Amazon: Macro-economic Uncertainty is the Biggest Risk (Phone Conference Memo)

Below is the summary of the Amazon 2022Q3 conference call. For financial analysis, see "Scandal-ridden Amazon's "Two Crimes" and "One Pot" Behind the Scenes.

I. Financial Incremental Information

1. For online retail business, Prime Day made a 4pct contribution to the revenue growth in 3Q. We saw the growth rate of many businesses begin to slow in the latter part of the third quarter, affecting consumer purchasing power and businesses' spending on technology and advertising due to macroeconomic uncertainty. To stimulate growth, the company will launch a new promotional season called Prime Early Access (Youth Edition Prime Day).
2. For AWS cloud services, growth remained at around mid-20% in the latter half of Q3, and this trend is expected to continue into Q4. Due to increased economic uncertainty, customers are expecting to save money, and demand for cloud services is declining in certain industries such as mortgage loans and cryptocurrencies in the financial services sector. We will continue to increase investment in AWS in the future, increase development and sales personnel, and help customers transition to the cloud more effectively.
3. In terms of costs and expenses, the company's investment in Prime video content increased in the third quarter, primarily due to the Lord of the Rings: The Ring of Power and NFL Finals, resulting in an increase in the company's expenses.

II. Analyst Q&A Q: Why is the Q4 guidance for online retail business and AWS cloud services in the US lower than seasonal trends? A: The Q4 guidance includes a negative impact of 4.6% on a year-on-year basis due to foreign exchange variability. In Q3, July performed well, Prime Day received a good response worldwide, inventory levels and delivery speeds began to recover and continued throughout the quarter. However, growth rates began to slow in the latter part of the third quarter. On the one hand, North America began to slow down; on the other hand, international business was most affected by macroeconomic weakness. Compared with the United States, Europe was more severely affected by the Russian-Ukrainian war and energy crisis. As for AWS cloud services, facing market uncertainty, customers are cutting budgets and working to reduce spending in the short term. This is reflected in the financials.

Q: It is expected that free cash flow will remain negative this year. What is the company's plan to restore free cash flow? Will capital expenditures on data centers and AWS ramp decrease? A: There are multiple factors affecting free cash flow:

1. The growth in operating costs: our (logistics) coverage network costs have doubled in the past 2.5 years. Although there has been significant improvement in efficiency and network optimization, operating costs are still higher than pre-pandemic levels.
2. Inventory and accounts payable cycles: Supply chain problems caused by the pandemic have increased the number of weeks of inventory for both the company and sellers, affecting cash flow, but we expect to return to normal by 2023.
3. Capital spending: the company's capital spending has been very high over the past 2 years. Currently, capital expenditures are decreasing year by year, and 2022 capital expenditures are 1/3 lower than budgeted. **The company's future capital expenditures will focus on the ability to meet customer demands in the AWS cloud business.

Overall, it is expected that as revenue recovers, inventory and accounts payable cycles return to normal, and capital expenditure efficiency improves, free cash flow will improve.

Q: AWS cloud business profit margin is lower than expected. Is this due to the impact of employee stock compensation issued earlier this year on Q3, or will it be a new normal for AWS cloud business? Is the reason for the higher-than-expected loss in international business expected to become a new normal?

A: The reason for the lower-than-expected profit margin of the AWS cloud business is partly due to stock compensation, and there is severe inflation in salaries this year. On the other hand, pricing of electricity and gas has led to energy costs higher than pre-pandemic levels, which are more than twice as high as two years ago. The company is working hard to offset these adverse effects on the AWS cloud business and optimizing operations to reduce energy usage.

The profits of the international business mainly come from mature countries and regions such as Europe and Japan, while they will be offset by emerging countries and investments in Prime. The main source of the increased Q3 loss is the rise in fuel costs in European operations, even higher than in the United States.

In addition, the profit margin during Prime Day is always low, as the company sells a large amount of hardware equipment (such as Amazon's TV terminals). The company does not make money by selling equipment, but by users using the equipment, which also hurts this quarter's profitability.

Overall, the company is now working hard to improve capital efficiency and operational models in North America and internationally to ensure that the current level of profitability does not become the norm.

Q: Reasons for the recent significant decline in customer demand in cost optimization and efficiency improvement; why is the increase rate of AWS Backlog high at over 60% and has a big difference compared to the revenue growth rate?

A: At the end of Q3, the AWS Backlog was $104 billion, a year-on-year increase of 57%. The number of newly signed customer contracts is also healthy. The slowdown in AWS revenue is mainly due to customers optimizing their spending.

As for the optimization of customer spending, it has been mentioned before that companies such as mortgage and cryptocurrency companies in the financial services sector are cutting back on expenses, and Amazon has a larger exposure to these companies.

However, in the long run, the benefits of cloud computing are to help customers convert fixed costs into variable costs and hedge against fluctuations in inflation and fees such as electricity costs, allowing customers to conduct their business in a highly secure manner.

Q: When will cost control measures and their effects be reflected in profits, and how does demand during the holiday season compare to last year?

A: In terms of expectations for holiday season demand, the company has made sufficient preparations for the holiday season, and inventory levels are very high, with delivery speed approaching expected levels. Prime Early Access can also stimulate consumer demand. However, it is uncertain what the level of consumer demand during the holiday season compared to last year will be. The good news is that the company is confident that consumers are looking for affordable goods, and advertisers are looking for effective advertising channels. On cost control, there are 3 main factors affecting operating costs: efficiency, fixed cost leverage, and inflation:

1. The company has made good progress in improving delivery efficiency, but the large volume of orders in Q4 will still put pressure on delivery efficiency.

2. Regarding fixed costs, the company has tightened capital expenditures, which are made in any given year to meet future capacity needs.

3. Inflation has prompted the company to save funds, ensuring trucks are fully utilized and reducing long-distance transportation.

Overall, the company is working hard to address these challenges, which will persist until the end of the year. It is expected that these challenges can be resolved in the first half of 2023.

Q: How long will it take for the operating profit margin of the retail business to return to historical levels?

A: The goal for the retail business is to improve by $1.5 billion QoQ in Q3. However, the actual result fell short of the target by about $500 million, mainly due to issues with fulfillment efficiency. With Prime Day and Prime Early Access preparations, inventory levels were very high, putting pressure on fulfillment logistics. The company will continue to improve in this area.

Disclaimer and risk disclosure for this article: Dolphin Analyst Disclaimer and General Disclosure