☁️ Amazon: Everyone gets an LLM
AWS slows down, advertising accelerates, and cash flow improves
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Amazon (AMZN) reported its Q1 FY23 earnings last week.
Today, we’ll cover the following:
Amazon Q1 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
We dropped a new video on the How They Make Money YouTube Channel, where we explore the secrets behind Amazon’s business model!
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Reviewing quarterly earnings can offer valuable insights into a company's recent business developments, but it's easy to get caught up in short-term fluctuations.
As Morgan Housel wisely suggests, we should ask ourselves,
"Will I still care about this a year from now?"
This perspective helps filter out the noise and focus on what's important.
When analyzing Amazon's quarterly earnings, it's essential to keep this question in mind. So as we delve into AWS workload optimizations and various macro headwinds affecting margins, let's consider what will still matter a year from now and beyond.
Let's dive in!
1. Amazon Q1 FY23
Here is a bird’s-eye view of the income statement.
💻 Online store (40% of overall revenue): Amazon.com flat Y/Y.
🏪 Physical store (4%): Primarily Whole Foods Market. +7% Y/Y.
🧾 3rd party seller (23%): Commissions, fulfillment, shipping +18% Y/Y.
📱 Subscription (8%): Amazon Prime memberships, Audible +15% Y/Y.
📢 Advertising (7%): Ad services to Amazon sellers, Twitch +21% Y/Y.
☁️ AWS (17%): Compute, storage, database, & other (B2B) +16% Y/Y.
Other (1%): Various offerings, small individually.
Revenue grew +9% Y/Y to $127 billion ($2.9 billion beat), or +11% fx neutral.
The fastest-growing segments were:
Advertising (+21% Y/Y), accelerating from +19% Y/Y in Q4.
3rd party seller services (+18% Y/Y), vs. +20% Y/Y in Q4.
AWS (+16% Y/Y), slowing down from +20% Y/Y in Q4.
North America grew +11% Y/Y to $77 billion.
International grew +9% Y/Y fx neutral to $29 billion.
Gross margin was 47% (+4pp Y/Y).
Operating margin was 4% (+1pp Y/Y).
AWS had a 24% margin (-11pp Y/Y and flat Q/Q).
North America had a 1% margin (+3pp Y/Y).
International had a -4% loss margin (flat Y/Y).
Non-GAAP EPS (earnings per share) was $0.31 ($0.11 beat).
Cash flow (trailing 12 months or TTM):
Operating cash flow TTM was $54 billion (+38% Y/Y).
Free cash flow TTM was ($3) billion (negative) due to significant purchases of property and equipment ($58 billion), more than offsetting the cash generated from operations.
Cash, cash equivalent, and marketable securities: $64 billion.
Long-term debt: $67 billion.
Q2 FY23 Guidance:
Revenue growth of +5% to +10% Y/Y in the mid-range (vs. +7.5% Y/Y expected).
Operating margin between 2% and 4%.
So what to make of all this?
Amazon had a strong quarter, with overall revenue exceeding expectations, and the AWS slowdown not as bad as feared.
The strong dollar created a 2 percentage points currency headwind. As a result, revenue growth would have been +11% Y/Y fx neutral, which is a better representation of the growth profile of the business.
AWS exceeded expectations in Q1 but disappointed in the Q2 outlook. As most of Amazon's valuation relies on AWS's long-term potential, any underperformance in this high-margin segment can lead to significant stock price fluctuations.
First, the Q1 good news: In the Q4 earnings, management warned AWS was growing in the mid-teens. Given the slowdown trend, a mid-teens growth had become the high-case scenario for Wall Street. Yet, AWS grew +16% Y/Y(vs. ~12-13% expected) and had a 24% operating margin (flat Q/Q). This initial news in the earnings report led to AMZN rising as high as 10% in after-hours.
Second, the Q2 letdown: During the call, management indicated that AWS revenue growth in April was 5 percentage points below Q1, implying an 11% Y/Y growth. Given the steady deceleration, we might look at an AWS growth of around 10% or slightly below in Q2 FY23. The stock turned red on this commentary. It’s important to note that Q2 FY22 may be a more challenging comp (more on that in a moment).
Advertising was a bright spot in a challenging quarter for ad businesses, with 23% fx-neutral growth.
Operating margin improved by 1 percentage point, mainly due to non-AWS segments reaching breakeven after several difficult quarters. This improvement also translated into better operating cash flow. The operating income was impacted by $470 million of employee severance charges in Q1, including $270 million related to AWS. Amazon eliminated 9,000 roles across various departments (AWS, Twitch, devices, advertising, and HR).
Revenue guidance for Q2 (+7.5% Y/Y) was mainly in line with expectations.
Is the business sustainable?
Despite Amazon's free cash flow turning negative since the last quarter of 2021, the company remains in control of its destiny.
Amazon generates sufficient cash from its operations to fund investments, with the negative free cash flow stemming from a rise in growth capex (capital expenditures excluding depreciation and amortization).
In essence, Amazon is heavily investing in future growth initiatives ($14 billion in the trailing 12 months net of maintenance Capex), allowing it to adjust its cash burn if the business's sustainability were at risk.
2. Recent business highlights
Amazon is heavily investing in Large Language Models (LLMs) and Generative AI, playing a role in all layers of the AI tech stack:
First layer: Infrastructure (Trainium and Inferentia)
At the bottom of the stack are the compute hardware and chips. Amazon CEO Andy Jassy explained that Amazon has been developing customized machine learning chips, such as Trainium for training and Inferentia for inference. The combination of price and performance for these chips is highly differentiated.
Second layer: Models (Bedrock)
Amazon recently announced Bedrock, a managed foundational model service. Customers can run foundational models from Amazon's Titan or use LLMs from providers like AI21, Anthropic, and Stability AI.
Andy Jassy explained:
“Every single one of our businesses inside Amazon are building on top of Large Language Models to reinvent our customer experiences, and you’ll see it in every single one of our businesses, stores, advertising, devices, entertainment.”
This also applies to Alexa, which will soon have a larger, more generalized LLM.
Third layer: Apps (Code Whisperer)
Amazon released CodeWhisperer, a free alternative to GitHub Copilot for individual developers. It's undercutting the $10/month pricing of the Microsoft-made rival. It supports various languages and integrated development environments and offers security scanning.
While it remains to be seen if Code Whisperer will gain popularity, the free tier for individuals is a promising start.
3. Key quotes from the earnings call
Brian Olsavsky, SVP and CFO, touched on the product mix:
“We saw moderated spending on discretionary categories as well as shifts to lower-priced items and healthy demand in everyday essentials, such as consumables and beauty.”
On sellers and advertising:
“Sellers comprised 59% of overall unit sales in Q1, up from 55% one year ago. We also saw strong engagement in our advertising services. […] In particular, our sponsored product and brand offerings remain a key driver of growth as we work with advertisers to help customers make more informed purchase decisions. Our teams remain focused on delivering performance through our comprehensive and flexible measurement capabilities along with insights that allow advertisers the ability to measure the return on their advertising spend and help them grow their business.”
On AWS and its growth rate of AWS in April 2023:
“Given the ongoing economic uncertainty, customers of all sizes in all industries continue to look for cost savings across their businesses, similar to what you’ve seen us doing at Amazon. As expected, customers continue to evaluate ways to optimize their cloud spending in response to these tough economic conditions in the first quarter. And we are seeing these optimizations continue into the second quarter with April revenue growth rates about 500 basis points lower than what we saw in Q1.”
He also touched on why Amazon is helping customers spend less:
“As a reminder, we’re not trying to optimize for any one quarter or year. We’re working to build customer relationships and a business that will outlast all of us. Therefore, our AWS sales and support teams continue to spend much of their time helping customers optimize their AWS spend so that they can better weather this uncertain economy. This customer orientation is built into our DNA and how we think about our customer relationships and business over the long term.”
CEO Andy Jassy touched on the long-term opportunity at AWS:
“We’re not close to being done inventing in AWS. Our recent announcement on Large Language Models and generative AI and the chips and managed services associated with them is another recent example. And in my opinion, few folks appreciate how much new cloud business will happen over the next several years
On fulfillment and the new regions:
“We doubled the size of our fulfillment center footprint and largely built the transportation network the size of UPS in a couple of years. This ended up substantially changing the number of nodes and connections in our fulfillment network. […] We’ve created 8 interconnected regions in geographic areas with each of these regions having broad relevant selection to operate in a largely self-sufficient way while still being able to ship nationally when necessary. We just recently completed this rollout and are quite bullish on the early results. Not surprisingly, shorter travel distances means lower cost to serve and customers getting their orders faster.”
“(We’ve made) very substantial investment in machine learning to make sure customers see relevant ads when they’re looking for various items […] These advertisements have performed unusually well for brands, which makes them want to advertise on Amazon.
It’s also worth noting that we’re still very early in our efforts to find a way to thoughtfully place ads in our broader video, live sports, audio and grocery properties. We have a lot of upside still in advertising.”
4. What to watch looking forward
AWS market share and margins
Cloud scalability allows businesses to adjust resources according to demand, and currently, customers are prioritizing cost optimization.
As Amazon continues to help its customers optimize their workloads, the big question is how much optimization still lies ahead.
Andy Jassy had this to say during the Q&A:
“It’s hard to say exactly where we are in the process. […] I think it’s important to remember that customers are pretty explicitly telling us that this is not a cost cutting effort where we intend on spending less money on technology or on the cloud.”
Success is not linear. Q2 FY22 was one of the strongest quarters for AWS in the past four years, adding $1.3B sequentially (+7% Q/Q). That makes it a “tough comp,” which could partially explain the weaker April growth.
If Q2 FY23 grows +10% Y/Y, AWS will add $0.3 billion sequentially, which would be better than the flat growth we saw in Q1 FY23.
According to Synergy Research Group, cloud infrastructure services market spending reached $64 billion in Q1 2023 (+20% Y/Y and +4% Q/Q). So AWS sightly trailed the rest of the market.
Amazon maintained a 32%-34% market share in the past five years, and while Microsoft and Google gained market share, the overall pie is growing for all participants.
A key aspect of Amazon's growth strategy is its international expansion. North America and several established countries have already demonstrated Amazon's potential at scale, making the company optimistic about its emerging business, which has expanded into 10 countries over the past five years.
Amazon's international consumer segment generated $118B in revenue in 2022, with strong growth in established markets like the UK, Germany, and Japan. The company has also invested in new geographies, such as India, Brazil, Mexico, Australia, Europe, the Middle East, and Africa. Despite challenges in infrastructure and services in emerging countries, Amazon collaborates with partners to deliver solutions and remains optimistic about future growth.
Amazon's Kuiper project is an ambitious initiative to provide affordable broadband internet service to underserved areas using a low-Earth orbit satellite system. The company has developed low-cost, compact customer terminals that deliver up to 400 Mbps.
Amazon plans to launch prototype satellites this year and start beta testing with commercial customers in 2024. Kuiper presents a considerable opportunity, sharing similarities with AWS in terms of capital intensity, customer base, and revenue potential. This bold project will be fascinating to watch.
Amazon's healthcare journey started with the launch of Amazon Pharmacy in 2020, which introduced innovations like the RxPass for Prime members.
Customer demand for improved healthcare experiences led Amazon to venture into primary care, acquiring One Medical in July 2022. One Medical's patient-centric approach, digital app, easy appointment scheduling, and solid relationships with specialty physicians and local hospital systems make it a compelling foundation for Amazon's primary care expansion.
Amazon's advertising services reached $9.5 billion, representing:
24% of Google's revenue from Search (+5% pp Y/Y).
34% of Meta's advertising revenue (+5% pp Y/Y).
So what drives this success?
Andy Jassy provided some answers in his shareholder letter, including:
Amazon's use of machine learning algorithms to tailor sponsored products to customer searches, resulting in more relevant and better-performing ads.
Significant investments in machine learning to enhance advertising selection algorithms.
Comprehensive, flexible, and durable planning and measurement solutions for marketers, such as the Amazon Marketing Cloud (AMC).
Opportunities to integrate advertising into video, live sports, audio, and grocery products in the future.
Amazon advertising’s growth relative to other advertising giants is a sign the moat is widening. As I explained in my review of Q4 FY22 results:
“Amazon has been gaining market share in the digital ad space with consistency in the past few years. And the moat around Amazon’s ad business may be more sustainable, given the underlying investments needed to match its operations network.”
AWS may slow down even more, but the long-term opportunity remains intact.
Advertising continues its growth unabated, a sign of an expanding moat.
AI capabilities are coming for all three layers of the tech stack.
New ventures are costly but add optionality to the business.
Jassy added in the recent shareholder letter:
“While we have a consumer business that’s $434B in 2022, the vast majority of total market segment share in global retail still resides in physical stores (roughly 80%). And, it’s a similar story for Global IT spending, where we have AWS revenue of $80B in 2022, with about 90% of Global IT spending still on-premises and yet to migrate to the cloud. As these equations steadily flip—as we’re already seeing happen—we believe our leading customer experiences, relentless invention, customer focus, and hard work will result in significant growth in the coming years.”
That’s what investing in secular trends is all about.
That’s it for today!
Stay healthy and invest on!
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Disclosure: I am long AMZN, GOOG, and META in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.
Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
I have a question regarding cloud that might seem a little basic(newbie here, recent highschool graduate waiting to attend college). AWS is the leader in cloud infrastructure as confirmed by their marketshare. However, in their financial statements, Azure seems to bring in more revenue. Why is this?