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If you’re an investor who’s turned negative on Amazon Web Services because of its much-reported growth slowdown of 2023, you might want to look again. While the pioneer of cloud computing is no longer posting red-hot topline expansion numbers, growth picked up meaningfully in the first quarter. Meanwhile, its profit margins are looking healthier than ever. And it’s a good bet AWS will keep them that way, despite the big investments required by artificial intelligence products.

AWS’ operating profit margin hit a record high in the first quarter of nearly 38%, 8 percentage points higher than the fourth quarter and roughly 10 percentage points above the average annual margin it had reported since 2018. While some of the margin improvement is due to accounting changes and layoffs, AWS’s new boss, Matt Garman, should be able to make some of it last.

That would be a big deal for Amazon. In the 12 months ending March 31, AWS’ operating profit totaled $29 billion, or about 60% of Amazon’s total. AWS’ ability to permanently lift its profit margin buttresses the entire company’s prospects.

What’s particularly notable is that some of the improvement in AWS’ margin likely comes from recently introduced products that carry higher profit margins than its older cloud services, according to TD Securities equity analyst John Blackledge.

The company has made a steady stream of announcements in recent months about improvements to longstanding products such as Amazon Connect, which helps suggest actions to customer service agents during their calls, and AWS AppFabric, a service that connects different software applications to one another. Notably, sales growth accelerated to 17% in the first quarter, compared with 12% to 13% over the preceding three quarters. Executives attributed the recovery to customers once again shifting computing to the cloud, after a period where customers pulled back a bit on cloud spending.

And it’s not just software that presents an opportunity for AWS to fatten its margins. At the infrastructure layer, Amazon has been tweaking its own custom silicon chips, such as Trainium. If it can get enough AWS customers to buy them, that could help improve AWS’ margins. That’s a big if, though. AWS customers typically prefer to use Nvidia chips to train and run their AI models. But CEO Andy Jassy told investors last month that many, including AI model-builder Anthropic and social media firm Snap, have started using Amazon’s custom chips because they are cheaper than the alternatives.

“Amazon is saving a ton of money and not spending as much on Nvidia chips… If more customers used Amazon’s chips, Amazon would be internalizing all the margin that Nvidia is capturing right now,” said Ram Ahluwalia, CEO of investment advisory firm Lumida Wealth.

In the future, new AI-powered applications released by Amazon could also prop up its margins. One example is its AI assistant, Q, that helps software engineers write code, which Amazon released to the public last week.

Depreciation and Layoffs

Another factor which likely helped in the first quarter: layoffs. Throughout 2023, Amazon cut employees from every unit including AWS, an effort that has continued this year. Amazon confirmed last month that it was slashing hundreds of workers from the AWS sales and marketing teams, as well as some who built the technology it had used in its physical retail stores.

While AWS can’t lay people off indefinitely, there are probably other layers of fat to cut. Notably, Amazon in January shifted a finance executive, John Felton, from its stores business to AWS as CFO. Felton did a lot of cost-cutting at the stores unit. It’s likely he can repeat that feat at AWS.

Still, the single biggest factor driving the quarterly uptick was an accounting change made by Amazon effective in January, where the company increased its estimate of how long its servers would last, to six years from five. That allowed it to spread the depreciation for the servers over a longer time period, lifting operating profit.

When CFO Brian Olsavsky announced the accounting change, he said it would add $900 million in operating income to Amazon’s results in the first quarter. Olsavsky added in April that AWS got most of that benefit.

Even excluding that depreciation reduction, AWS’ margin would have been about 34% without the accounting change, which is still very high relative to the recent past.

The cut in depreciation prepares AWS for an expected increase in the same expense, thanks to the fortune Amazon is spending developing AI. Like other tech companies, Amazon signaled when it reported first quarter earnings at the end of April that its capital expenditures would rise steadily in the coming quarters, as it adds chips and servers needed for training and running AI models. (AWS’ capex has already risen steeply in recent years, more than doubling to $27.8 billion in 2022 from 2019, although it fell slightly in 2023, securities filings show.)

That capex will eventually flow through to higher depreciation expense, as it will for all the big tech companies, which will hurt operating margins.

Long Term Deals

TD Securities’ Blackledge suggested one simple theory that supports the idea that Garman will be able to maintain AWS’s high margins, even as its depreciation expense starts to rise. Cloud firms have been increasingly striking long-term deals with customers, giving cloud firms more certainty about near term revenue, which at least in theory makes it easier for them to manage their fixed costs, he said.

Indeed, Microsoft’s “Intelligent Cloud” unit—which includes Azure and other services such as healthcare speech-recognition tool Nuance—also showed a strong improvement in its profit margin in March. Google Cloud has also begun reliably turning a profit, although its margin badly trails its rivals, just below 10% for the March quarter.

For AWS, though, expectations are sky-high. Ahluwalia noted that of all the “Magnificent Seven” stocks – Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta and Tesla – Wall Street analyst projections are highest for Amazon in terms of its ability to grow its free cash flow. With AI demanding a boatload of new investment, Garman and his colleagues may have to work overtime to keep clearing the high bar AWS has now set for itself.