’s more likely a competitor will have the same TV, leading to lower prices and reduced margins. TVs are also relatively infrequent purchases, and customers are likely to research the best price, leading again to lower prices and reduced margins. Moreover, while an individual book is a commodity, that same book is highly differentiated from another book; not so with TVs, where the most expensive TV still accomplishes the same thing as a cheaper one, which leaves little room for luxurious 50% retail markups. This again leads to lower prices and reduced margins. And, on the flip side, while a book is a book is a book, so you can buy it anywhere with confidence, many consumers consider a TV worth checking out in person, and it’s expensive to ship to boot.

That said, TVs are, relative to books anyways, expensive , as are computers, furniture, car accessories, and all the other businesses that Amazon has been developing over the last decade. In other words, all of this stuff that Amazon is selling is perfect for increasing revenue, but not so great at producing profit (that said, the benefits of a negative cash conversion cycle very much apply to these items as well; they are not being added in vain).

That leaves the old stand-bys — books, CDs, DVDs, and video games — to produce the actual profit that funds all of the new businesses Amazon wants to build, and they have done just that for 20 years now. The problem, though, is obvious: each of these categories is being replaced by digital distribution, and Amazon has only been successful in reaping the benefits of that shift in the case of books and the Kindle (although they’re competing in all four areas with Amazon Music, Amazon Prime Video, and the Amazon App Store). Moreover, the impact of digital distribution is showing up in the financial results ; Amazon has long broken out the sales of ‘Media’ and ‘Electronics and General Merchandise’ in their financial reports , and in the last quarter ‘Media’ declined three percent even as ‘Electronics and General Merchandise’ increased 20%. This raises the long-run question for Amazon: if ‘Media’ is in secular decline, how will they fuel eternal investment into their business, much less the fabled returns that at least theoretically underpin their sky-high stock price?

Enter Amazon Web Services

The incredible potential of Amazon Web Services is as clear as its initial prospects in 2006 were, well, cloudy. AWS only came about after Amazon had experimented with more full-service offerings like powering the websites of Target or Toys-R-Us, 4 and there were plenty of skeptics as to whether companies would entrust critical operations to a 3rd party. It soon became apparent, though, that both economics and simplicity were overwhelmingly in the public cloud’s favor, and Amazon was years ahead of everyone.

Today, public clouds are the future for the vast majority of businesses; the economics of scale achieved by Amazon (and its closest competitors, Google and Microsoft) are so incredible that multi-billion dollar companies like Netflix view it as more efficient to pay Amazon than to build their own data centers. The calculus is even more stark when it comes to any sort of startup: it’s so much easier and cheaper to get started with AWS that the idea of buying your own server infrastructure — an expense that consumed the majority of venture capital in the dot-com bubble era — is preposterous. This is great from Amazon’s perspective: the company effectively has a stake in nearly every significant startup, and for free; if the company succeeds, Amazon will be paid, handsomely, and if they fail, well, Amazon covered their own costs of providing cloud services along the way.

The big question about AWS, though, has been whether Amazon can keep their lead. Data centers are very expensive, and Amazon has a lot less cash and, more importantly, a lot less profit than Google or Microsoft. What happens if either competitor launches a price war: can Amazon afford to keep up?

To be sure, there were reasons to suspect they could: for one, Amazon already has significantly more scale, which means their costs on a per-customer basis are lower than Microsoft or Google. And perhaps more importantly is the corporate culture that results from a “your-margins-are-my-opportunity” mindset: Amazon can stomach a few percentage points of margin on a core business far more comfortably than Microsoft or Google, both fat off of software and advertising margins respectively. Indeed, when Google slashed prices in the spring of 2014, Amazon immediately responded and proceeded to push prices down further still, just as they had ever since AWS’s inception (the price cuts in response to Google were the 42nd for the company). Still, the question remained: was this sustainable? Could Amazon afford to compete?

This is why Amazon’s latest earnings were such a big deal: for the first time the company broke out AWS into its own line item, revealing not just its revenue (which could be teased out previously) but also its profitability. And, to many people’s surprise, and despite all the price cuts, AWS is very profitable: $265 million in profit on $1.57 billion in sales last quarter alone, for an impressive (for Amazon!) 17% net margin.

A New Foundation for Amazon

The profitability of AWS is a big deal in-and-of itself, particularly given the sentiment that cloud computing will ultimately be a commodity won by the companies with the deepest pockets. It turns out that all the reasons to believe in AWS were spot on: Amazon is clearly reaping the benefits of scale from being the largest player, and their determination to have both the most complete and cheapest offering echoes their prior strategies in e-commerce.

Moreover, Amazon has cleverly found a way to approximate the negative cash conversion cycle trick: instead of paying billions to build data centers up-front, before they are ever used to earn revenue, Amazon is building its data centers with capital leases that effectively let the company pay for the data centers as they use them. True, this is a riskier strategy, and one that casts a pessimistic hue on Amazon’s admonition that investors look at free cash flow, 5 but it’s also a strategy that presumes growth, an excellent assumption to make when it comes to AWS — provided the company’s investment can keep up. Contrary to my initial skepticism ( members-only ), I think the capital leases are a win-win.

Perhaps the biggest implication of AWS, though, is its impact on Amazon.com. Last summer I lost my patience with the company , wondering when if ever Amazon would fully focus on seizing what looked to be a massive e-commerce opportunity, instead of dallying with devices and video. More importantly, would they do so before the ‘Media’ money train ran out of steam?

Today that is a moot point: the sky is the limit for AWS, and if the service is profitable at its current scale, what expectations should we have for five years from now, or ten? More importantly, that profitability can over time replace the role of ‘Media’ in the Amazon engine: cash to build new e-commerce businesses, or to explore what is next (a la AWS), or both of the above. Or, in the fantasy of Amazon’s investors, to actually provide a return to shareholders. 6

Discuss this post in the Stratechery Forum ( subscribers-only )

1. With an ‘m’! [ ↩ ]
2. Amazon’s market cap has since decreased to $197 billion; like I said, I’m being facetious — this isn’t a real proxy for AWS’s value — but the spike was meaningful [ ↩ ]
3. This was the foundation of my bullish article on Amazon in 2013 called Amazon’s Dominant Strategy [ ↩ ]
4. but ultimately, why help your competitors? [ ↩ ]
5. Amazon is now reporting “Free Cash Flow Less Finance Principal Lease Repayments and Capital Acquired Under Capital Leases” which is what their cash flow would be if they purchased data centers up-front; it’s significantly lower than the number the company trumpets publicly [ ↩ ]
6. So yes! As predicted , I am changing my mind about Amazon. Again. [ ↩ ]