Amazon Web Services (AWS), a subsidiary of Amazon.com, is the world’s largest public cloud provider.

With nothing more than a credit card - any person, company or government can access the same infrastructure that powers Amazon’s e-commerce platform.

It eliminates a customer's potential high upfront costs of buying servers. That’s why we think so many people love it.

As an example, Netflix continues to use AWS instead of building its own server farms despite its massive scale.

AWS provides on-demand cloud computing products and services ranging from servers, storage, networking, remote computing, email, mobile development, and security.

Because of its scale, AWS is now Amazon’s second largest source of revenue behind only its ecommerce business with revenues of $17.459b and profits of $4.331b according to Amazon’s 2017 Annual Report.

To put that into perspective, Netflix’s revenue was $11.69b according to its 2017 Annual Report. If AWS existed outside of Amazon – it would be one of the world’s most successful technology companies.

Because of AWS, Amazon is far more than just ‘the everything’ store. It’s the market leader in enterprise cloud services.

We think it’s important to understand Amazon as a business before diving into the particulars of AWS, so we’ll start there.

Why does scale matter for Amazon and AWS?

We have found that if you talk to people about Amazon, there are generally two camps: one group are skeptics who see Amazon’s lack of profits as evidence that the company is dramatically overvalued by the market, and the other group point to Amazon’s growing revenue numbers as equally obvious evidence that the company is undervalued.

The most important thing to understand is that Amazon isn’t one monolithic company. Like AWS itself, Amazon is made up of different entities like its ecommerce business (Amazon.com), logistics, and a common technology backend (AWS).

Even inside its ecommerce business, there are bookstores, home furniture, and everything in between (as well as its third-party seller business).

What you need to understand is some of these businesses are more mature than others, and basic economics tells us that the more mature businesses are funding the new initiatives to get them off the ground.

This is what we call an aggressive reinvestment strategy in businesses that benefit heavily from economies of scale. An economy of scale is when a business has a large fixed cost base that can be spread across more customers as it scales up, bringing large benefits when it gets to scale. What you need to understand is Amazon is not not making money, it’s just reinvesting every dollar into growing its new businesses. If it were to stop reinvesting it would likely start making a healthy profit.

AWS is no different. In our opinion, AWS gives Amazon the ability to scale up its data centers to a far greater size than it would be able to if it only served Amazon’s internal customers (because its market is every developer).

Amazon founder and CEO Jeff Bezos outlines the reinvestment strategy as:

"I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … [I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it."

And as Eugene Wei said in Amazon and the "profitless business model" fallacy:

"If Amazon has so many businesses that do make a profit, then why is it still showing quarterly losses, and why has even free cash flow decreased in recent years?

Because Amazon has boundless ambition. It wants to eat global retail. This is one area where the press and pundits accept Amazon's statements at face value.

Given that giant mission, Amazon has decided to continue to invest to arm itself for a much larger scale of business. If it were purely a software business, its fixed cost investments for this journey would be lower, but the amount of capital required to grow a business that has to ship millions of packages to customers all over the world quickly is something only a handful of companies in the world could even afford."

How does Amazon Web Services work?

AWS is powered by server farms, which consists of thousands of computers at each farm, scattered around the world. These require a large amount of power to run and to keep cool (a large fixed cost base).

These server farms are then split up into virtual clusters that can emulate most attributes of a real computer including hardware (both CPUs and GPUs for processing, local/RAM memory, and hard-disk/SSD storage), choice of operating system, networking, and preloaded applications like web servers, databases, or CRMs as examples.

As an AWS customer, you can access any of these virtual clusters with nothing more than an internet connection and a credit card.

Each AWS system also virtualises its console input/output (keyboard, display, and mouse) allowing access to the virtual computer, allowing subscribers to log-in, configure, and use it as they would use a real physical computer.

The cost of any AWS service will depend on usage, hardware requirements, operating systems, software, networking features, required availability, redundancy, security, and other service options.

If this all sounds too complicated, the most important thing to understand is AWS has componentised computing.

This is important because as components, each part of the system is far more scalable than if it were a predefined resource. Need more storage, no worries? Need more computing power, that’s fine. Whatever you need AWS can serve it up for you.

This is particularly important for any startup who will find AWS far easier (and cheaper) than building their own server infrastructure. This means Amazon will get exposure to customer's growing companies indirectly such that, if the company succeeds, AWS’s revenue will scale with the company, and if the company fails, Amazon still gets paid up until the company goes under.

If you would like to dive deeper into how AWS works, we recommend reading Amazon’s Overview of Amazon Web Services Whitepaper.

Where did Amazon Web Services come from?

Brad Stone’s book The Everything Store outlines the problem early 2000s Amazon had from being served by one monolithic technical team that had to authorise and spin up resources for every new and existing project. Stone wrote:

"At the same time, Bezos became enamored with a book called Creation, by Steve Grand, the developer of a 1990s video game called Creatures that allowed players to guide and nurture a seemingly intelligent organism on their computer screens. Grand wrote that his approach to creating intelligent life was to focus on designing simple computational building blocks, called primitives, and then sit back and watch surprising behaviors emerge.

The book…helped to crystallize the debate over the problems with the company’s own infrastructure. If Amazon wanted to stimulate creativity among its developers, it shouldn’t try to guess what kind of services they might want; such guesses would be based on patterns of the past. Instead, it should be creating primitives — the building blocks of computing — and then getting out of the way. In other words, it needed to break its infrastructure down into the smallest, simplest atomic components and allow developers to freely access them with as much flexibility as possible."

The reason Amazon could start AWS is because Amazon.com would be AWS' first and best customer and would enable it to get its server farms to scale even if it had no outside customers – now the outside customers provide Amazon with revenue (and profit), and deepen its ecommerce moat by providing scale for its own data centres meaning a lower cost for Amazon’s internal customers.

Basic economics suggests that the larger AWS becomes, the greater advantage Amazon has in pricing its AWS services, which means it can either earn more profits (by keeping the price the same) or reduce the cost to attract more customers (and bring even more scale).

Social+Capital Founder Chamath Palihapitiya, when asked what company he would invest in if he could only choose one, responded with Amazon because:

"I think Amazon is the most interesting company right now and represents the surest path to a $5T (15-20x from current levels) market cap within 50 years. The reason I think this has nothing to do with ecommerce although ecommerce is their way of dogfooding the real reason: AWS.

AWS is a tax on the compute economy. So whether you care about mobile apps, consumer apps, IoT, SaaS, etc, more companies than not will be using AWS vs building their own infrastructure. Ecommerce was AMZN's way to dogfood AWS, and continue to do so so that it was mission grade. If you believe that over time the software industry is a multi, deca trillion industry, then ask yourself how valuable a company would be who taxes the majority of that industry.

1%, 2%, 5% - it doesn't matter because the numbers are so huge - the revenues, profits, profit margins etc. I don't see any cleaner monopoly available to buy in the public markets right now."

If you think about Amazon’s ecommerce business, especially its third-party sellers and logistics businesses, you can see some similarities to AWS. We consider that Amazon is effectively componentising commerce (and taking a cut just like it does with computing) but that’s for another post.