​Amazon finds its profit horse in AWS: Why it's so disruptive to IT's old guard

Amazon's e-commerce background combined with cloud services for the enterprise turns out to be a deadly combination for legacy IT providers. As a result, AWS is 8 percent of Amazon sales but 52 percent of the operating profit.

It's becoming clear that Amazon is in the wrong business. E-commerce?!? Puhleeze. E-commerce is really just an excuse to build out infrastructure to be sold as cloud services. Amazon Web Services is where all profit fun is.

Amazon's third quarter results told the tale. Actually Amazon's results shouted the story. Amazon Web Services accounted for 8 percent of Amazon's total sales, but 52 percent of the operating profit. Amazon Web Services is as profitable as Amazon's North American commerce operations.

The catch? It takes Amazon $15 billion in sales in North America to garner an operating profit of $528 million. It takes AWS $2.08 billion in sales to garner $521 million in operating profit.

Add it up and my crystal ball in 2008 turned out to be correct. Way back then I said:

Amazon announced persistent storage for its EC2 service and what's notable is how quickly the e-tailer is running ahead of the competition. In fact, Amazon's real business down the line will be its cloud services. Amazon will be like a book store that sells cocaine out the back door. Books will be just a front to sell storage and cloud computing.

Turns out that quip is pretty much on target. Analysts on Friday were gushing about AWS. What's especially comical is that the same analysts that were screaming about Amazon's multi-year investments a year ago are now singing the praises of the payoff.

A simple run through Amazon's business model could have you asking why e-commerce is a big deal at all. If you're following the bottom line--not that Amazon does really--it's easy to conclude that the company should think cloud first then commerce.

Previously: Cloud shift spurs enterprise tech mergers as customers hit pause

However, it's not that simple. Amazon's commerce background is what makes AWS successful. First, Amazon is customer centric and as a result doesn't necessarily care much about profit margins. Amazon's working theory is that if the company wins with customers it'll pay off in the long run no matter what the business ultimately becomes. And second, Amazon was born and raised on razor-thin profit margins from e-commerce.

Here's why that e-commerce background is so disruptive to the enterprise technology status quo.

  1. Many IT vendors have lived off fat margins for years and still are. The money paid to vendors for legacy infrastructure for maintenance borders on crazy. And instead of cutting those maintenance prices, enterprise vendors are doing audits and other routine ball busting to keep customers paying up for old products.
  2. Enter Amazon, who comes from the land of itty bitty profit margins. Let's say AWS gross margins stick around the 25 percent range. For an enterprise incumbent taking AWS' gross margin may be a 50 percent drop or worse in some cases. For Amazon that 25 percent gross margin is 22 percent higher than what the company makes selling you stuff and shipping it. Advantage: Amazon.
  3. Amazon is moving up the value chain. What Amazon is doing to the enterprise ecosystem is straight out of a Clay Christensen innovation book. Amazon starts at the bottom with infrastructure and much larger rivals pooh pooh the idea. The incumbents say AWS can have the low end of the market because they are moving to higher value pursuits. Then AWS begins to move up the stack and the incumbents run out of head room. Toyota did it to Detroit. And AWS is doing it to enterprise incumbents by entering into big data, analytics, databases and business intelligence.

Traditional IT vendors are revamping, merging, scaling, splitting up and doing other corporate gymnastics to embrace the cloud, but the math may never work well for them. AWS is coming from nothing to a margin reality that's way below what enterprise vendors are used to landing. Some IT giants will make the transition, but rest assured it's gonna hurt.

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