☁️ Amazon: Your margin is my opportunity
☁️ Amazon: Your margin is my opportunity
Advertising remains a bright spot while AWS slows down
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Amazon (AMZN) reported its Q4 FY22 earnings last week.
Today, we’ll cover the following:
Amazon Q4 FY22.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
“Your margin is my opportunity.”
This quote is attributed to Jeff Bezos in a 2012 Fortune article:
“A favorite Bezos aphorism is “Your margin is my opportunity.” In fact, whereas Apple has long prided itself for premium prices—with the operating margins to show for it: 31% in 2011, vs. 2% for Amazon—Amazon sells at the bare minimum needed to break even, on the assumption it will make money elsewhere.”
Amazon’s razor-thin margins are nothing new. It always had a razor-thin operating margin (between 0% and 6%), leaving little room for competitors to seize an opportunity.
On the other hand, what is new is the company's free cash flow turning negative since the end of 2021. The chart below shows revenue, operating income, and free cash flow in the past decade.
The global pandemic has prompted Amazon to double down on its investments in its operations network. But today, the COVID pull-forward has normalized back to the original trendline.
PYMNTS compared the U.S. census data and projections of e-commerce sales based on e-commerce share data from 2010 to 2019 (aka “pre-COVID”). It does a great job illustrating the recent normalization.
As Amazon tried to meet the surge in demand in 2020, it increased its fulfillment network investments for 2022 and ended up with more capacity than needed. So after boosting its operations, assuming demand would be permanently stronger, the company needs to return to “optimization mode.”
So how did this unfold in Amazon’s latest quarter?
Let’s dive in!
1. Amazon Q4 FY22
Income statement:
Here is a bird’s-eye view of the income statement.
Revenue breakdown:
💻 Online store (43% of overall revenue): Amazon.com -2% Y/Y.
🏪 Physical store (3%): Primarily Whole Foods Market. +6% Y/Y.
🧾 3rd party seller (24%): Commissions, fulfillment, shipping +20% Y/Y.
📱 Subscription (6%): Amazon Prime memberships, Audible +13% Y/Y.
📢 Advertising (8%): Ad services to Amazon sellers, Twitch +19% Y/Y.
☁️ AWS (14%): Compute, storage, database, & other (B2B) +20% Y/Y.
Other (1%): Various offerings, small individually.
Revenue grew +9% Y/Y to $149 billion ($3.4B beat), or +12% fx neutral.
The fastest-growing segments were:
AWS (+20% Y/Y).
3rd party seller services (+20% Y/Y).
Advertising (+19% Y/Y).
These numbers include 3.6 percentage points of fx headwinds.
Excluding AWS:
North America grew +13% Y/Y to $93 billion.
International declined -8% Y/Y to $34 billion.
Gross margin was 43% (+3pp Y/Y).
Operating margin was 2% (-2pp Y/Y).
AWS had a 24% margin (-6pp Y/Y and -2pp Q/Q).
North America had a -0% loss margin (flat Y/Y).
International had a -6% loss margin (-2pp Y/Y).
Non-GAAP EPS (earnings per share) declined -10% Y/Y to $0.03 ($0.14 miss).
Cash flow (trailing 12 months or TTM):
Operating cash flow TTM was $46 billion (+1% Y/Y).
Free cash flow TTM was ($12) billion (negative) due to significant purchases of property and equipment ($58 billion), more than offsetting the cash generated from operations.
Amazon Q4 FY22 Earnings Presentation
Balance sheet:
Cash, cash equivalent, and marketable securities: $70 billion.
Long-term debt and liabilities: $161 billion.
Q1 FY23 Guidance:
Revenue growth of +6% Y/Y in the mid-range (vs. +7% Y/Y expected).
Operating margin between 0% and 3%.
So what to make of all this?
It was a mixed quarter. The overall revenue exceeded expectations, but AWS is slowing down faster than expected.
The strong dollar affected the quarter with a 3 percentage points currency headwind. Revenue growth would have been +12% Y/Y fx neutral, which is a better representation of the growth profile of the business.
AWS came in below expectations. It grew +20% Y/Y(vs. ~23% expected) and had a 24% operating margin (vs. 26% in Q3 FY22). Most of Amazon’s valuation is based on the long-term potential of AWS. So any underperformance in the revenue trend can lead to big swings in the stock price. One of the benefits of public clouds is that customers can reduce their spending when their needs have changed. AWS costs remain the same for Amazon, while customers spend less than usual, resulting in a lower margin. Amazon is actively helping customers manage workloads better to save money, which should help retention.
Advertising was once again a bright spot (+19% Y/Y and +23% fx neutral) in a tough quarter for most ad businesses.
The operating margin declined by 2 percentage points. It was explained by three large items that are non-recurring, for a total impact of $2.7 billion:
Employee severance for $0.6 billion (more on that in a minute).
Impairments of property and equipment and operating leases for $0.7 billion (primarily related to Amazon Fresh and Amazon Go physical stores).
Changes in estimates related to self-insurance liabilities for $1.3 billion.
The net margin turned negative, but it was primarily due to a $2.3 billion non-operating loss from Amazon’s investment in Rivian Automotive (RIVN), which says nothing about Amazon’s ongoing operations.
Revenue guidance for Q1 (+6% Y/Y) is an improvement from the +5% Y/Y provided for Q4 FY22 three months ago, but still short of the consensus.
Is the business sustainable?
Amazon’s free cash flow turned negative since the last quarter of 2021, 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 current 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 ($22 billion in the trailing 12 months net of maintenance capex). So the company is in control of its destiny and could adjust its cash burn if the sustainability of the business is at stake.
2. Recent business highlights
Two recent announcements deserve added context:
First, the restructuring.
As the management team considered the ongoing macro uncertainties, it decided to eliminate 18,000 roles, primarily impacting:
Stores.
Device businesses.
Human resources teams.
Amazon is not moving away from stores and devices, but the company needs to re-evaluate the best strategy.
Let’s add some context to this restructuring.
First, most big tech firms had to adjust their workforce in the past few months to optimize their cost and “right-size” their ship after the COVID-induced growth.
The chart below shows Amazon’s headcount since 2019. If we consider the post-COVID demand curve, the headcount trend makes perfect sense.
Second, the launch of RxPass.
Amazon just launched a new program called RxPass that lets Prime members get all the medicines they're using, unlimited, for a service cost of $5 per month (on top of the Prime membership fee).
The subscription includes over 50 generic medications for common conditions, such as high blood pressure or anxiety. Amazon said 150 million Americans already take at least one of the prescriptions available on the service. As a result, it could drive more healthcare spending toward Amazon and improve Prime retention metrics.
3. Key quotes from the earnings call
Brian Olsavsky, SVP and CFO, touched on sellers and advertising:
“In Q4, sellers comprised a record 59% of overall unit sales. Sellers, vendors and brands continue to look to Amazon's advertising capabilities to reach customers in the always competitive holiday season, even as the macro environment required them to scrutinize their own marketing budgets.”
On Prime Video:
“During the quarter, we completed our first season of The Lord of the Rings: The Rings of Power, the most watched Amazon original series in every region of the world, reaching over 100 million viewers and driving more Prime sign-ups worldwide during its launch window than any previous Prime Video content ”
On original content on Prime:
“In aggregate, we invested approximately $7 billion in 2022 across Amazon Originals, live sports and licensed third-party video content included with Prime. That's up from about $5 billion in 2021.”
On AWS:
“Starting back in the middle of the third quarter of 2022, we saw our year-over-year growth rates slow as enterprises of all sizes evaluated ways to optimize their cloud spending in response to the tough macroeconomic conditions. As expected, these optimization efforts continued into the fourth quarter.”
On the growth rate of AWS in January 2023:
“As we look ahead, we expect these optimization efforts will continue to be a headwind to AWS growth in at least the next couple of quarters.
So far in the first month of the year, AWS year-over-year revenue growth is in the mid-teens.”
Management pointed to softness in financial services (particularly crypto), mortgage companies, and advertising.
On the investment made through COVID and the need for optimization:
“We're now trying to, again, regain our cost structure that we've had in the past, and get more efficient on the assets we've added in the last 2, 3 years.
CEO Andy Jassy touched on cost optimization:
"We're working really hard to streamline our costs and trying to do so at the same time that we don't give up on the long-term strategic investments that we believe can meaningfully change broad customer experiences and change Amazon over the long term. […] probably the #1 priority that I spent time with the team on is reducing our cost to serve in our operations network.”
Jassy continues:
“We took a fulfillment center footprint that we've built over 25 years and doubled it in just a couple of years. And then we, at the same time, built out a transportation network for last mile roughly the size of UPS in a couple of years. And so when you do both of those things to meet the huge surge in demand, you're going to -- just to get those functional, it took everything we had. And so there's a lot to figure out how to optimize and how to make more efficient and more productive.”
On the grocery effort with perishables (Amazon Fresh):
“We've decided over the last year or so that we're not going to expand the physical Fresh doors until we have that equation with differentiation and economic value that we like, but we're optimistic that we're going to find that in 2023.”
On international markets:
“There's a certain amount of fixed investment you have to make when you enter a new geography, and then you have to drive a certain amount of revenue to be able to cover that fixed investment. But they're all […] following trajectories that roughly look like what we saw in North America [...] We're going to have a large profitable international e-commerce business.”
This is important to remember in a challenging context for the International segment, with Europe particularly affected by the war in Ukraine.
On AWS and the opportunity ahead:
“I think it's useful to remember that 90% to 95% of the global IT spend remains on-premises. And if you believe that, that equation is going to shift and flip, I don't think on-premises will ever go away, but I really do believe in the next 10 to 15 years that most of it will be in the cloud if we continue to have the best customer experience, which we have to work really hard at an event which we're working to do. It means we have a lot of growth in front of us in the AWS business.”
4. What to watch looking forward
AWS market share and margins
For how much longer will AWS's operating margin contract? Hard to tell in this environment. It’s the first business cycle where the public cloud is facing such a slowdown in demand. After all, AWS was only two-year-old during the Great Financial crisis of 2008 and was still growing like a weed at the time.
I’ve argued before that AWS alone could justify Amazon’s valuation. AWS is, in many ways, a trillion-dollar cloud business hiding in plain sight. So it remains critical to watch the growth and margin profile of the segment.
In a fast-growing market, Amazon has maintained a 32%-34% market share in the past five years. But it’s hard not to spot the elephant in the room: Microsoft has almost doubled its market share since 2017, to 23%. And Google Cloud Platform (GCP) is the fastest-growing of the top three competitors.
Of course, the market share only tells one part of the story. The overall size of the pie is still growing fast. Synergy Research Group estimates the public cloud will double in the next four years. And the categories where AWS is involved are among the fastest-growing (such as infrastructure and platform-as-as-service (Iaas and Paas), and hyperscale infrastructure).
Prime everywhere
It’s no secret that Amazon is focused on third-party seller services (a higher-margin business). In this effort, the company just expanded its “Buy with Prime” feature to all US merchants.
Buy with Prime allows Prime members to benefit from their shopping benefits (fast shipping, easy returns, seamless checkout) to online stores beyond Amazon.com. The company said the feature increased shopper conversion rate by 25% on average.
We’ll start seeing the impact of Buy with Prime when the reports for Q1 2023 trickle in (Shopify will be interesting to watch). With 172 million Amazon Prime members in the US and 6 in 10 American households having a Prime account, the potential for this feature is significant.
Digital advertising
Amazon's advertising services reached $11.6 billion in Q4 FY22 (+23% Y/Y fx neutral).
For context, Amazon’s advertising revenue represented:
27% of Google’s revenue from Search in Q4 FY22 (a segment that saw close to no growth fx neutral).
37% of Meta’s advertising revenue in Q4 FY22 (a segment that grew +2% Y/Y).
The media is focused on how Microsoft could take market share away from Google in the Search category. But 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.
In summary:
AWS could slow down for at least another couple of quarters.
Prime goes beyond its walls for a significant untapped market.
Advertising continues its growth unabated.
New ventures add optionality to the business.
Jassy added:
“We are very enthusiastic about our investments in streaming entertainment devices, our low Earth orbit satellite and Kuiper, health care and a few other things.
Do I think every one of our new investments will be successful? History would say that, that would be a long shot.
However, it only takes one or two of them becoming the fourth pillar for Amazon for us to be a very different company over time.”
This is what optionality is all about.
Limited downside and unlimited upside.
That’s it for today!
Stay healthy and invest on!
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.
Great breakdown as usual. Amazon has long dominated in e-commerce sales, but appears to be overly dependent on extremely low-margin business which is clearly saturated and has few major competitors in the US.
The fact that AWS doesn't make up even 1/3 of the gross revenue for the quarter is unexpected, considering how much advertising and hype was pumped into their tv and streaming strategy. I watched The Rings of Power show, which was overall pretty well-written. The fact that it cost Amazon over $1B is insane, though, because they aren't going to recoup that expense through their streaming video on Prime.
Would be interesting to see how many more years Amazon can afford to spend as they have, without selling new bonds or shares to finance future growth. As the US economy implodes, spending on cloud computing will decline drastically, and AWS will be hit hardest as they are the world's leader.