☁️ Amazon: Day 1
Putting customers first in a challenging environment
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Amazon (AMZN) reported its Q3 FY22 earnings last week.
The stock fell more than 10% since then, so let’s find out what the fuss is all about.
Today, we’ll cover the following:
In Amazon’s 1997 annual shareholder letter, Jeff Bezos explained:
“This is Day 1 for the Internet, and, if we execute well, for Amazon.com.”
‘Day 1’ is a critical component of Amazon’s DNA. It involves a culture and an operating model that puts the customer at the center of everything Amazon does. It fosters a perpetual innovation process.
“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”
Appreciating Amazon’s core principle to remain a ‘Day 1’ company gives unique insights when reviewing the company’s performance.
To Bezos, there are key elements needed to maintain a Day 1 mindset:
A skeptical view of proxies
Eager adoption of external trends.
As we watch the company experiment patiently, fail in many areas, and plant seeds for long-term growth initiatives, we are witnessing the application of its Day-1 core principles.
Before we start, let’s discuss how Amazon makes money:
Revenue has 7 main components:
💻 Online store (42% of overall revenue): Amazon.com.
🏪 Physical store (4%): Primarily Whole Foods Market.
🧾 3rd party seller services (23%): Commissions, fulfillment, shipping, etc.
📱 Subscription (7%): Amazon Prime memberships, Audible.
📢 Advertising (8%): Ad services to Amazon sellers and Twitch.
☁️ AWS (16%): Compute, storage, database, and other services (B2B).
Other (1%): Various offerings, small individually.
Cost of revenue includes:
The purchase price of consumer products, shipping, and handling costs.
Digital media content costs (similar to Netflix).
Operating expenses are primarily:
Fulfillment costs (operating and staffing fulfillment centers and stores).
Technology & content (R&D and infrastructure costs to support AWS).
AWS is the crown jewel of Amazon. The cloud segment had a 26% operating margin in the most recent quarter. It funds the entire business.
Other segments are lumped together by region (North America and International). They historically have razor-thin margins. In 2019 (pre-COVID), the ‘North America’ segment had a 4% margin, while the ‘International’ segment had a small 2% loss margin.
Gross margin has improved over time, from the low 20s a decade ago to 45% today as AWS becomes a larger portion of revenue (the cost to operate AWS is below the gross profit line).
Operating margin has oscillated between 0% and 6% in the past decade.
So it may come as a surprise that the main business fueling Amazon’s profits is the one many retail investors are not familiar with: its cloud platform for businesses.
I read a comment on LinkedIn today that made me chuckle:
“Amazon is a data center business (AWS) with a gift store in the lobby.”
Is it a fair assessment? Let’s find out!
1. Amazon Q3 FY22
Here is a bird’s-eye view of the income statement.
Q3 FY22 highlights:
Revenue grew +15% Y/Y to $127 billion ($0.4B miss).
The fastest growing segments were AWS (+27% Y/Y) and Advertising (+25%).
All segments showed healthy growth despite 5pp fx headwinds.
Gross margin was 45% (+2pp Y/Y).
Operating margin was 2% (-2pp Y/Y).
AWS had a 26% margin.
North America had a -1% loss margin.
International had a -7% loss margin.
EPS (earnings per share) declined -10% Y/Y to $0.28 ($0.21 beat).
Cash flow (trailing 12 months):
Operating cash flow TTM was $20 billion.
Free cash flow TTM was ($20) billion due to significant purchases of property and equipment, more than offsetting the cash generated from operations.
Cash, cash equivalent, and marketable securities: $59 billion.
Total debt: $164 billion.
Q4 FY22 Guidance:
Revenue growth of +5% Y/Y in the mid-range (vs. +13% Y/Y expected).
Operating margin between 0% and 3%.
So what to make of all this?
It was a mixed quarter. For one thing, the Q4 guidance came well below expectations in a challenging macro environment.
The strong dollar affected the quarter with a 5 percentage points currency headwind. Revenue growth would have been +19% Y/Y fx neutral.
AWS came in below expectations. It grew +27% Y/Y(vs. ~30% expected) and had a 26% operating margin (vs. 29% in Q2 FY22). Since it’s the cash cow of the company, any underperformance can lead to big swings in the valuation. AWS customers are looking to save money versus committed spend (particularly in the financial services industry). In short, AWS costs remain the same, but customers are spending less than they normally would, resulting in a lower margin. For Amazon, retention is more important, and they actively help their customers manage workloads better to save money.
Advertising was a bright spot (+25% Y/Y) in a tough quarter for most ad businesses (see my Google review here).
The operating margin declined by 2 percentage points due to a rise in technology and content costs and marketing costs.
Revenue guidance for Q4 (+5% Y/Y) is the lowest in Amazon’s history. I know, that sounds scary, right? It’s primarily the result of macro headwinds.
Is the business sustainable?
Amazon’s free cash flow turned negative recently, making some analysts wonder how long it can sustain this run rate.
Amazon is generating plenty of cash from its operations to fund its investments. The recent negative free cash flow is caused by a rise in growth capex (capital expenditures excluding depreciation and amortization).
In short, Amazon is investing a ton to fuel its future growth initiatives ($27 billion in the trailing 12 months). So the company is in control of its destiny and can adjust its cash burn if the sustainability of the business is at stake.
2. Recent business highlights.
Prime Day was the biggest ever, reaching 300 million items purchased. It contributed 0.4 percentage points to the revenue growth Y/Y because Prime Day was in Q2 last year.
Amazon debuted the two largest Prime Video releases: The Lord of the Rings: The Rings of Power (25 million viewers on the first day) and NFL Thursday Nights (more than 15 million viewers during the first game).
Management shifted ~$10 billion in capital investments from fulfillment and transportation to technology infrastructure. The goal is to expand the AWS footprint.
Amazon made recent strategic acquisitions. They're relatively small, but they could lead to tremendous opportunities when leveraged with the company’s reach:
One Medical: An all-cash transaction valued at $3.9B. I've used One Medical in San Francisco and see the potential for a HealthCare service included with Prime (more than 200 million members). For now, it's a boutique provider with only 47 offices, but the potential is there.
iRobot: An all-cash transaction valued at $1.7B. Amazon likes IoT (Internet of Things) and wants to play a more prominent role in turning our homes "smart." The Roomba is incredibly popular and joins other smart devices (Echo, Ring). Amazon has first-hand knowledge of the success of the best products in its marketplace and has been working with iRobot to make the Roomba compatible with Alexa.
3. Key quotes from the earnings call
Brian Olsavsky, SVP and CFO, explained:
“Third-party sellers and the products they offer remain an important strength of our offering for consumers, representing 58% of total paid units sold in Q3, the highest percentage ever. It's up from 56% in Q3 of last year.”
Third-party sellers offer a better margin profile than first-party sales, so this is great news for the long-term margin profile of the company.
With the ongoing macroeconomic uncertainties, we've seen an uptick in AWS customers focused on controlling costs. And we're proactively working to help customers' cost optimize, just as we've done throughout AWS' history, especially in periods of economic uncertainty.
About AWS growth in Q4:
“I would say that although we had a 28% growth rate for the quarter for AWS, the back end of the quarter, we were more in the mid-20% growth rate. So we've carried that forecast through to the fourth quarter. We're not sure how it's going to play out, but that's generally our assumption.”
It remains to be seen how long such a slowdown would last.
“The continuing impacts of broad-scale inflation, heightened fuel prices and rising energy costs have impacted our sales growth as consumers assess their purchasing power and organizations of all sizes evaluate their technology and advertising spend.”
Let’s all prepare for an ugly Q4! 😅
4. What to watch looking forward
AWS market share and margins
I’ve argued before that AWS alone could justify Amazon’s valuation. So it will be critical to watch the growth and margin profile of the segment.
If we zoom out, AWS delivered another strong quarter, maintaining a leading market share in a very fast-growing industry. The expectation game every quarter can make us miss an otherwise formidable trend up and to the right.
Prime beyond the walled garden
Prime is expanding its content at a fast clip, and not just on the video side. Yesterday, Amazon VP Steve Boom made the entire Amazon music catalog free with Prime.
Amazon is focused on third-party sellers (a higher margin business) and could expand its reach with "Buy with Prime" on the open web (competing directly with Shopify).
Amazon's advertising services reached $9.5 billion in Q3 FY22 (+30% Y/Y fx neutral). According to eMarketer, Amazon will represent 14.6% of the US Digital Ad revenue market in 2023, getting closer to Meta.
AWS is the pillar of the thesis (watch out!).
Prime is expanding its value beyond its walls.
Advertising should improve the margin profile ex-AWS.
Strategic M&A continues to offer optionality to the business.
So let’s brace for a challenging Q4 and see if Amazon can remain a ‘Day 1’ company through this challenging environment.
It wouldn’t be the first time.
That’s it for today!
Stay healthy and invest on!
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