Amazon.com Inc (AMZN) — Q4 2017 Earnings Call Transcript

Hello, and welcome to our Q4 2017 financial results conference call. Joining us today to answer your questions is Brian Olsavsky, our CFO. As you listen to today's conference call, we encourage you to have our press release in front of you, which includes our financial results as well as metrics and commentary on the quarter. Please note, unless otherwise stated, all comparisons in this call will be against our results for the comparable period of 2016. Our comments and responses to your questions reflect management's views as of today, February 1, 2018, only and will include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results is included in today's press release and our filings with the SEC, including our most recent annual report on Form 10-K and subsequent filings. During this call, we may discuss certain non-GAAP financial measures. In our press release, slides accompanying this webcast and our filings with the SEC, each of which is posted on our IR website, you will find additional disclosures regarding these non-GAAP measures, including reconciliations of these measures with comparable GAAP measures. Our guidance incorporates the order trends that we've seen to date and what we believe today to be appropriate assumptions. Our results are inherently unpredictable and may be materially affected by many factors, including fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce and cloud services and the various factors detailed in our filings with the SEC. Our guidance also assumes, among other things, that we don't conclude any additional business acquisitions, investments, restructurings or legal settlements. It's not possible to accurately predict demand for our goods and services, and therefore, our actual results could differ materially from our guidance. I'd also like to update you on the impact of the recent U.S. tax reform legislation. In our fourth quarter results, we recorded a provisional tax benefit for the impact of the new tax legislation of approximately $789 million, which is primarily driven by the remeasurement of federal net deferred tax liabilities, resulting from the permanent reduction in the U.S. statutory corporate tax rate to 21% from 35%. As we complete our analysis of this new legislation, we may make adjustments to the provisional amounts. Those adjustments may materially impact our provision for income taxes in the period in which the adjustments are made. With that, we will move to Q&A. Operator, please remind our listeners how to initiate a question.

I'd like to focus on the North American retail operating margins. That 4.5% was the highest, I think, we've seen in a couple of years, maybe the highest since you've actually broken that segment out. So could you just go through the drivers behind that? I know you called out Alexa as being better than expected. Was that one of the factors? Was it the full quarter of the Whole Foods impact? Was it advertising revenue? Just what drove that result and how sustainable is it?

Sure, Mark. Let me address your question by answering the entire company on noteworthy North America elements are strongest. So for the quarter, we came in at the highest end of our revenue range, $60.5 billion, 36% FX-neutral growth and 25% FX-neutral growth, excluding the Whole Foods acquisition. The fact that we came in at the high end of the range, volume was high, especially in North America, and a lot of times in Q4 and other quarters actually, we see better efficiencies when the warehouses are busy. So it's a very clean operational quarter, I would say. The operations team did a great job handling record volumes in Q4 and also incorporating all the new capacity we had opened in 2017. If you remember, we added over 30% to our fulfillment square footage in 2017, coming off a similar increase in 2016. So amid all these new buildings, many of them late in the year, the operations team did a fantastic job. Advertising was also a key contributor as we're continuing to make more value, the offerings more valuable to customers and advertisers alike, and that was particularly strong in North America, although not in the North America segment. I would also point out, AWS had a strong quarter, accelerating growth versus Q3 and also expanding operating margins by 100 basis points. So particularly in North America, I would say there's the strong top line volume combined with increased advertising revenues and also very clean operational performance. Obviously, there are a lot of things that can happen in Q4 from weather to demand patterns changing. We've seen additional costs creep in, in the name of customer experience in prior years, and this was, in hindsight, probably one of the cleaner Q4s recently.

Brian, I was hoping you could talk about how you're thinking about your primary investment areas in 2018 and perhaps if you could put it in context of '17. Are there things that are notably different this year relative to last year and also, how do you think about the margin trajectory relative to what we saw last year?

Sure. I will be giving you guidance quarter by quarter, but I can talk to the general trends in the large investment areas. Let me start with AWS infrastructure and the growth in technical and sales teams. That will continue. We're approaching a $20 billion run rate in top line revenues for AWS, up from $18 billion last quarter. So we're very happy with both the progression in new services and features that we've been able to bring to customers and also their response with continued geographic expansion and continuing to build on our tech teams and our sales teams. So that expense is going to continue and likely increase. Prime benefits will continue to increase as well. Prime Now, Prime Video, AmazonFresh, all of our major Prime benefits, we continue to expand globally. Devices, as Jeff said in the press release, we are very happy with the results of Alexa. It's a very positive surprise for us both on a performance level and customer adoption. We had record device sales with very high levels of customer engagement, including increased levels of voice shopping, growth in functionality, and partnerships that we've rapidly developed. We're over 30,000 skills for Alexa and we have over 4,000 smarthome devices from 1,200 unique brands. The relationships we're having with external companies is actually helping to accelerate the adoption of Alexa with customers. So really strong usage of Alexa with our devices including the Echo family and Fire TV. Alexa usage on Fire TV is up 9x year-over-year. Music listening time on Alexa was 3x higher this holiday season. So that's what we mean when we say we're far exceeding our expectations. Those are the things that I would point to. And that is an area where we'll continue to invest heavily, and as you say, double down on that. Fulfillment, again, is strong top line growth and growth in Amazon fulfilled units, which again is growing much quicker than our unit growth rate. We expect that and hope that to continue as well into 2018. Video content, we spoke about on the last call. We do like the results we're seeing with customer engagement, buying habits, and their usage of the video content on devices. We will continue to increase our budget in that area. But I'd be really incorporating that into the guidance each quarter as we move through the year.

Hey guys, just two questions. AWS reaccelerated again this quarter. Can you just give us some color on what the key drivers are there? Was it lapping some of the price activity from a year ago? Was it higher utilization, moving up the stack? Any color there would be helpful. And then a question on shipping costs. It looks like it grew about 31% in shipping costs in the quarter, and that's been kind of moving in tandem with the Amazon fulfilled unit growth. Is that the right way to think about it? It looks like it might be getting a little bit of leverage in the model right now what's driving that, the shipping cost leverage?

Sure. Let me start with that last one. Yes, the shipping costs are going to be very tied to AFN unit growth and also the impact of greater Prime adoption and faster shipping methods. So we consider that a very strong quarter. Again, it was a very strong operational quarter in Q4, and we've expanded the number of items that shipped free. There are now over 100 million items in the U.S. So shipping cost is always going to be a strong part of our offering, and we're looking to minimize the cost by getting more and more efficient in that area. AWS, yes, if you remember last year, we did have price increases in December of last year towards the end, which had a partial impact on the quarter. But generally, just strong usage growth continues to be strong, growing at a higher rate than our revenue growth rate, and customers continued to add workloads and expand. We're very happy with the performance in the AWS business, now over a $20 billion run rate.

Brian, if you look back historically, your Q1 operating income guidance is typically about $300 million to $400 million lower than your Q4. Obviously, it's significantly greater than that this quarter. Maybe if you could shed a little light on why that is so and what are some of the key drivers there. AWS and cloud pricing appears to have been more subtle in the recent quarters. Maybe if you could talk a little bit about the pricing environment and why that has been the case at least compared to trends from back in '14, '15, previously.

Sure. Let me start with guidance. So yes, the operating income guidance is $300 million to $1 billion. Operating income last year was $1 billion. Q1 is generally when we see the volume drop off from Q4, obviously, but a lot of the costs remain from the year-over-year build-up in costs, particularly in the fulfillment network. So it's generally a headwind every Q1. Given the 30% plus growth in square footage last year that we've built, that's one major headwind from Q4 to Q1. But we also continue to invest, particularly in Alexa and our device area. As I mentioned in a number of comments earlier, we're very happy with the results, the customer adoption, the device sales that we're seeing and the general customer acceptance there. So we will continue to invest there. That's probably the two largest factors in Q1, I would say.

This is Dave. Just on the second piece on pricing. I think on the pricing environment, there's nothing really to call out there. I guess, just a reminder on our pricing philosophy for AWS, I mean periodic price reductions are a normal part of our business where we've reduced prices more than 60 times with AWS since launching. Our goal philosophy here is to drive efficiencies in our operations and pass those savings on to customers, which has resulted in those more than 60 price reductions, but also new services and future launches, providing better options for customers.

First, Brian, any comments on the impact of ASC 606 accounting changes on your first quarter guidance here? And then just second on the advertising business, in particular, the ads that we see in the search results on the site, you have line search product sponsored ads, do you aim for a certain particular ad load across the entire platform? Do you look at sort of tailoring it based on users' activity, maybe a combination of both? I would just be interested in your thoughts on that.

Yes, this is Dave. I'll take the first part of that question just around the new revenue recognition standard. We did adopt a new standard on January 1 of this year, 2018, and you'll see that reflected in our financials for the first quarter coming up. It touches on a number of different parts of our business in terms of how we recognize revenue, but the impacts to our expectations for the revenue guidance for the first quarter are not material. There are a number of different areas that we've previously called out in our filings that will be on file shortly regarding the different areas that are impacted, but again, not material in the aggregate.

On advertising, I would say our strategy is to enhance the customer experience through the ad process. We want customers to see new brands and easily discover products that they are looking for. For brands, we think the value proposition is that we can find ways for them, especially emerging brands, to reach new customers. So we're working with advertisers of all types and sizes to help them reach our customer base with the goal of driving brand awareness, discovery, and better purchase decisions by customers.

I think I have two questions. First, your Whole Foods, you've got over a quarter under your belt. How's it going versus your expectations? And what can Amazon really bring now that you've been there for a while, how are you thinking about that? And then secondly, your international decelerated a little bit this quarter, just wondering if there was any country to call out or anything going on there? And we know that you spent about $3 billion on International investment last year. Where do you think the high watermark is on that? So just maybe a little more color on your international business.

Sure. Let me start with the Whole Foods question. We're continuing to be very excited about the opportunities we have to innovate with the Whole Foods and Amazon teams together. In our physical stores, it feels there are supplemental disclosures that physical stores revenue was $4.5 billion in Q4, which is primarily comprised of Whole Foods and was slightly better than what was built into our guidance that I gave you last call. So far, our focus has been on continuing to lower prices even beyond the initial ones that we discussed at the close of the deal in late August. We've launched Whole Foods products on our Amazon website, and the technical work continues to make Prime the Whole Foods customer rewards program, and we expect to have more on that later in the year. We've also added Lockers, and much more is to come. So we're very happy with the initial results out of the team in Whole Foods down in Austin. Also, I will mention that we did see a small operating income loss for the quarter from Whole Foods. At the time of the acquisition, we had stepped up the fair market value of certain assets on the balance sheet. This will increase the amortization as a non-cash charge, but it will increase the amortization over the useful life, and much of that is frontloaded, leading to higher amortization in the first few years that will reverse later. So excluding this non-cash expense item, Whole Foods had a positive operating income in Q4, but you'll see in the 10-K that the operating income, including the charges, was slightly negative in Q4. Regarding international growth, your comment about slowing down, I think there's a slowdown versus Q3, but there was 28% growth in Q3, FX neutral, which was helped quite a bit by Prime Day and the strengthening of Prime Day in various locales. Although we've had Prime Day in most of those countries, it's really starting to gain more traction there. So we continue to pursue the same strategy as we have in North America, adding Prime benefits, devices, video content, and AmazonFresh, providing a lot of value to Prime customers in international markets as well. In India, it's a fantastic story for us. More Prime members joined India's Prime program in the first year than in any other country historically. The selection is increasing as well; Prime eligible selection is up over 25 million items. We're launching Video there and also adding other Prime benefits such as Prime Music, and Amazon Family. As I mentioned, we had our first Prime Day in India.

I have two. First one, in the press release, you talked about the strength of the Prime member growth in 2017. Could you talk a little bit about the growth in Prime subscribers in the United States at this point? And are you still seeing a similar tick up in consumer spending as they come into Prime as you have in the past? And the second one, Brian, regarding earlier on areas of investment this year, you didn't talk a lot about new categories to expand into beyond the old retail business. I'd be curious about your investment needed in logistics, healthcare, and kind of new areas you haven't really cracked into as hard yet.

Just on the first piece, in terms of Prime membership and Prime behavior, we continue to see strong sign-ups from memberships. When we look at the year-over-year growth in paid Prime members on a global basis, it remains consistent in Q4 year-over-year, similar growth rates to earlier quarters this year. Our focus continues to be on adding features around Prime and ensuring more selection through our own efforts as well as programs like Fulfillment by Amazon, which continues to rapidly grow.

Yes, and on new businesses or category expansion, while I cannot discuss specific plans not publicly announced, I can say that efforts are underway. In terms of logistics, we will continue to build our logistics capability all the way to end delivery. We'll increase service levels by sometimes delivering ourselves. Although we have a strong partner network, we leverage our strength and knowledge about shipments both within our network and to final customers, creating new opportunities. Our biggest effort will be on groceries and consumables with the Whole Foods acquisition. We're continually looking at how our whole offering of AmazonFresh, Prime Now, and Whole Foods can work together to create better offerings for our customer base.

I wanted to go back to your focus on consumables now, Fresh, and Whole Foods. There's been a lot of press on the Whole Foods front regarding out-of-stock issues. I was wondering what your plans are to correct these issues, considering the reputational risk involved. What is your view on these out-of-stock issues not just for Whole Foods but across the consumables business in Fresh and Now?

Yes, let me make a more general statement. Whole Foods is fully committed to providing the best selection of high-quality products and having them in stock for customers. We made no changes post-acquisition that would have impacted anything related to in stock, except perhaps that the price decreases have driven demand and there is an element of rebalancing related to that. The out-of-stock issue may be tied more to the increased demand we're seeing and also to weather-related restocking issues. The commitment remains to have a healthy, high-quality selection in stock for products. That's a commitment from the Whole Foods team, the Amazon team, and across all delivery channels. Where there are issues, they will be corrected. We're confident that we can deliver a good service and continue to delight customers.

We've seen the number of private label products on the site increase dramatically over the last 12 to 18 months. Could you speak to your private label strategy, in general? How big is that segment today? How big can it become? And broadly speaking, how are the margins in that segment versus comparable third-party products?

When looking at our strategy, it's focused on providing a broad selection for customers across categories, so they can find and buy what they're looking for. Private brands are meant to supplement that great selection. We find ways to create private label items that are high quality and that broaden the selection and convenience available for customers, supplementing what vendors and sellers already provide. We have not broken out the significance of this segment yet, as many of these initiatives across categories are still in their earlier stages. We've launched several private apparel brands in Amazon Fashion such as Good Threads and Amazon Essentials, which are basic men's and women's items; consumables is another area where we are working with Whole Foods private label as well as some of our own Amazon brands like Happy Belly, among others. We will keep iterating on those and trying to find different areas to learn from customers what they want.

Could you just remind us of the thinking behind keeping AWS and Retail under one corporate structure, and does it make sense given AWS's scale right now? Also, we're hearing from marketers just how important Amazon is to their media strategy, so could you share your approach and philosophy towards that business?

We see a lot of value in all of our businesses. AWS is a key component, as is the physical consumer business. The common management team allows for synergies between these segments. The consumer business is one of the largest customers of AWS. This dynamic helps AWS to drive great infrastructure efficiencies, just like other companies experience when using AWS, transforming fixed costs into variable costs and pooling resources. As an internal customer, the consumer business is very happy with AWS, and it benefits AWS by having a large internal beta customer that uses many of their products and services. This structure works effectively for us.

Regarding advertising, our focus is on collaborating with vendors and sellers to offer a great experience on our website, enabling them to reach customers effectively. We're seeing strong growth in advertising revenues, which is becoming a significant part of our overall revenue line item. We aim to continue to build new tools to better serve our customers based on what we're learning.

Thanks for joining us on the call today and for your questions. A replay will be available on our IR website, at least through the end of the quarter. We appreciate your interest in Amazon.com and look forward to talking to you again next quarter.