Amazon – A giant with momentum and growth

On Thursday, Amazon released their Q2 FY 2020 results and it was nothing short of impressive. Below are my notes:

Even during the pandemic, Amazon net sales were $89 billion in Q2, up 40% YoY. In fact, if you look at their net sales in Q2 in the last 5 years, it’s an astounding 31% CAGR.

Figure 1 – Data Source: Amazon. Chart by me

North America still led the way among their three main segments with more than $55 billion in net sales. AWS is now an annualized $43 billion business and responsible for 13% of Amazon’s total net sales. In the last 5 years, CAGR for North America, International and AWS is 33%, 23% and 39%! If you look at a deeper level, online stores were still responsible for the bulk of Amazon’s net sales while 3rd party and AWS were the next two largest segments. Advertising accounted for 5% of Amazon’s net sales. Their shares have stayed largely the same for the past 3 years,

Figure 2- Data Source: Amazon. Chart by me
Figure 3- Data Source: Amazon. Chart by me

AWS continued to account for more than half of Amazon’s operating income. Historically, Amazon lost money on their International front, but in this quarter, the segment recorded $345 million in Operating Income. Total operating income was up to more than $5.8 billion, almost up by 90% YoY. Once again, this was during a pandemic.

Figure 4 – Data Source: Amazon. Chart by me

Shipping costs grew to more than $13.6 billion in Q2 FY 2020, from $4.56 billion in Q2 FY 2017. In the last four years, shipping costs rose at a faster pace (44% CAGR) than the combined net sales of online stores and 3rd party (28%). As share of cost of sales, shipping costs accounted for 26% of total cost of sales (AWS’ cost of sales weren’t recorded here), up from 19.5% in Q2 FY 2017. According to Amazon’s 10Q, here is how they define Cost of Sales

Cost of sales primarily consists of the purchase price of consumer products, inbound and outbound shipping costs, including costs related to sortation and delivery centers and where we are the transportation service provider, and digital media content costs where we record revenue gross, including video and music.

Source: Amazon’s Q2 FY 2020 10Q

There are two ways to look at Amazon’s shipping costs in my opinion. First of all, the increase in Q2 FY 2020 is likely due to Covid-19. The rising trend can also come from Amazon’s effort and investment in last-mile delivery which is the most expensive delivery type. Amazon is now the fourth largest delivery service as of May 2020. If other retailers want to compete in terms of delivery, this level of commitment and investment will likely await them. In fact, Figure shows the level of capital expenditure by Amazon over the years. Just. Look. At. The. Growth!

Figure 5- Data Source: Amazon. Chart by me

Figure 6 – Source: Koyfin

In business, cash is king and Amazon is a phenomenal cash-generating machine. As of Q2 FY 2020, their operating cash flow trailing twelve months (TTM) stood at $51+ billion, up 42% YoY. Free Cash Flow TTM was almost $32 billion.

Figure 7- Data Source: Amazon. Chart by me

Additionally, AWS’ momentum is reflected in the remaining performance obligation in the last three years. Performance obligations from contracts whose original terms exceed one year stood at $41 billion as of June 2020, up from $16 billion two years ago. It’s indicative of the revenue in pipeline for AWS.

Figure 8- Data Source: Amazon. Chart by me

Lastly, I think this is the first time Amazon broke out their expenses for digital content, including video and music.

The total capitalized costs of video, which is primarily released content, and music as of December 31, 2019 and June 30, 2020 were $5.8 billion and $6.1 billion. Total video and music expense was $1.8 billion and $2.8 billion in Q2 2019 and Q2 2020, and $3.5 billion and $5.2 billion for the six months ended June 30, 2019 and 2020.

Source: Amazon’s Q2 FY 2020 10Q

In summary, I am in awe of Amazon as a well-oiled company. Even at its size, the company seems to have a lot of good things going in their direction and real competitive advantages. The retail and cloud markets are big enough for Amazon to grow more in the future.

Disclaimer: I own Amazon stocks in my personal portfolio.

Mixed Feelings from Netflix’s Earnings Report

Netflix released its earnings yesterday. There are causes for optimism and concern from what I have seen.

Important metrics improved YoY significantly

This quarter, Netflix added 517,000 domestic paid subscribers and more than 6.2 million international paid members, bringing the total subscriber count domestically and internationally to more than 60.6 million and 97.7 million approximately.

Contribution margin for domestic and international streaming is 41% and 20% respectively, resulting in the margin for streaming to be around 30%. Contribution margin of Domestic DVD is around 61%. Contribution margin represents what is left of revenue after all the variable costs to pay for fixed costs and to generate profit.

On a year over year basis, revenue, operating income and paid memberships saw remarkable growth for a company this size

Cause for concerns

Even though domestic paid memberships increased, Netflix missed its own expectation by almost 300,000, making it the second consecutive quarter that it did so. The company blamed the miss on the higher pricing elasticity than expected

That’s really on the back of the price increase. There is a little more sensitivity. We’re starting to see the – a little touch of that. What we have to do is just really focus on the service quality, make us must-have. I mean we’re incredibly low priced compared to cable. We’re winning more and more viewings. And we think we have a lot of room there.

But this year, that’s what’s hit us. And we’ll just stay focused on just providing amazing value to our members in the U.S. And I think that gives us a real shot at continuing to grow net — long-term net adds on an annual basis. But we’re going to be a little cautious on that guidance and feel our way through here.

CEO – Reed Hasting in Earnings Call (Per Seeking Alpha)

I saw a sentiment floating around on Twitter a while back that argued that Apple TV+ and Disney+ aren’t really competitors to Netflix. I mean, to some extent, they may differ a bit from Netflix, but if we want to talk about competing for viewers’ attention, time and disposable income, how can they not be? Sure, boats move different from trains, but if patrons can choose either to go from point A to point B, how can they not compete with each other? Now Reed Hasting admitted the challenge from other streamers, especially Disney+

From when we began in streaming, Hulu and YouTube and Amazon Prime back in 2007, 2008, we’re all in the market. All 4 of us have been competing heavily, including with linear TV for the last 12 years. So fundamentally, there’s not a big change here. It is interesting that we see both Apple and Disney launching basically in the same week after 12 years of not being in the market. And I was being a little playful with a whole new world in the sense of the drama of it coming. But fundamentally, it’s more of the same, and Disney is going to be a great competitor. Apple is just beginning, but they’ll probably have some great shows, too.

But again, all of us are competing with linear TV. We’re all relatively small to linear TV. So just like in the letter we put about the multiple cable networks over the last 30 years not really competing with each other fundamentally but competing with broadcast, I think it’s the same kind of dynamic here.

Source: Seeking Alpha

Chief Product Officer Gregory Peters made an important point below

I would say our job and then what we think our pricing for a long-term perspective is continue to take the revenue that we have that our subscribers give us every month, judiciously and smartly invest it into increasing variety and diversity of content where we really want to be best-in-class across every single genre.

And if we do that and we’re successful in making those investments smartly, we’ll be able to continue to deliver more value to our members. And that really will enable us to, from time to time, ask for more revenues so that we can continue that virtuous cycle going

Source: Seeking Alpha

Quite an important “if” condition there. In short, Netflix borrows capital to invest in content to the tune of billions of dollars every year and hopes that their subscriber base growth and revenue will keep enabling them to do so. In essence, every streamer will do that. Every single one of them needs to churn out quality content to convince viewers to choose their service. Failure to produce quality content to justify expensive investments will be costly for these streamers.

For Netflix, the stakes seem to higher. Other competitors have additional revenue streams apart from their streaming service. Netflix essentially relies on their subscription revenue. As this quarter shows, the price elasticity already has some negative effect, and it’s BEFORE other heavy-marketed competitors such as Apple TV+ and Disney+ debut in 2-4 weeks. The new challengers price their services at much lower points than Netflix. The room to increase price to recoup their investments faster is getting smaller. I do think a price hike will negatively affect Netflix.

Some may say: oh Amazon kept investing heavily in their early days as well and Netflix can be the same. They are not, as I wrote here. Their free cash flow continues to be in the red while Amazon was in the black for years.

The expensive bidding war for content may play into Netflix’s favor. Their huge subscriber base enables them to spread the cost much better than competitors, especially new ones that have to acquire subscribers from scratch. Hence, it can be argued that Netflix will be one of the only few standing after the dust settles. It does make sense to think about the streaming war’s future that way. As does it make sense to think that there is a possibility that the game Netflix is playing may not work out for them, given the intense competition, the decreased price inelasticity, the huge debt they have incurred and the continuous negative free cash flow.

I think that we will have more clues around the next earning call or two as we’ll see how Netflix will fare after the arrival of Apple TV+ and Disney+. Even then, we won’t know definitively who will win in the end. Fascinating times ahead.

Are money-losing companies similar to Amazon?

A bullish argument for money-losing companies (companies that have negative operating income) I have seen so far is that they are following the footsteps of Amazon in the early 2000s before the juggernaut became what it is today. Set aside the differences in business environments, the nature of industries and technological advances, there is one important caveat; even though Amazon reported negative net income for a few years before turning profitable, it had POSITIVE free cash flow during that time.

Per corporatefinanceinstitute, Free Cash Flow (FCF) “represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company”. It’s equal to, simply speaking, cash generated from operations minus Capital Expenditure (CAPEX). It is a metric to show investors how efficient a company is generating cash and whether the company at hand has enough to pay investors after operational needs and capital expenditures.

This is what Amazon’s annual and quarterly free cash flow looks like over the years. Data is from macrotrends:

Over the years, free cash flow noticeably grew bigger for Amazon, but it was positive even before the introduction of AWS in 2006, which has been the margin maker for Amazon recently. Hence, if a company has negative operating income and still makes capital expenditures to grow, they are NOT similar to Amazon.

A particularly intriguing case is Netflix. The streaming king debuted its streaming service in 2007 and has grown to become the de facto leader in the market. It has had positive operating income, but increasingly invested a massive amount of money in original content, much more than the cash it generates from operations every year.

Since Q3 2014, Netflix hasn’t had a single quarter with positive FCF. The challenge Netflix is facing compared to its competitors is that Netflix has only one source of revenue. Disney, Amazon and Apple, to name just three competitors, have different sources of income. In the case of Amazon and Apple, their streaming services can be argued to be add-on services that function to lock in customers. It is true that given its almost 150 million subscribers, Netflix can spread its content costs across more subscribers than its competitors. Nonetheless, it has to keep investing every year in original content to appeal to consumers. If there is no change in how Netflix can generate revenue besides subscription, I struggle to see how its FCF outlook will differ. Hence, Netflix’s story is NOT similar to Amazon’s in the early 2000s.

Amazon’s Quarterly Earnings

On that FY2019 Q2 earnings by Amazon…

Revenue

In the last 90 days, Amazon recorded $63 billion, meaning that it took the company less than 36 hours to make $1billion. An extraordinary rate. Compared to last year’s Q2, revenue rose by 20% with Services (31%) outperforming Products (12.5%). Nonetheless, gross margin slipped as this quarter’s figure is at 4.8% compared to 5.6% last year.

Source: Amazon

AWS

Among Domestic, International and AWS categories, the latter continues to lead the way in terms of YoY growth. AWS’s revenue in the last 90 days is $8.3 billion, a rough equivalent of about $32 billion annually. It’s pretty impressive for just a segment of a company. Not many standalone companies can generate that much revenue in a quarter. It’s even more telling when we put AWS next to GCP. Google announced last week that GCP’s annual run rate is $8 billion, meaning that AWS is approximately 4 times bigger than its rival from Google.

Despite making up only 13% of Amazon’s revenue, AWS is responsible for about 69% of the company’s operating income.

At 37%, AWS’ YOY growth is the lowest recorded in a long time, but the law of big numbers should be taken in account here as the division is not as small as it used to be. If broken down into more strategic categories, AWS isn’t the segment with the biggest YoY growth (Excluding FX) in the company. It’s Subscriptions. Subscription memberships, especially Prime, play a crucial role in Amazon’s ecosystem. The fact that it notched the biggest growth, ahead of AWS, is very positive for the company.

Advertising

As can be seen above, advertising slowed down significantly after a hot streak just 12-15 months ago. YoY growth decreased noticeably compared to the 3-digit growth just a while ago. Still, it contributed $3 billion to the company’s top line.

Free Cash Flow and Shipping Costs

Amazon’s free cash flow this quarter is truly insane with 65% YoY improvement in Operating Cash Flow and a 3-digit growth in Free Cash Flow.

Source: Amazon

Shipping costs continued to rise with 36% YoY difference compared to previous second quarter’s. It’s worth noting that none of the Online Stores, Physical Stores and 3rd Party Seller Services have the same growth (all grew at a slow pace than shipping costs)

Sometimes, it’s hard to believe that a company founded roughly 25 years ago can be this powerful and big. A segment responsible for only 13% of its revenue is the dream of so many and it continues to deliver at an impressive rate.