Reading recommendation - Software Stack Investing
Picks and shovels and AWS
Software Stack Investing (SSI) is my favorite cloud research blog. Despite working at a software company as my day job, I find it really difficult to figure out what companies have moats or are building them in enterprise software.
SSI’s recent post called Hyperscalers - Friend or Foe was a fantastic read (note - this is a super long but worth it post - I recommend using this Chrome extension to put it on your Kindle if you have one) on how public cloud vendors (AWS, Azure and GCP - what SSI calls the “hyperscalers”) are now partnering with independent software vendors like Snowflake to grow their market share. Peter Offringa (the author of the blog) notes how these internal divisions of Amazon, Microsoft and Google are growing faster than previous cloud darlings like CRM:
Investors should note that all three of these cloud providers delivered revenue growth 10-15% higher than Salesforce’s most recent quarter. AWS and Azure did this at much higher revenue run rates. I think this demonstrates the special place that software infrastructure companies occupy. While consumer internet and B2B software companies will wax and wane in rapid cycles, the picks and shovels providers that enable those digital experiences will continue to grow. This is because they benefit regardless of which end user software solution is popular at the time. Each new wave of CRM, e-commerce or social networking tools will utilize their software infrastructure. This allows software infrastructure companies to keep growing proportionally to cloud migration and digital transformation as a whole.
I think this point on picks and shovels gives me even more conviction AMZN, MSFT and GOOGL have a lot of runway for their public cloud divisions. I wrote about a month back that just buying megacap tech remains a simple and arguably alpha-generating idea, in part because there is a consensus narrative forming that a tech bubble has burst and capital is moving from growth to value.
The megacap tech that plays in public cloud I think all is still in the early innings of public cloud being a big contributor to FCF. Some more thoughts:
AWS from my experience is the best-in-breed solution and still preferred by developers over Azure, GCP, Digital Ocean and other players. Despite being relatively “mature” (remember Amazon released AWS in 2006), AWS is growing 40% y/y as of last quarter and now at $71bn in TTM revenue and 30% EBIT margins for Q4. Per the excellent The Science of Hitting:
I’m not sure I see Amazon’s growth slowing down in the next few years. I think the “old economy” and “new economy” will be tailwinds here. On the “old economy” - from my own scuttlebutt having done some contracting gigs for companies migrating off on-prem to the cloud and friends working on similar projects, there is a shockingly large number of companies who are still “migrating” to AWS. Amazon even has their own division within AWS that works on these migrations. If your company is old enough to be doing a migration like this, you’ve probably survived a decade plus(said another way, migration candidates are mature businesses who can write large checks to AWS). On the “new economy” side - the YCombinators and other VCs of the world have agreements with AWS and the other cloud vendors where the portfolio companies get cloud credits for free. For any of these companies that make it big, they’re to an extent locked into the vendor they chose as a start-up.
If your response to this is “Sure I’ll buy your top line thesis, but are 30% EBIT margins sustainable when the cloud is being commoditized?”, my response is “probably not but I think that’s okay”. I think operating leverage counts here (ex. new EC2 compute from company ABC doesn’t require AWS to proportionately increase its variable costs) and I think the industry is likely to remain an oligopoly in the medium-term feature (I don’t hear about many companies being funded trying to disrupt the hyperscalers).
While I think vanilla services like compute and storage will keep going down in cost, I also think the proliferation of new AWS services is going to be accretive to margins. The more specialized, the more accretive. And the more specialized, the more vendor lock-in.
Putting it all together, if you think AWS could eventually do $500mm in revenue (they’d get there by 2030 at a 30% CAGR) at a 25% EBIT margin, that’s $125mm in operating income. If you throw a 12x+ multiple on that, we’re getting close to Amazon’s current $1.56 trillion market cap. I don’t necessarily agree AWS is worth the whole market cap, but I am saying the napkin math is there.
Overall, some great stuff from SSI and this last post on public clouds and independent software providers like Snowflake is a great read. I always prefer to buy picks and shovels during a gold rush and now is no exception. Amazon in my opinion is the highest quality picks and shovels choice.