Amazon: The Cash Printer is Back On
Q3 2023 ER
Edited by Brian Birnbaum and an update of my original Amazon deep dive and my Q2 update.
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In Section 1.0 I review the Amazon thesis and explain how the company´s cash flow profile is turning around.
In Section 2.0 I explain how North America is driving differential cash flows.
In Section 3.0 I analyze the potential of AWS, now that it is pointing at Generative AI.
In Section 4.0 the surprising strength of Amazon´s advertising business.
In Section 5.0 I review Amazon´s balance sheet and I conclude the write up.
1.0 Thesis Recap
Amazon´s operating and free cash flows are evolving as I hypothesized both in my original deep dive and in my Q2 update.
I published my Amazon deep dive on the 29th of January 2023, just one month after the stock hit $81–levels not seen since 2019. I pointed out that, despite the market´s pessimism, Amazon was gearing up to yield record operating and free cash flow per share.
I predicted that free cash flow would ultimately track Amazon´s increased capacity–i.e. ability to serve customers–at a lower cost. Indeed, it has.
Amazon is now serving customers more rapidly, expanding the use cases for which customers resort to the company.
Building on the momentum from last quarter, we set another record for delivery speed. For the year-to-date period through the third quarter, we have delivered at the fastest speeds ever in the United States.
These improvements in delivery speeds have been a key driver of growth and are resulting in increased purchase frequency by our Prime members.
-Brian Olsavsvky, Amazon CFO during the Q3 2023 conference call.
Below we see cash from operations reversing upwards. reaching new highs for twelve trailing months.
Free cash flow, although not at record levels, is trending in the right direction and is set to soon reach all time highs.
During this period, share count has barely increased, setting the company up for record levels of free cash flow per share in the near future.
Next, we’ll cover how Amazon managed to drive cash flows to near record levels.
2.0 North America is Thriving
Amazon’s North America business has recaptured positive operating income. A fundamental restructuring of fulfillment networks across the US over the last few quarters sent Amazon into the red. But it’s also why the company has achieved record-level cash flow.
On the other hand, International business is close to breakeven. Reaching operational leverage will only expand margins and profits in the future.
Q3 marks Amazon´s second full quarter of North American regionalization, which broke a single national fulfillment network down into eight regional networks. The shift was a tremendous risk, especially after doubling the network during the pandemic.
Yet Amazon has emerged on the other side, now providing record delivery speeds regionalization for customers.
The new system shortens distances and lessens touch points in delivering items to customers. According to Olsavsky´s comments in the Q&A section, the new setup has yielded shorter distances than expected while bolstering local in-stock levels. The new system seems to be luring consumers into purchasing everyday essentials via Amazon, which is likely to increase the network´s frequency of consumption per customer over the coming years.
And as I talked about last quarter, we know how important speed of delivery is to customer satisfaction and buying behavior.
A good example is the significant growth we're seeing in consumables and everyday essentials.
-Andy Jassy, Amazon CEO during the Q3 2023 conference call.
As has happened in the past, higher frequency will enable Amazon to achieve optimization–in turn driving higher frequency, and so on. Amazon becomes something very different in the eyes of customers when it can be used to make same-day purchases.
North America’s operating income came in at $4.3B for the quarter, up from $3.2B last quarter and $(412M) a year ago. The previous all-time high was $3.45B, which Amazon has now exceeded by 24%. It is worth noting, however, that tamed inflation aided increased profits, primarily lower line haul, ocean, and rail shipping rates, which were partially offset by higher fuel prices.
Additionally, according to Amazon, the company has seen improvements in working capital lately. As I explained in the deep dive were also hindering Amazon´s ability to produce cash.
The graph below illustrates that North America´s operating income dips negative between Q4 2021 and Q1 2023–just one quarter before overall free cash flow turns positive.
AWS operating income was relatively unaltered during Amazon´s most recent CapEx cycle. North America has become the differentiator for cash flows. Further, Amazon is only starting to gain operating leverage on new infrastructure. Continued increases in operating leverage in North America will drive overall operating income much higher from here.
Capital investments (CapEx + equipment finance leases) are expected to come in at $50B in FY2023, versus $60B in FY2022. This $10B in new efficiencies translates comfortably into the positive free cash flow exhibited in Section 1.0.
Below we can see that North America’s rebound is striking:
According to management, most operational productivity initiatives are focused on the US. But the company is taking steps to implement them in the international markets as well. In the last six years, Amazon has launched in ten new emerging-market nations alone. I expect them to trail the US, both in terms of customer satisfaction and, ultimately, financial performance.
Hence, over the coming quarters–especially Q4–I expect North America to continue driving most of Amazon´s outperformance. However, beyond, we will see Amazon’s foreign markets begin piling cash atop the heap as well.
Incidentally, during the conference call Olsavsky remarked that consumers “remain cautious” with regards to prices, trading down whenever possible and eschewing discretionary items. (Tangentially, Spotify´successful price increases appear all the more noteworthy, exhibiting their pricing power.)
3.0 AWS Leverage and Generative AI
AWS is exhibiting increased operative leverage due to headcount reductions. The Generative AI unit has tremendous long-term potential and will serve to accelerate service revenue growth.
Though AWS is not driving Amazon´s differential financial performance at present, the segment continues to advance well. Operating income came in at $6.97B in Q3 2023, up from $5.4B (or 29%) from a year ago, despite customers’ “elevated cost optimization.”
During the same periods, net sales came in at $23B and $20.5B, respectively, an increase of 12%. Notice how AWS operating income has increased more than twice as fast as net sales. According to Olsavsky, this leverage stems from headcount reductions in Q2 and “continued slowness” in hiring.
The cost discipline can be seen in the evolution of AWS´operating income:
It seems that, over the past year, Amazon, like many other companies, has been experiencing elongated sales pipelines. According to management, the pace of sales is now “picking up.” However, rather than focusing on the quarterly fluctuations of the business, I believe it is more important to focus on where it is headed over the next decade.
In September 2023, Amazon launched Bedrock: a platform that enables customers to access, test, deploy, and manage LLMs from third parties. Bedrock allows users to re-train instances of third party LLMs with their own proprietary data without it leaking back into the parent model. In many ways, Bedrock can be seen as a competitor of GitLab´s MLOps solutions.
And then we have a $92 billion revenue run rate business where 90% of the global IT spend still resides on premises. - Brian Olsavsvky, Amazon CFO during the Q3 2023 conference call.
Note: In the above quote, Olsavsky is explaining how only 10% of enterprise workloads have moved to the cloud. Thus, AWS has a huge runway ahead, with the remaining 90% yet to get on the cloud.
If Bedrock succeeds, AWS will more likely stay relevant as Gen AI permeates the economy. Even more interesting than Bedrock, perhaps, is that Amazon is using Gen AI to optimize its own operations. Not for the first time, it is likely that Amazon figures out productive use cases that it can then resell to customers.
In Section 2.0 of the Amazon deep dive, I explain why Amazon´s future lies with services. Generative AI is ever faster pulling Amazon into that future. Gen AI enables Amazon to encapsulate and distribute operational intelligence at a marginal cost, via characteristic and non-stop iteration.
At this stage, creating an e-commerce infrastructure that rivals Amazon´s–creating a flywheel of data and sales–is near impossible. Winning in AI is a function of possessing the most data and deploying it most effectively. As such, Amazon´s moat in e-commerce is also its moat in generative AI.
The more Amazon continues to scale up its operations, the better its generative AI will be, both for itself and others.
Jassy mentioned the following example applications in the Q3 conference call:
Inventory forecasting: “We use generative AI models to forecast inventory we need in our various locations and to derive optimal last mile transportation routes for drivers to employ.”
Merchant operations: “We're also making it much easier for our third-party sellers to create new product pages by entering much less information and letting the models to the rest.”
Advertising: “In advertising, we just launched a generative AI image generation tool, where all brands need to do is upload a product photo and description to quickly create unique lifestyle images that will help customers discover products they love.”
Renewed focus on LLM seems enhances Amazon´s efforts with the Alexa. As I explained in the deep dive, Alexa promises to be a gateway for the delivery of high margin digital services down the line:
[…] we built a much more expansive LLM and previewed the early version of this.
Apart from being a more intelligent version of herself, Alexa's new conversational AI capabilities include the ability to make multiple requests at once as well as more natural and conversational requests without having to use specific phrases.
-Andy Jassy, Amazon CEO during the Q3 2023 conference call.
4.0 The Strength of Amazon’s Advertising Business
Sponsored items seem to thrive during both good times and bad, and advertising revenue was equal to 52% of total AWS revenue in Q3.
Amazon’s advertising business (light blue below) has been growing healthily despite online ad spending withering over the last year or so. According to Jassy, sponsored products make up most of the advertising revenue. Even when they tighten their belts, people still buy things online. For merchants, getting in front of buyers is a priority during good times and bad.
In this sense, Amazon´s advertising business has proven to be particularly anti-fragile and, at a run rate of nearly $50B, now accounts for a considerable portion of Amazon´s revenues. The graph below depicts the evolution of revenue from advertising services as compared to AWS.
As mentioned earlier, total advertising revenue equaled 52% of total AWS revenue in Q3 2023. As such, it’s now positioned to be a key driver of Amazon´s financial health going forward.
In terms of additional things we're excited about. I think that we have barely scraped the surface with respect to figuring out how to intelligently integrate advertising into video, into audio and into grocery. So I think we're early days in that.
--Andy Jassy, Amazon CEO during the Q3 conference call.
5.0 Balance Sheet Overview and Conclusion
Amazon ended Q3 2023 with:
$64.1B in cash, equivalents and marketable securities.
$61B in long term debt.
$75.9B in lease liabilities.
And $21B in other long-term liabilities.
With $21.4B in free cash flow in Q3, it looks like the balance sheet is doing fine, although I would certainly like to see a wider net cash position.
Perhaps the most valuable takeaway here is that qualitatives front-run quantitatives. So long as a world-class company retains its extraordinary cultural and organizational properties, it can be trusted to continue performing over time.
In the case of Amazon, its history of intense CapEx cycles that generate operating leverage is well documented. During times of pessimism, such as January 2023, only an in-depth understanding of the qualitatives can help one understand Amazon’s inherent value, allowing them to buy shares at depressed levels.
Until next time!
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Spectacular article, great job Antonio!