Thank you for standing by. Good day, everyone, and welcome to the Amazon.com Q3 2018 financial results teleconference. At this time, all participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session. Today's call is being recorded. For opening remarks, I will be turning the call over to the Director of Investor Relations, Dave Fildes. Please go ahead.
Hello, welcome to our Q3 2018 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 2017. Our comments and responses to your questions reflect management's views as of today, October 25th, 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, 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, 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, therefore, our actual results could differ materially from our guidance. With that, we'll move to Q&A. Operator, please remind our listeners how to initiate a question.
At this time, we will now open the call up for questions. We ask each caller, please limit yourself to one question. If you would like to ask a question, please press star one on your keypad. We ask that when you pose your question, you pick up your handsets to provide optimum sound quality. Once again, to initiate a question, please press star, then one on your touch-tone telephone at this time. Please hold while we poll for questions. Thank you. Our first question comes from the line of Justin Post with Merrill Lynch. Please proceed.
Great. Thank you for taking my question. I guess the big one is the deceleration in unit growth or online stores, which is probably related to that. I know it was a tough 3Q comp, but could you comment a little bit about that, and then what initiatives could be most interesting to maybe re-accelerate that over the next couple of years? What categories? Thank you.
Thank you, Justin. Let me just remind you of a couple of things from last year. We had two reductions in our Super Saver Shipping threshold in the first half of the year between February and May. That did spur a lot of unit growth in the second and third quarter. We also have issue with digital content, not an issue, but the fact that digital content is moving to subscriptions, Amazon Music Unlimited and Kindle Unlimited in particular, which has been really popular. I would just remind you that the units, those do not count in our unit totals, nor do the units from Whole Foods Market. I would say essentially, with that backdrop, we're still very encouraged by the demand and the reception from customers on the consumer side. We have Amazon fulfilled units are still growing faster than paid units.
3P is now up to 53% of total paid units. In-stock is very strong, especially as we head into the holiday period. I think we're well-positioned for the holiday. We have over 100 million Prime eligible items available for free two-day shipping for Prime members. When we're talking about the unit deceleration, a lot of the fastest-growing areas, things like subscription services, AWS, and advertising are not caught in that metric.
Justin, this is Dave. Just to add on to that, you mentioned the online stores. Just a reminder, there is a little bit of impact from the revenue recognition. You see the online stores revenue growing about 11% ex FX, to be higher than that, but for the adoption at standard. There's a little bit of a headwind there as well.
Thank you. Our next question comes from the line of Mark Mahaney with RBC Capital Markets. Please proceed.
I was going to also ask you to drill down a little bit on the international retail business. That seemed to slow down, I guess, whatever, 15% or something year-over-year. Any particular color, any markets that would have led to that? I know the comp was tougher, but anything else you'd call out there? Thanks a lot.
Sure. On a year-over-year basis, I think you have to look at two things. We did the Souq.com acquisition last year in May, the full pick-up on that year-over-year was in 2017, and now we're lapping that. There's also material change in the Diwali calendar in India. About half of our Diwali sales last year were in Q3. This year, they'll be fully in Q4. Those are a couple of factors that hit the international growth area in particularly. I also point out that we launched Turkey in the quarter, and now we have 17 Amazon websites globally. We're still very pleased, again, with the international business. Continue to invest in Prime benefits, international expansion, as I just mentioned, and we're still seeing very good pickup. Story's different country by country, obviously. Some are much further along than others, but overall, we're very happy.
The India, although Diwali moved into Q4, so far that's going really well. We've seen great response from customers. We've had 60% growth in new customers during the period. Orders are coming in from 99% of the PIN codes in the country. A great first wave of the, we call the Amazon Great Indian Festival, which is the lead into Diwali.
Thank you. Our next question comes from line of Douglas Anmuth with JP Morgan. Please proceed.
Thanks for taking the question. You had significant operating income upside in 3Q relative to your guide. Can you just talk about the biggest drivers there in terms of outperformance? When you think about your 4Q outlook, how should we think about the minimum wage increase that you've talked about, and then any other one-time or special items that might be weighing on that operating income outlook? Thanks.
Sure. Let me start with Q3, this will be commentary pretty much on the whole year that was especially true in Q4. First of all, we've had very strong growth in some very profitable businesses that we have, most notably AWS and advertising. We've also had great cost performance this year, in three specific areas I'll call out. First on headcount. If you'll remember, we grew headcount 48% in 2016 and 38% last year if you adjust for Whole Foods. With Whole Foods, it was 66%, without Whole Foods, we still grew 38%. We have looked to really leverage our investment from the last couple of years, as we funded and moved, invested in a lot of new areas, as we've talked about AWS, devices, digital content, we've had a lot of movement within the company that has filled a lot of those roles.
We're only up 13% on headcount through nine months year-over-year. A real step down in that. Again, the theme here is going to be banking some of the investments from prior years and looking to gain greater control. In our fulfillment center world, we had grown square footage for our fulfillment center and shipping areas by over 30% the last two years, 2016 and 2017. I've talked about that on prior calls. It's making that investment to match up with very strong Fulfilled by Amazon demand, and AFN or Amazon Fulfillment Network units that are growing at a faster rate than our paid units. This year we're only adding about 15% to our square footage. Again, getting better efficiencies on what we have and banking the multi-year investment that we've been making. The last one, which is really significant, is on the infrastructure side.
You see the operating margin for AWS is up to 31% this quarter. A lot of that is based on efficiencies of our data centers, not only for the AWS businesses, but also for our Amazon consumer businesses, who's AWS' biggest customer. If you look at capital leases, which is where we spend money for the data centers, it's up only 9% year-over-year, trailing 12 months, and it was up 69% last year at the end of the year. Those three areas have driven a lot of the cost performance and a lot of the deviation from probably the estimates that I've come up with this year. We are really happy that, again, we're seeing great cost performance in a number of areas across the business.
Thank you. Our next question comes from line of Mark May with Citi. Please proceed.
Thank you. Question on AWS. Obviously, the last few quarters you've seen accelerating revenue growth. This quarter, 46% still quite strong, but dollar and percentage growth did slow. Just kind of curious, are you just reaching a point in terms of law of large numbers where it will be more difficult to sustain not only accelerating growth, but sustain kind of the 40-plus percent growth levels where we've been recently, or was there something else going on kind of in the quarter that maybe drove that? Thanks.
No. Thanks for your question. This growth rate's going to bounce around. We've had sequential increase in growth rate the last prior three quarters, I believe it was. This quarter is slightly down, but still 46% growth is very strong. We are at an annualized run rate above $26 billion, and that was about $18 billion this time last year. We're very happy with the growth in the business, the momentum that we're seeing with enterprise customers. As Amit just mentioned, on the cost side, it's been a very good year from gaining greater efficiencies in our infrastructure costs.
Thank you. Our next question comes from line of Brian Nowak with Morgan Stanley. Please proceed.
Thanks for taking my questions. I have two. The first one, the fourth quarter revenue guide and the fourth quarter revenue deceleration. Maybe could you just help us understand a little bit any of the specific categories or countries that have been the largest contributors to revenue growth throughout the course of this year, and which of those are really slowing down sort of driving this potential deceleration that you're guiding to? The second one, you've applied robotics to the warehouses now around Kiva. Curious for your thoughts about the need or desire to invest in autonomous driving technologies. You think about some of the other retailers partnering with Waymo and other players, et cetera.
Sure. Let me talk about guidance. Our guidance for the fourth quarter implies 10%-20% growth, and includes an 80 basis point unfavorable impact from foreign exchange. I wouldn't point to any specific country. Once you adjust for the fact that Whole Foods, it was purchased in August of last year, and that has impacted every quarter since then. Q4 will be the first solid non-Whole Foods comp since Q2 of last year. Even factoring that in, we're looking at Q4, and we put very high error bars on the quarter. Much of not only our revenue for the quarter, but also for the year, comes in that very tight window between middle of November and the end of the year. It's always a very difficult period for us to estimate.
What I would say is that we feel like we're in great shape for the holiday. The warehouses are very clean. We feel like we're going to have great capacity not only for our retail products, but also for FBA. We're going to have great capacity for shipping to our customers. We're very ready to go. Selection should be at its highest point, especially for Prime members. We're very bullish on the fourth quarter, and we'll just have to see how revenue comes in. I will say there's one housekeeping item on Prime revenue recognition that you should be aware of and may have remembered from prior quarters. This year, we took Prime subscription revenue and amortized it over the quarters on a straight line method. Previously, we had done it on a, that was tilted more to Q4. It was based more on shipping units.
What you've seen is a push of revenue and income from Q4 into Q1, Q2, and Q3 that we've mentioned on each call. This is the quarter where that will reverse. That is, to scale it for you, under the old methodology, we would have had $300 million more of both revenue and operating income in the quarter. That has again, been caught up for in prior quarters. Again, not a huge factor on the growth rate for revenue, but just another item to consider. On the robotics, I don't have much to say on autonomous driving. We are putting most of our efforts right now, continue to, into our robotics program. We think it's been a great addition to our fulfillment capacity. It makes the jobs in our warehouses that much better. It makes the people around the robots that much more productive.
It allows us to have much greater density of product storage and a number of other benefits. It has some additional capital intensity, but it has good return on invest capital from our standpoint.
Thank you. Our next question comes from the line of Eric Sheridan with UBS. Please proceed.
Thanks for taking the question. With a lot of offline retailers talking more about omnichannel, I wanted to understand some of the investments you might be making around unifying the efforts with Whole Foods and Amazon Prime Now, speeding up delivery, giving consumers as much choice as possible, and moving SKUs closer to households. How should we be thinking about that push in 2019 and 2020, and how that might open up new areas of wallet share for the company? Thanks, guys.
Sure. Yeah, I think we've started to show our strategy on the Whole Foods side. You'll see even this quarter, we started to have greater expansion of our grocery delivery out of Whole Foods using Prime Now. We're now in 60 cities in the U.S., giving customers delivery in as fast as an hour on thousands of great organic products from Whole Foods. We've also expanded grocery pickup, and that's available in 10 cities, so customers can pick up at the Whole Foods store. You'll see that we've started to tie Whole Foods into Alexa. You can build your cart using Alexa and then check out using the Prime Now app. There's going to be a lot of, as you say, omnichannel overlap, especially in the grocery business. On the storefront, we're also, as you can see, experimenting with numerous store formats.
Amazon Go is now up to six stores. We opened five in the quarter. We're getting great feedback on that. Customers love the ability to quickly walk in, select items they want, and leave without waiting in a checkout line. We opened up an Amazon 4-Star location in New York City, where we're going to test the concept of a highly curated selection of top categories across Amazon. We, of course, have Amazon bookstores, 18 bookstores in the U.S. We're going to experiment with multiple ways of reaching the customer wherever they happen to be.
Thank you. Our next question comes from the line of Ross Sandler with Barclays. Please proceed.
Great. I have two questions. Any color on, it looks like shipping costs and maybe labor costs might see some inflation in 2019. Do you agree with that, or what are some of the things you can do to potentially offset some of that pressure? The 15% fulfillment square footage growth. You're obviously deploying a lot of automation, and there's a lot more efficiency gains in the current generation of fulfillment centers than maybe the older ones. How should we think about that 15%? Is that not a good leading indicator on growth into 2019, or is it any color that'll be helpful? Thanks.
Sure. That last question first. I think the 15% is comparable to the 30% plus that I mentioned in 2016 and 2017. We are debating whether the dynamics of the warehouse are changing so that square footage may not be the main indicator. It might be cubic feet. If we switch to that way of looking at it, we'll make sure that we bridge the gap on the difference between the two. Your other comment about cost, I believe you're probably referring to the rumored USPS rate hikes in transportation costs. We're not expecting a material impact from these rate changes in 2019. Annual rate increases from our transportation partners is a really regular occurrence, and we negotiate hard, and we'll always work hard internally to get even more efficient on our own shipping methods. We don't see that as being a huge issue.
On wages, of course, we did raise wages. Starting November 1st, just under 400,000 employees, both full-time and part-time in the U.S. and U.K., will be getting a substantial wage increase. That is factored. I'm not quantifying that today, but it's factored into our Q4 guidance, and it will be obviously factored into guidance into 2019.
Thank you. Our next question comes from the line of Youssef Squali with SunTrust Robinson Humphrey. Please proceed.
Great. Thank you very much. Two quick questions. First, can you quantify the contribution of PillPack acquisition in the quarter? Maybe help us understand the strategy there. There were some news reports suggesting that you guys were working on an ad-supported video streaming service under the IMDb brand. Can you just help shed any more light on that, especially relative to your Prime Video offering? Thank you very much.
Let me start with PillPack. The deal closed in September, so it wasn't a material impact on the quarter. We're excited, really excited to start working with the management team there. They're very strong. They've done a great job building a highly differentiated customer experience. They're customer-centric like we are. Right now, our focus on learning from them and innovating with them on how best to meet customer needs over time. I'll let Dave handle the second question.
Yeah. We have no plans to build an ad-supported Prime Video offering for free at this time.
Thank you. Our next question comes from the line of Jason Helfstein with Oppenheimer & Company. Please proceed.
Thanks. Two questions. First, I think I may have missed earlier if you gave out the impact of ASC 606. Second question, I think what one of these people are trying to think through is you obviously guide to revenue and operating income. As the business shifts more to 3P and advertising, gross profit's that much more important than just the way you kind of capture the value you provide. Maybe if you can guide, is there a way to just help us foot the perhaps slower revenue growth we're seeing versus what's obviously you extracting more value for your partners and customers and for yourself? Thanks.
Thanks, Jason. This is Dave. Just quickly on the ASC impact. Brian mentioned earlier that, of course, we've been talking about it all year, the changing in the subscription revenue recognition's now straight line. On a comp basis, you'd expect to see subscription revenue be about $300 million lower due to that accounting change. The other piece that we hadn't talked about is the reclass that we've given the past few quarters, specifically around the advertising services that have moved from contra COGS into other revenue beginning in 2018. That was about $750 million increase to that other sales revenue category here in the third quarter.
Your comment on revenue versus operating income versus potentially gross profit. I would say, in the impact of third-party growth, we're now up to 53% of our paid units in the quarter were third party. It's steadily been going up. It's up 300 basis points year-over-year. I think the impact on revenue growth rate, since the revenue component of that is not as large, is probably something to consider on a year-over-year period. I think it tends to not be as big a factor sequentially quarter-over-quarter since the gradual growth in it. We'll continue to give revenue guidance and also operating income to an appropriately conservative level that we've tried to maintain over time.
Thank you. Our next question comes from the line of Anthony DiClemente with Evercore ISI. Please proceed.
Thanks very much. Just wanted to dig in a little bit on advertising and the growth opportunity there. If you can help us on the potential for higher ad pricing in terms of the ROI for your marketers hopefully being reflected in higher price per ad. What about the ad load? Are we kind of close to being at a full ad load? Is there a long runway there? Just trying to get a sense for pricing and volume underneath advertising. Along the lines of advertising heading into the holiday season, should we expect any increase in your efforts around Alexa commercialization, voice keyword ads, let's say, and does that fit into your broader advertising growth strategy? Thanks.
Let me talk a little more broadly about advertising. We are seeing really strong adoption across a number of groups, Amazon vendors and sellers for sure, authors, as well as third-party advertisers who want to reach Amazon customers. As far as penetration, we don't have that quantified for you, but we still believe that there's a lot of room to continue to improve the presentation of, and bringing to our customers new and more relevant purchase options. We're continuing to invent both on the product side, the tool side, with our goal being improve the usability of the tools for advertisers, make smarter recommendations for customers, automate activities so that advertisers don't have to work as hard, and invent new products for advertisers. If we do this right, we think we will both help advertisers and help Amazon consumers at the same time.
I know it doesn't answer the question about specific rate increases or capacity, but that is the general strategy that we're seeing in advertising.
This is Dave, just jumping in on the Alexa point. The short answer is we don't have any plans to add paid advertising to Alexa. We clearly had a lot of exciting things happen in the last month or two, in terms of new announcements and devices out there. The goal is make customers' lives easier, and make them more convenient. A lot of that is you're seeing that in the homes, and to some extent on the go. If you look at the recent announcements, you're seeing a few things. One, we're bringing a lot of cool hardware options to customers. Second thing, making the Alexa service smarter. It's getting smarter and more capable. Delivering tools for developers, helping them build for and really with Alexa.
I think, making her smarter and seeing that she gets smarter with all the skills, leveraging the cloud and AI, becoming more knowledgeable, and introducing a lot of really cool new features. Really excited about the customer response with those devices and those tools so far, and looking forward to doing even more.
Thank you. Our next question comes from the line of Lloyd Walmsley with Deutsche Bank. Please proceed.
Thanks. Wanted to just follow up on the advertising side, and get a sense for how much you guys feel like you're demand constrained versus supply constrained, either in the ability to put more ads on your property and/or just provide the tools to advertisers. Do you feel like there's more demand than you can satisfy? Any color you can share there?
This is Dave. Nothing specific. I think so much of what we're focused on is making sure that there's a high degree of relevancy and usefulness for customers when you look at advertisements that you see on the site in particular, and how we position those. We spend a lot of time looking at the data to make sure that customer behavior and feedback is telling us that it's useful and helpful, and customers making those purchase decisions. We're always testing different levels of that and trying to understand in the various features, whether it's display or some of the sponsored elements that are out there, what kind of feedback's out there. Certainly keep that in mind as we roll out new things.
Thank you. Our final question will come from the line of Colin Sebastian with Baird. Please proceed.
Great. Thanks. I guess two quick ones. Any change in the trajectory of Prime membership growth since the June price increase? How would you describe the pricing environments for the core AWS services? Is this still a key lever that you use for business development? Thank you.
Yeah, sure. Let me start with the Amazon Prime price increase. Of course, that went into effect earlier the year in May. We're very pleased with the renewal data and annual sign-up data that we've seen since then. Program remains very strong, both in membership and engagement, in a lot of our video content, music, and shipping, definitely, as well as other Prime benefits. We just continue to see that ramp up, not only in the U.S., but in other countries. We do continue to make the Prime offer better as well. I mentioned earlier, the linkage with Prime member savings at Whole Foods Market that we set up in Q2, the expansion of grocery delivery to more than 60 cities in the U.S. using Prime Now in Whole Foods stores, the ability to pick up groceries from Whole Foods. Adding content.
We have a great slate of content coming out in the fourth quarter here. Hopefully you've seen already "Jack Ryan" and "The Romanoffs," and pretty soon you'll see the follow-up season to "The Marvelous Mrs. Maisel," and also a couple other things. Hopefully you'll see Thursday Night Football tonight when you get home.
Yeah. This is Dave. Just on the AWS pricing philosophy. Just a reminder, when we look at this, our pricing philosophy is work relentlessly, take costs out of our own cost structure, and when we can, pass savings on to the web services customers in the form of lower prices. It's easy to lower prices, but it's much harder to be able to afford to lower prices, and that's something we work really hard in all our businesses, including AWS, to do that. When you look at AWS now, we've lowered prices 67 times since we launched, including a few more in the last few months. Those periodic price reductions are a normal part of our business for us. 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 with you again next quarter.