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Cloud business: Reason why Amazon Web Services is sustainable

Amazon Web Services

Oracle share price has outperformed the S&P 500 over the past year. This is because the company’s cloud business has grown by high double digits in its most recent reported quarter. Amazon’s stock, on the other hand is down more than 50%.

In a macroeconomic setting where there are now recession risks and high inflation, I use a comparative approach to evaluate the viability of their growth strategies. In order to demonstrate that Amazon is emerging as the strongest contender in what was previously thought to be one of Oracle’s key strengths, I concentrate on the components of the AWS EC2 (Elastic Compute) cloud and database for this purpose.

The growth of Oracle, which includes Cerner, was 25% in constant currency or excluding currency headwinds caused by a strong dollar, which has had an effect on software exporters from the United States in 2022. On the other hand, compared to AWS’s 28% organic growth, its organic growth was only 9%, four times lower.

Specifically, Cerner contributed 21 percent of Oracle’s $3.8 billion in SaaS and IaaS revenues to Oracle’s healthcare and information technology intersection. The merged entity should now see some margin gains as a result of merger synergies, but Oracle’s growth strategy may jeopardize this.

In this regard, the CEO’s statement that the company “continues to benefit from economies of scale in the cloud, it will not only continue to grow operating income but will also grow the operating margin percentage” does not appear to be appropriate. Safra Catz made the statement. Leo Leung, vice president of products and strategy, claims that Oracle’s prices are lower and that “there are a lot of services that we don’t charge for at all.” This is the reason Oracle has to use an aggressive pricing strategy. They are simply included.

I look at the hybrid cloud, a market that is experiencing high growth, as a means of further illustrating my point that scaling further will be detrimental to profitability. Oracle has the OCI Dedicated Region here, a hybrid cloud solution that gives customers a cloud-like experience in their own data centers. However, such projects can cost at least $4 million for at least four years. Now, after Oracle reduced prices, this is the price.

As a result, Oracle’s gross margins, which are currently trending downward, should continue to suffer, despite the fact that offering substantial discounts may continue to aid revenue growth as shown in the blue chart below.

Additionally, there are more IT environments to manage with a hybrid infrastructure, including private clouds and public multi-clouds. This necessitates a more consultative approach, which International Business Machines (IBM) has chosen, particularly in light of the high degree of doubt regarding the viability of IT spending by businesses. When the future is uncertain, it does not work to simply offer substantial product discounts.

Borrowing costs are still high now, with debt rising to $83.6 billion and the federal funds rate currently at 4.25%-4.5% and likely to rise to 5.1% next year. When looking at quarterly figures, it appears that a price-cutting-driven growth strategy has reached a tipping point, so the question is how long it can last before the effects start to show up in free cash flow.

AWS, on the other hand, has been active in the hybrid cloud primarily due to its long-standing agreement with VMware (VMW), against whom Oracle had shown hostility for a long time, despite not having the vast on-premises customer base of Oracle. Additionally, the cloud hyperscaler’s strategy appears to be more focused on lowering its customers’ total cost of ownership (TCO) than price reductions. Customers can save up to 40% on total cost of ownership (TCO) with AWS-designed ARM-based processors, which are more energy efficient than x86-based processors. Databases and big data/analytics are just two of the many use cases that 48 of the top 50 EC2 customers currently employ.

In this regard, Amazon now offers more than 200 services related to databases and analytics, including Amazon Aurora, Amazon Redshift, and Amazon DynamoDB. The company began as a provider of elastic or expandable storage, virtual servers, and messaging in 2006.

Although these database management systems are less well-known to investors, they have been gaining traction among users and have been recognized for a long time by Gartner, which has given AWS a leadership position alongside Oracle, Microsoft (MSFT), Google (GOOGL) (GOOG), Snowflake (SNOW), and others for the past eight years in a row. Companies are now categorized as leaders, challengers, visionaries, or niche players by Gartner.

Investors will notice that the difference between December 2021 (right picture below) and December 2022 (left picture below) indicates that AWS has now been elevated to the pole position, well ahead of the trio of Microsoft, Oracle, and Google. This is because, out of the 12 vendors evaluated, Gartner ranked it highest in execution and lowest in vision.

Even though this change does not bode well for AWS’s rivals as a whole, it is especially hard to understand for Oracle, which has been very vocal about how its autonomous databases are better than AWS Openshift databases since last year. With its Graviton processors for its public cloud, AWS not only has a superior product but also offers a lower total cost of ownership (TCO), so it does not necessarily need to offer the same discounts as Oracle in the cloud price war.

The public cloud services market will reach a record $592 billion in 2023, according to Gartner. However, it adds as a note of caution that the outlook could get worse in the event that IT budgets shrink because of inflationary pressures and the fact that the cloud accounts for the majority of IT spending.

Given that recession risks have increased, this may be the case. Vertically integrated cloud computing services like AWS can assist businesses in selecting elastic and scalable solutions or a more long-term alternative to Oracle’s relatively brief product discounts. Simply put, CFOs are unable to conduct discount-based long-term budgeting.

In addition, service providers face lower profit margins as a result of aggressive pricing, particularly in a highly competitive market, as evidenced by the fact that the number of competitors in the preceding leader’s quadrant increased by two in just one year. Because of this, analysts’ projections that Oracle’s earnings per share will rise in the future may be incorrect, and the stock is not a buy despite a forward PE of 16.69x.

In addition to profitability, Oracle’s expansion results in increased debt. In this regard, the blue chart below demonstrates that the debt-to-sales ratio of 700 percent above requires $7 of debt for every $1 of sales. In addition, the chart’s trajectory does not indicate that debt will decrease anytime soon. At a time when credit was cheap, this strategy was appealing. However, Oracle’s interest costs have increased by 26% to $856 million in the most recent reported quarter.

Amazon now uses debt to finance its sales as well, but its debt-to-sales ratio is much lower. Additionally, AWS has higher margin sales than Amazon’s retail business. Consequently, it contributes approximately 74% of Amazon‘s profit. In terms of technology, it also enables the online retailer to expand its logistics ecosystem with the most recent AI in a more efficient manner because it is able to extract greater returns from investments, both for internal use and for EC2 customers.

Analysts are also hopeful that AWS’s EPS will rise in the coming years, which is good news for valuations. Because of its superior product in the $4.4 trillion database market, it is certain to be able to increase its global cloud market share beyond the current 33 percent by the end of 2021 without having to offer steep discounts to attract customers, which is good news for profitability. This is why, despite having a forward PE of 50.46x, the company is not overvalued. Based on an 18% increase in its $84 share price, the stock could return to the $100 level after a one-year drop of 50 percent.

As a market leader with a sizable share and superior database products, this thesis has demonstrated that AWS’s organic growth strategy is more sustainable. In addition, it is able to provide customers with a better total cost of ownership (TCO) in a time of economic uncertainty thanks to its more vertically integrated cloud model.

In a cautious note, inflation has been impacted by aggressive interest rate hikes, but it remains elevated and the Fed remains hawkish, which typically does not bode well for technology. In light of the deteriorating financial situation, anticipate additional volatility until a clear announcement of a change in policy is made.