Amazon: spending money to make money

Most pundits thought that Amazon's Web Services business was lossmaking. This week, Amazon proved them wrong, disclosing figures on its cloud services business for the first time. In growth and margins, AWS looks magical. Sales surged 50 per cent from a year ago in the first quarter. Its operating margin was 17 per cent; Amazon's retail business managed 2 per cent. Its share price leapt 15 per cent on Friday.

This is Amazon, though. That means the story is spending, not earning. Capital investment in AWS was $4.3bn last year, including assets acquired under capital leases; it grew almost twice as fast as sales. Expenses outgrew sales, too, as price wars in cloud services took their toll. Margins are falling. How long can this go on?

Unlike many tech companies, Amazon does not let cash languish on the balance sheet. Recently its debt has increased, in the form of capital leases that finance servers for AWS - $3bn worth last year. At the end of March, Amazon's net debt stood at $2.2bn, including long-term liabilities such as capital lease obligations (CLOs).

Amazon had $6.8bn in operating cash flow last year. It is spending faster still: total capital investment was $9.5bn (again including CLOs). The heavy investment on AWS also has a distorting effect on the segment's profitability. Because it has grown so quickly, depreciation expenses (which come out of accounting profits) lag far behind investment (which does not). This imbalance cannot last for ever.

Debt is cheap right now. Interest payments were $115m last quarter and principal repayments of CLOs were $1.5bn - manageable sums. But as AWS keeps growing, the investments required will grow ever more unwieldy. Rivals such as Microsoft, Amazon's main competitor in the public cloud, have plenty of dollars to deploy. Microsoft has $55bn in net cash. AWS may look like a magic growth engine today, but it will be hard to make the magic last.

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