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Edited by Brian Birnbaum.
1.0 Amazon’s Frequency Jumped Up in Q4
US customers are now relying on Amazon for everyday essentials. I believe this will equate to much higher levels of free cash flow from here.
Over the long term, Amazon’s free cash flow per share broadly tracks the total volume of problems it solves for customers.
Per every increment in CapEx, the company increases convenience, selection breadth and price competitiveness at scale in a way that is almost impossible to imitate. This leads to marketshare gains which, coupled with ever increasing levels of operating leverage, equate to buoyant cash flow production.
As I explain in my original deep dive, every time Amazon steps up CapEx cash from operations and free cash flow temporarily dwindle, until the newly deployed capacity becomes fully operational. But at the end of each investment cycle these two metrics reach all time highs.
From 2020 to 2022, Amazon doubled the size of its fulfillment network. Although the magnitude of the expansion was unprecedented and was coupled with a reversal of working capital, the aftermath is no different.
This is because the underlying driver of this recurrent phenomenon is culture. Amazon is able to effectively deploy increasing volumes of capital thanks to its genuine customer centricity and relentless innovation, driven by a high tolerance of failure.
Although Amazon’s business has many moving parts, the best way to the understand its financial evolution is by tracking how much more important it becomes in the lives of its customers, year after year.
In Q4 2023, Amazon became much more important for its customers, which likely means that the financials are about to get a lot better. Let me explain.
Just a few years ago I can remember that people in Spain would buy things on Amazon here and there. Now they buy almost everything and expect the purchases to arrive quickly at their doorstep.
The same seems to be happening across all of Amazon’s markets.
As people rely more on Amazon, they shop more (demand side frequency goes up). As folks buy more things and expect them to arrive quicker, Amazon has more and higher frequency inbound traffic that it can use to optimize its infrastructure.
The higher the frequency of the inbound traffic, the higher the frequency of Amazon’s infrastructure can go as they fine tune it to continue improving convenience, selection and price.
As frequency rises, it becomes harder for competitors to imitate Amazon, because keeping the cost to serve low becomes exponentially harder. Over time, this puts Amazon on a league of its own which leads to better unit economics and thus enhanced cash flow production.
In 2023, Amazon delivered more than seven billion (four billion in the US and two billion in Europe) items arriving same or next day, with the fulfillment network operating at the fastest speed ever. In the US, this has been enabled by two things:
The regionalization of the fulfillment network, initiated in Q2 2023.
The expansion of same day facilities, which increased the number of items delivered the same day or overnight by more than 65% YoY.
In the words of CFO Brian Olsavsky during the Q4 call:
Operating income tripled year-over-year to $36.9 billion.
Trailing 12-month free cash flow adjusted for equipment finance leases was $35.5 billion, up $48.3 billion versus last year.
These financial outputs are a result of a lot of improvements in our key input metrics such as stores' cost to serve, which decreased year-over-year for the first time since 2018 and our ability to deliver to customers at our fastest speeds ever.
The operating income rebound of the North America segment is spectacular and as you can see, is driving much of the increased financial performance with respect to last year.
In the Q4 earnings call, CFO Brian Olsavsky also mentioned that the increased speeds have strengthened the demand for everyday essentials, especially in categories like beauty, health and personal care.
I believe that thanks to its faster delivery speeds, Amazon has unlocked a new dimension of commerce which will spin the above flywheel faster. I see it as a new platform that is going to non-linearly strengthen Amazon’s moat going forward.
2.0 Digital Services
As I explain in my deep dive, Amazon is poised to expand margins and enhance its cash flow profile further via digital services, especially in the domains in which Amazon has a proprietary data moat.
Apart from the ever increasing frequency in its fulfillment network, Amazon has two additional main drivers of operating leverage for the next decade:
Advertising.
Digital services enabled by their vast data trove.
Advertising is growing very quickly and is up 26% YoY. The acceleration over the past year can be appreciated in the graph below and what is even more striking is that total advertising revenue is quickly catching up with AWS revenue.
The advertising business has vast upside. With Amazon becoming increasingly harder to imitate, it is capturing a growing share of the world`s B2C (business to consumer) commerce information, which is highly monetizable via ads.
Advertising only works if the ads are helpful to customers and there's a lot of value in tailoring sponsored products, so they are relevant to what a customer is actually searching for.
We're also continually focused on improving our measurement capabilities, which allow brands to see the payback of their advertising spend.
-Brian Olsavsky, Amazon CFO during the Q4 earnings call.
Further, Amazon is vertically integrating the infrastructure their customers need to leverage Generative AI. Amazon’s stack has three layers:
Compute: here Amazon has its “traditional” AWS business and is also making its own AI chips, like Trainium (Trainium 2 launched in Q4 2023).
Bedrock: this platform allows Amazon customers to iterate on LLMs (large language models) at a marginal cost, in order to make the training, deployment and maintenance of these models as simple as possible.
Applications: at this layer, Amazon is focused on building co-pilots like Amazon Q, which is an “expert on AWS, writes, debugs and tests code, does translations and can query customer data across various data repositories.”
We're building dozens of Gen AI apps across Amazon's businesses, several of which have launched and others of which are in development.
This morning, we launched Rufus, an expert shopping assistant trained on our product and customer data that represents a significant customer experience improvement for Discovery.
According to management, Amazon is also working on a security layer which both Bedrock and the apps will share. Management cites this is as a very important part of the stack, which analysts should not underestimate.
I wonder, once a customer company deploys LLMs that employees rely on to work, what happens if they get hacked?
Going back to the stack, I believe the Bedrock and application layers are the most promising, because they will be propelled by Amazon’s data, which is ever increasing in terms of volume and quality.
Further, Amazon’s stack will shine most where driven by proprietary data, that it can use to train AI models that one one else can.
For instance, regarding Bedrock, other cloud players like Google and Microsoft will have also access to the data generated by customers iterating on their LLMs. Thus Bedrock will likely not be unique in the market.
However, an app like Rufus will likely outperform any other alternatives in the market, as the flywheel outlined in Section 1.0 continues to spin faster and Amazon collects more and better data on people shopping.
This is not to say that other levels of the stack will be irrelevant but rather that financial outperformance will likely occur where Amazon has a proprietary data moat.
3.0 Financials
The health of Amazon’s balance sheet has been restored.
Income and Cash Flow Statements
Without getting deep into the aspects discussed in Section 1.0, it would be hard to tell what is going on at Amazon just by looking at the graph below. What is appreciable in this graph is both the uptick in the top line and in the cash flow profile.
You can specifically see the pink and green lines, cash from operations and free cash flow, respectively, hit all time highs.
As discussed, this is simply a a result of the increased marketshare and operating leverage stemming from the CapEx increase in the 2020-2022 period. Margins initially contracted and they are now expanding, as the Amazon gains leverage on the newly deployed infrastructure.
Balance Sheet
Notice how the temporary reversals of Amazon’s net cash position roughly coincide with the CapEx expansions that I have spotted in the past. This goes to say that when analyzing the business in hindsight, these periods of time look rather leisurely.
However, as is the case with stock market declines, the latest tumble looks disproportionately big and scary. When I analyzed the company last year, pessimism levels were high and the market generally lost track of Amazon’s excellent organizational properties.
Now, Amazon is back to a positive net cash position, but the degree of complexity of the task that the company has carried out in the last few years has been gargantuan. In 2020, the CEO had a good salary and the company was already quite big, but Amazon chose to act once again like it was day one.
This is perhaps the best example I have come across in my career of the importance of culture and how it broadly determines fate.
4.0 Conclusion
Amazon stock is up 64% since I wrote my deep dive on the company, explaining how free cash flow was set to explode. I reached this conclusion based on my understanding of the company’s CapEx cycles and culture.
However, I only broadly touched on Amazon’s margin expansion prospects driven by digital services. As I explain the deep dive, I did not know exactly how Amazon would go about this but I did understand that both had the raw materials and the corporate culture to take on this task.
I am pleased with the company’s progress in this sense and with the way it is framing its Generative AI stack. As reviewed in Section 2.0, I now expect most of the financial outperformance in the digital services domain to emerge from Amazon’s commerce proprietary data.
In the past few decades, Amazon has given us the infrastructure we need to frictionlessly shop. Now it’s going to do the actual shopping for us via an AI assistant.
Until next time!
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