Amazon Q3:2024 Earnings:
Amazon’s third quarter 2024 sales increased 11%, operating income grew 55% (as its operating margin expanded from 7.8% to 11%), and diluted EPS increased 52% year-over-year. Amazon’s margin expansion story is the biggest takeaway from the quarter…the North America and International segments have each delivered seven consecutive quarters of year-over-year operating margin improvement, and Amazon management believes that over time international margins can approach the same level as North America margins. AWS also generated healthy margin improvement but some of that was the result Amazon extending the useful life of its servers (this is a common practice among hyperscale cloud providers that has the accounting result of lowering depreciation expense and boosting margins). Free cash flow (FCF) over the trailing twelve months grew 122% to nearly $48 billion and it generated a return on equity (ROE) of 22% and a cash flow return on invested capital of nearly 30%.
Results were strong across all three segments with North American sales growing 9% (at 5.9% EBIT margin), international growing 12% (at 3.6% EBIT margin), and Amazon Web Services (AWS) growing 19% and generating a 38% GAAP operating margin. Importantly, operating margins expanded year-over-year across all three segments, supporting the thesis that Amazon will be a structurally and sustainably higher margin business in the future. In my opinion, the margin improvements should be driven by AWS and advertising which are faster growing and higher-margin, Amazon Prime subscription growth and pricing power, and higher retail/ecommerce margins driven by the international segment continuing to scale (international margins were 3.6% in the quarter, up from negative in the same period last year) and higher sales/volumes driven through its fixed-cost, but highly efficient logistics network (including increasing use of robotics and automation).
Looking out at the horizon, it’s very encouraging to think about how nearly all of Amazon’s newer businesses (AWS, advertising, pharmacy/healthcare, logistics) are structurally higher margin than its legacy retail business, but that its retail business has room to improve margins as well.
In the near-to-intermediate term some of this margin potential will be counteracted by heavy investments into Project Kuiper (Amazon’s broadband satellite internet product). Like most projects that are highly technical, capital intensive, and that require extensive government regulation and approval, the program is experiencing delays, but Amazon is expected to start delivering broadband service in select areas in 2025. Based on a map of the world with regions that still do not have reliable internet access and based on current Starlink (a part of SpaceX) subs, I am hopeful that Kuiper can provide the world with an essential service and can eventually scale up to be another fast growing, profitable business line for Amazon. (Note that Kuiper was not mentioned on the call, but I think it’s important to add this in).
The market is myopically focused on the infrastructure layer of Ai right now so it’s important to note that over the trailing twelve months AWS generated $103 billion in sales and $36.4 billion in EBIT (for a 35% EBIT margin). More specifically to Ai, Amazon’s Ai revenue is growing triple digits and is growing 3x faster than AWS did at this stage of its lifecycle. Amazon’s CEO Andy Jassy said, “The AWS team continues to make rapid progress in delivering AI capabilities for customers in building a substantial AI business. In the last 18 months, AWS has released nearly twice as many machine learning and gen AI features as the other leading cloud providers combined. AWS’ AI business is a multibillion dollar revenue run rate business that continues to grow at a triple-digit year-over-year percentage and is growing more than 3x faster at this stage of its evolution as AWS itself grew, and we felt like AWS grew pretty quickly.”
Jassy said that demand for its Ai data centers and tools is so strong that it still wouldn’t be able to fill demand even if Amazon had more capacity, and Jassy thinks that its Ai revenue could even accelerate from today’s extremely fast rates.
Here is the full quote: “I believe we have more demand that we could fulfill if we had even more capacity today. I think pretty much everyone today has less capacity than they have demand for, and it’s really primarily chips that are the area where companies could use more supply. And so we’re growing at a very rapid rate and have grown a pretty big business here in the AI space. And it’s early days, but I actually believe that the rate of growth there has a chance to improve over time as we have bigger and bigger capacity. And I think that one of the reasons I mentioned in my opening comments that we have a very deep partnership with NVIDIA, we tend to be their lead partner on most of their new chips. We were the first to offer H200s in EC2 instances. And I expect us to have a partnership for a very long time that matters. It’s also true that for customers that start to scale out their implementations on the inference side, particularly, they realize pretty quickly that it can get costly. And it’s really why we have pursued building Trainium and Inferentia, which is our custom silicon. And the second version of Trainium, Trainium2 will start to ramp up in the next few weeks. And I think it’s going to be very compelling for customers on a price performance basis. And we have a lot of customer interest. We have gone back to our manufacturing partners a couple of times now to produce a lot more Trainium than we anticipated. Some of that, for sure, is due to the fact that we have very large demand, and we want more capacity and supply to be able to provide them. But a lot of it is that customers are excited about the price performance that they believe they’re going to get in Trainium.”
Jassy explained that its investment in Ai infrastructure is on-going (never ending) and the faster AWS grows the more capex is required to build the supporting infrastructure to support the weight of all that growth. But the good news is that Jassy says these are high margin, high FCF, and high ROIC investments:
“the thing to remember about the AWS business is the cash life cycle is such that the faster we grow demand, the faster we have to invest capital in data centers and networking gear and hardware. And of course, in the hardware of AI, the accelerators or the chips are more expensive than the CPU hardware. And so we invest in all of that upfront in advance of when we can monetize it with customers using the resources. But of course, a lot of these assets are many-year useful life assets. Data centers, for instance, are useful assets for 20 to 30 years. And so I think we’ve proven over time that we can drive enough operating income and free cash flow to make this very successful return on invested capital business. And we expect the same thing will happen here with generative AI. It is a really unusually large, maybe once-in-a-lifetime type of opportunity.”
He continues: “I think one of the least understood parts about AWS over time is that it is a massive logistics challenge. If you think about we have 35-or-so regions around the world, which is an area of the world where we have multiple data centers, and then probably about 130 availability zone through data centers, and then we have thousands of SKUs we have to land in all those facilities. And if you land too little of them, you end up with shortages, which end up in outages for customers. So most don’t end up with too little, they end up with too much. And if you end up with too much, the economics are woefully inefficient. And I think you can see from our economics that we’ve done a pretty good job over time at managing those types of logistics and capacity. And it’s meant that we’ve had to develop very sophisticated models in anticipating how much capacity we need, where, in which SKUs and units. And so I think that the AI space is, for sure, earlier stage, more fluid and dynamic than our non-AI part of AWS. But it’s also true that people aren’t showing up for 30,000 chips in a day. They’re planning in advance. So we have very significant demand signals giving us an idea about how much we need. And I think that one of the differences, if you were able to get inside of the economics of the different types of providers here and how well they manage that utilization and that capacity, it has a very direct impact on what kind of margins you have over time and what kind of capital efficiency you also have over time. And so I think you’re right, Ross, that there are some similarities in the early days here of AI, where the offerings are new and people are very excited about it. It’s moving very quickly and the margins are lower than what I think they will be over time. The same was true with AWS. If you looked at our margins around the time you were citing, in 2010, they were pretty different than they are now. I think as the market matures over time, there are going to be very healthy margins here in the generative AI space.”
The beautiful thing about these Ai tools is that Amazon can (1) sell them to enterprise cloud customers, (2) use them to improve the shopping experience for consumers and improve advertising placement and ROI, (3) use them to improve device functionality (of Alexa, Kindle, etc), (4) as well as use them internally to improve efficiency/productivity and to cut costs. For example, Jassy said that Amazon’s Ai saved “Amazon’s teams $260 million and 4,500 developer years in migrating over 30,000 applications to new versions of the Java JDK.”
In addition to AWS, I am excited about the opportunities for Amazon to further expand same day delivery and lower the cost to serve ecommerce customers, by its long runway of high-margin advertising growth, by its custom in-house advanced semiconductor business (sometimes referred to as accelerators), by innovation around consumer-facing Ai devices (ex: Alexa), and by the scaling of its online same-day-delivery pharmacy business.
Here are several quotes from the call referencing these growth initiatives…
“Second, we continue to roll out same-day delivery facilities, which is not only the fastest way to get products to customers but also one of our lowest cost ways to deliver. Over 40 million customers this past quarter have had their orders delivered for free with same-day delivery, an increase of more than 25% year-over-year. And third, we continue to innovate in robotics to speed delivery, lower cost to serve, and further improve safety in our fulfillment network. We recently launched our 12th-generation fulfillment center design with the first building launching in Shreveport, Louisiana. This is the first facility that incorporates our newest robotics inventions to simplify stowing, picking, packing, and shipping processes. Thus far, this new design reduces fulfillment processing time by up to 25%, increases the number of items we can offer for same-day or next-day delivery and is expected to drive a 25% improvement in our cost to serve during peak within this next generation facility. Though we believe we have more expansive automation and robotics than other retail peers, it’s still early days in how much automation we expect in our fulfillment network.”
“On the robotics piece, what I would say is even though we believe we have more expansive and advanced automation, robotics capabilities in our fulfillment network than other peers, it’s so early with respect to what we’re going to do automation, robotics-wise in our fulfillment network. We’re just at the stage right now where we’re starting to roll out. We had about a 5 or 6 very significant new robotics capabilities in the areas of stowing, picking, packing, and shipping that we finally put into 1 facility to get the entire workflow. It’s a facility in Shreveport, Louisiana that was just launched a few weeks ago…And of course, the reason why we’re trying to have more robotics and automation in our fulfillment network is it allows us to ship more quickly, to ship more cost effectively, and to make conditions even safer for our fulfillment teammates than what they already have today.”
“In advertising, we remain pleased with our progress, generating $14.3 billion of revenue in the quarter, 18.8% year-over-year growth…At the same time, some of our newer offerings are in their very early days. We’re just entering our first broadcast season for Prime Video advertising, following a very strong showing at upfronts. And we’re continuing to support brands of all sizes with our generative AI-powered creative tools across display, video and audio, including our video generator that uses a single product image to curate custom AI-generated videos. While we’re generating a lot of advertising revenue today, there remains considerable upside.”
“We talk about our AI offering as 3 macro layers of the stack, with each layer being a giant opportunity and each is progressing rapidly. At the bottom layer, which is for model builders, we were the first major cloud provider to offer NVIDIA’s H200 GPUs through our EC2 P5 e-instances. And thanks to our networking innovations like Elastic Fabric adapter and Nitro, we continue to offer advantaged networking performance. And while we have a deep partnership with NVIDIA, we’ve also heard from customers that they want better price performance on their AI workloads. As customers approach higher scale in their implementations, they realize quickly that AI can get costly. It’s why we’ve invested in our own custom silicon in Trainium for training and Inferentia for inference. The second version of Trainium, Trainium2, is starting to ramp up in the next few weeks and will be very compelling for customers on price performance. We’re seeing significant interest in these chips, and we’ve gone back to our manufacturing partners multiple times to produce much more than we’d originally planned.”
“we have a really broad number of Alexa devices all over people’s homes and offices and automobiles and hospitality suites. We’ve about 0.5 billion devices out there with a couple of hundred million active end points. And when we first were pursuing Alexa, we had this vision of it being the world’s best personal assistant and people thought that was kind of a crazy idea. And I think if you look at what’s happened in generative AI over the last couple of years, I think you’re kind of missing the boat if you don’t believe that’s going to happen. It absolutely is going to happen. So we have a really broad footprint where we believe if we rearchitect the brains of Alexa with next-generation foundational models, which we’re in the process of doing, we have an opportunity to be the leader in that space. And I think if you look at a lot of the applications today that use generative AI, there’s a large number of them that are having success in cost avoidance and productivity. And then you’re increasingly seeing more applications have success and really impacting the customer experience and being really good at taking large corpuses of data and being able to summarize and aggregate and answer questions. But not that many yet that are really good, on top of that, and taking actions for customers. And I think that the next generation of these assistants and the generative AI applications will be better at not just answering questions and summarizing the indexing and aggregating data, but also taking actions. And you can imagine us being pretty good at that with Alexa.”
“There are so many things we’re energized by right now, but we’ll quickly mention one more: the progress we’re making in improving customers’ pharmacy experience. Brick-and-mortar pharmacies account for just over 90% of prescriptions dispensed in the U.S. that require customers to make trips to forlorn physical venues with much of the selection behind locked shelves, waiting lines for meds and only finding out about pricing at the point of purchase. The largest mail order pharmacies offer delivery in 5 to 10 business days. We think customers deserve better. Today, we can deliver to 95% of first-time Amazon Pharmacy customers in the U.S. within 2 business days and to 20% of U.S. Prime members within 24 hours. Next year, we plan to launch operations in 20 new cities, so nearly half the U.S. will have the ability to have their medications delivered to their door within hours. We believe making it easier for customers to get their medications will improve medication adherence, which we know can directly improve health outcomes.
Here’s the last quote of the day on the retail opportunity and Amazon’s culture of placing the customer experience (and improving the customer value proposition) at the heart of every decision that is made at the company:
“I mean, we have a pretty big retail business, and yet we’re only about 1% of the market segment share of the worldwide global retail market segment. And still about 80% to 85% of that market segment share lives in physical stores. And so if you believe that equation is going to flip in the next 10 to 20 years, which we do, there’s just a lot of opportunity not just for us but for several players. There won’t be only 1 successful player. I do think that we have some elements of our customer experience that are really unusual and unlike others. I think we have meaningfully broader selection than almost all the players that you probably have seen and heard of. We have low prices with very significant deals that we go work with our third-party selling partners around key holiday shopping occasions. And then we have very significant advantages and speed of delivery to customers. And we just continue to see in every bit of testing and analysis that we do, that the faster that we’re able to promise customers that we can get them their items, the more frequently they buy and the more they actually use Amazon for their shopping needs. And so those are things that are pretty different. I also think we have a way of prioritizing customers that I think is unusual. Our orientation, our DNA and our core at Amazon starts with the customer, and everything moves backwards from that. Any meeting you go to inside of Amazon, we’re always asking ourselves what do customers want? What do customers say? What do they not like about the experience? What could be better? And that customer orientation is very important not just in how you take care of customers, but the world changes quickly all the time. And the technology is changing really quickly. And so if you have the combination of strong technical aptitude, propensity and a passion for inventing and then also a customer orientation where it drives everything you do, I think you have an opportunity to continue to build great trust in a business over a long period of time.”
Amazon has a net debt balance sheet (unlike mega-cap tech peers Alphabet, Apple, Meta, and Tesla that are all net cash), but its balance sheet is rock solid with a net debt-to-EBITDA of only 0.6x and an interest coverage (EBIT/interest expense) of 24x. Additionally, despite investing massive amounts of capex ($75 billion in 2024 alone and likely more in 2025) into Ai datacenters and its retail fulfillment and logistics network (including same-day delivery facilities, robotics, and automation), I estimate that Amazon will be generating over $100 billion in annual FCF in a few years and that the cash on its balance sheet will continue to swell. So, in my opinion Amazon is primed (pun intended) to begin returning capital to shareholders through the initiation of a regular quarterly dividend and a large and ongoing share repurchase program that begins to shrink shares outstanding above and beyond just managing dilution. And I think this will happen in the next couple years (possibly sooner). This is a one-of-a-kind business trading at only 23x three-year out numbers.
Official call details: https://ir.aboutamazon.com/events/event-details/2024/Q3-2024-Amazoncom-Inc-Earnings-Conference-Call-/default.aspx
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