Thank you for standing by. Good day, everyone, and welcome to the Amazon.com Q3 2016 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, Darin Manney. Please go ahead.
Hello, welcome to our Q3 2016 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 2015. Our comments and responses to your question reflect management's view as of today, October 27th, 2016, only, 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 are 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, 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, investment, restructurings, or legal settlements.
It is not possible to accurately predict demand for our goods and services, therefore our actual results could differ materially from our guidance. With that, we will move to Q&A. Operator, please remind our listeners how to initiate a question.
At this time, we will now open up the call for questions. In the interest of time, we ask that you limit yourself to one question. If you'd like to ask a question, please press star one on your keypad. We ask that when you pose your question, you pick up your handset 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 Douglas Anmuth with JPMorgan. Please state your question.
Thanks for taking the question. The international retail segment margin was the lowest we've seen in quite a while. If you could provide some of the key drivers there, in terms of the drag, and any color on how to think about the incremental international investment that might be impacting the 4Q guide. Thanks.
Sure. Thanks, Doug. Yes, specifically to international, we are seeing expansion to support selection, expansion at fulfillment network increases. We're also investing in digital content, and additional Prime benefits, Amazon Fresh location, Prime Now. By far, the biggest individual thing is the investment in India that we continue to make, and very excited about the initial reaction in India from both customers and also sellers. That is essentially the international margin guidance in Q4.
Thank you.
Thank you. Our next question comes from Gene Munster with Piper Jaffray. Please proceed with your question.
Great. Thanks. I guess when we think about the progression of margins in the second half versus the second half of 2015, and kind of the flatlining of overall margin at this point, excluding AWS, I guess, should we think about this as being a temporary kind of plateau that'll at some point resume once you start leveraging a fulfillment build-out, or is there something structurally or philosophically changing with the way that you operate your business? Thanks.
Yes. Thanks, Gene. Well, we will continue to invest in the business where we are seeing significant customer traction. The things I'm about to mention fall into that category. The largest individual reasons for the ramp-up in investment between the first half and second half of this year, also second half of this year versus second half of last year, are the things I mentioned on the call last quarter. First, video content and marketing associated with that is nearly doubling year-over-year in the second half of the year, and continues to be a large increase in both Q3 and Q4. In the quarter, in Q3, we added 18 fulfillment centers, and we've added five more in October. For the year, we'll add 26.
Most of those are in North America, that compares to 14 last year, and looking back, the last time we had double-digit increase in fulfillment centers was in 2012 when we added 11 in the third quarter.
It was a rare aggregation of startups in Q3 and into Q4 that's helping us position better for Q4 volumes, because paid unit growth continues to be strong and Amazon fulfilled unit growth, which includes what we ship, includes FBA, is significantly higher than even that. We're continuing to build for high AFN or Amazon Fulfillment Network demand, including both retail and FBA. The number of warehouses that we added represented a 30% increase in square footage year-over-year. Last year, we increased square footage by just under 20%. The definition of square footage in this case is all of our warehouses plus our sortation and delivery centers, and customer service centers. It's pretty much our full square footage that supports operations. Those will dissipate as they burn in.
We've talked about fulfillment centers, initial startup costs include increase in fixed costs, but also variable costs as we train workers and also bring in inventory. There's a number of transportation costs also related to the startup of a new fulfillment center, both inbound and outbound. They're inherently less efficient than more established, mature buildings. There will be a cycle where those will be more productive next year than they are this year and more productive in 2018 than they are in 2017. What you're seeing essentially in the second half of this year is a step-up investment, primarily around digital content also the fulfillment center investment, but also things like Echo and Alexa, which we're adding a lot of resources to India and AWS as we add people there to support additional service, that rapid growth in that business.
Thank you. Our next question comes from the line of Brian Nowak with Morgan Stanley. Please proceed with your question.
Thanks for taking my questions. I have two. The first one, just to go back, Brian, to the fulfillment build. In the past, I think you've talked about how it takes time to get the fulfillment centers to peak efficiency. With these new FCs opening, can you just talk about have you become more efficient? If you get into a lower volume quarter next year, there's less risk of deleverage, or should we still think about it's going to take time to get up to peak efficiency? The second one on AWS. Amazon as a company is very good at removing friction in the purchase process. Can you just talk about some of the main hurdles you still have to overcome for large enterprises to really start using AWS more? Thanks.
Sure. The fulfillment network, as we build it, yes, they'll be more productive next year than they are this holiday peak, and probably even more productive in 2018. I can't forecast it for you into next year quite yet, but we certainly had productivity and additional cost in Q3 and even into Q4 of this year as we built the additional capacity. Again, the underlying reason for that capacity build is the strength in paid units, and even more so in the units that we're fulfilling driven by our FBA program. The FBA program is the key pillar of our Prime offering. It adds selection, it makes Prime stronger, and then that's a self-reinforcing loop where the Prime success attracts more sellers. We're glad to have that problem. We are just working very hard to get capacity in place and in productive use for Q4 and beyond.
Hi, Brian, this is Darin. On the AWS question, we continue to invest in AWS on behalf of our customers. In addition to the technologies that make integrations easier, it helps companies move from an on-prem or a hybrid IT environment into AWS. We're going to continue to do that, and specifically things like the database migration tool that are helpful for customers when they move production databases from on-premises to the cloud with virtually no downtime. Many of our AWS customers are beginning to choose and continue to choose the AWS Schema Conversion Tool, which really switches database engines to get out of old guard proprietary databases and onto AWS. We'll continue to react to customer needs, and that will include opening up new regions.
We've opened up Ohio this past quarter, and we've highlighted that we'll have another number of regions coming online in a few months. Yeah, we're doing a lot of things to help make it easier for all customers to migrate to AWS.
Thank you. Our next question comes from the line of Mark Mahaney with RBC Capital Markets. Please proceed with your question.
Okay. Hey, Brian, would you give us any commentary on two categories, in particular, groceries and fashion and apparel, and particularly on groceries? I know in the release, there's a couple of data points about Amazon Fresh rolling out into newer areas like Maryland. Great to see that. Could you just talk about that in the investment horizon? Is that kind of moving the needle for you? How big that, anybody help us quantify how big that already is to the revenue growth that you're seeing, particularly on groceries, and any particular comments on fashion and apparel, same line of thinking. Thanks.
Okay, sure. Thanks, Mark. I will start with Amazon Fresh, and groceries in general. Yes, this quarter we launched in Northern Virginia, Maryland, Dallas, and Chicago. We also launched a new pricing plan, which is a monthly $14.99 add-on to Prime in the U.S. We've expanded, as you know, previously into London. We're very happy with the progression, both in the geographies that we've been in for a long time, where we're at continuing to add ZIP codes and additional neighborhoods, and also in these new cities. Certainly a business where we continue to work on costs and profitability, but we are finding it a very attractive service to our customers, which is what we're after. Similarly, but not exactly the same as the Prime Now business, which has a similar overlap on things besides groceries.
It's a slightly different model, obviously, where we're more about immediacy and a smaller list of items available in one to two hours. There's certainly a lot of people who are using that for groceries and consumable items. That is now up to 40 cities across seven countries versus 17 this time last year. We're also adding Amazon Restaurants delivery to the Prime Now offer in 19 metropolitan cities in the U.S., and that's up from two last year. We continue to believe consumables, groceries are a key part of the offer to customers, and we are playing with very different models to see which works and for what needs. We're very happy with the Amazon Fresh, and we've now expanded quite a bit, as you've seen this year.
Prime Now we're also very happy with, although obviously the economics in that business are even tougher. We do feel that our scale makes that possible because of the geographic footprint and how close we already are to customers.
Hi, Mark, this is Darin. On fashion and apparel continue to be a large part of our EGM business and one that we're very excited about. We continue to make it easier for brands and manufacturers to come on board in that category. We continue to work with brands to come on board, and we're happy with the traction we're seeing with those brands. As we get more and more selection, we're really pleased with the customer engagement that we have there, both from the discoverability, the technology that goes behind making it easier to shop for fashion on our site, as well as the increased selection by adding the brands.
To answer your question about whether that's part of investment, yes, it is certainly part of our investment. The large ramp, if you will, in investment that we're seeing from the back end of last year and also the first half of this year is more related to digital content and the build in our fulfillment network, which I've already discussed.
Thank you. Our next question comes from the line of Mark May with Citi. Please proceed with your question.
Thanks a lot. In some of these incremental investment areas like warehouses, logistics, and also content, I know in some cases you expense upfront, in some cases you amortize over time. Just wondering if you could give us a sense of how much of the recent step-up is being expensed. I'm particularly looking at your COGS as a % of retail revenues, which was up year-on-year for the first time in quite a while. How much of that was because of content that was expensed in the period? Just trying to better understand that. I think also you've been changing around, and this is happening here shortly, FBA pricing, including increasing your storage fees, but also reducing your handling fees.
I guess the question is, are these changes designed to just pass through increasing shipping costs, or is this more of a net neutral change where really the goal is to try to free up capacity in some of your facilities? Thanks.
Let me start with your second question on FBA. Yes, we did make some changes to the pricing formula for this holiday season. They're essentially meant to incent the right behavior among sellers around holiday. The biggest issue you're trying to get at is having the most valuable products for holiday in the warehouse, in the Prime space, and not having the warehouse filled with things that may not sell until after the new year. We are trying to incentivize that behavior. We're also trying to incentivize getting inventory into the warehouse quicker. Yes, the changes to the pricing formulas were really with that in mind to help the flow and the space utilization in Q4.
Yeah. Hi, Mark, this is Darin. On the capitalization point, I'd say the things that get capitalized are the core buildings and leasehold improvements in the buildings. The things that we're seeing hit the P&L are the fixed and variable expenses that it takes to run the building, and I think that's what Brian's pointing out most pointedly in terms of what is impacting the profitability of the second half. Yeah, the capitalization is relatively small other than the building itself.
Thank you. Our next question comes from the line of Youssef Squali with Cantor Fitzgerald. Please proceed with your question.
Yes. Thank you very much. Two quick questions. With the step-up in investments in content from Prime Video, which you mentioned before, would you also be stepping up the international expansion? Maybe you can just remind us how many countries you're in with Prime Video, and whether there is a potential chance of maybe stripping Prime Video from Prime to allow it to be extended to other countries. I know you're not guiding to 2017, but just looking at the capacity increase that you've had for FCs for 2016, should we expect that as an ongoing kind of expense going forward? Or is the current buildup enough to maybe give you some spare capacity to cool that down for 2017? Thanks.
Sure. First on your video comment, we're in 4 countries right now, the U.S., U.K., Germany, and Japan, and we have stated that we will be in India soon. The content that we are creating, especially through Amazon Studios, we are generally holding the worldwide rights to and can use that in other countries as well. The cost of that then gets amortized to those countries, become part of the international segment results. Yes, we consider that to be very valuable as opposed versus licensing many times by country, the third-party rights to content that we don't create ourselves. Your question on fulfillment expenses, I can't extend the guidance into next year. We will do that obviously at the end of next quarter.
I would say this was an extraordinary step-up, as I mentioned, in Q3 that is tied to very rapid growth in not only paid units, but Amazon fulfilled units. Really our forecast for additional capacity additions and the rate of additions will be tied to those growth factors as well. We'll have to see. We right now are working on getting the capacity in. It was very lumpy this time with 18 warehouses in one quarter and another five in the first three weeks of the next quarter. Obviously we'll be working on the efficiencies of all the warehouses we have, including the ones we just started up this year.
Thank you. Our next question comes from the line of Colin Sebastian with Baird Equity Research. Please proceed with your question.
Great. Thanks. A follow-up on the FC question, I guess more specifically, it sounds like you have enough capacity in terms of fulfillment centers for the holidays, also wondering what your comfort level is in terms of your shipping partners to manage those deliveries. Secondly, I was wondering how you would characterize the pricing environment for AWS, in particular with more deep-pocketed competitors in the space now. Google, in fact, highlighted this on their conference call today. Thank you.
Sure. Let me start with transportation. Yeah, we are looking forward to a great holiday, that includes working with our shipping partners both in the U.S. and globally. We've worked very closely with them to line up capacity, share capacity plans. We certainly have additional delivery capability of our own. With all of our partners, we work well in advance of the holiday to get our plans in place, we feel very confident we're looking forward to a great holiday, not only for customers, but also for sellers. On your question on AWS, I didn't listen to the Google call, you'll have to fill me in on that later. The thing I can tell you about pricing is that price reductions are a core part of our philosophy, of course.
We had a price decrease in Q3, that was our 52nd since we started this business. We are comfortable with price decreases. Not only do we lower the prices of our products, we also create new services that are cheaper that customers can switch to. They can also benefit from that as well. If you step back and say why do people choose AWS? I'll give you the points I said last quarter. Basically, what we hear are the functionality and pace of innovation is greater than our competition. We've added more new significant features and services this year already than we had all of last year when we added 722. We have a partner and customer ecosystem. You've read about the VMware deal that we signed this quarter. We continue to expand with partners and build ecosystems that better support customers.
Finally, experience. We've been in this business a long time, longer than anyone else, we've used that time to make our products and services better. There is going to be a lot of winners in this space, as we said, we are very happy with our position and the customer reception to our products.
Thank you. Our next question comes from the line of Justin Post with Merrill Lynch. Please proceed with your question.
Great. Thank you. I guess when you look at fourth quarter guidance and you back out AWS, it suggests that margins on the core business are going to be pretty down versus last year. Do you view this as an abnormal investment cycle or just part of the overall kind of ebbs and flows of the business? Long-term, I know several years ago you talked about maybe high single-digit, low double-digit margins long-term. I wonder if you could refresh us on that, and also just let us know if you think international has structural margin differences in the U.S. for the core retail business. Thank you.
Sure. Yes. As far as the continuation of the investment into next year, I cannot give you much color on that today. What I can tell you again is that we've ramped up considerably. We've been investing quite openly in a lot of areas, and continue to do so. We are experiencing a ramp-up, if you will, in the second half of this year, particularly tied again to the fulfillment center and spend, and also the video content spend. We will continue to invest in video content. We'll continue to invest in fulfillment space to handle higher and higher paid unit volumes and shipped unit volumes. We'll continue to invest in things that we believe enhance the customer experience, particularly the Prime experience. Devices we'll continue to invest in, particularly Alexa and the Echo products.
We'll continue to invest in getting faster and faster shipping methods for our consumers. We believe that's working. We're very happy with the results. We're very happy with all the customers we have, but particularly the Prime customers that we have. As far as long-term operating margins, I can't forecast that right now. I can't forecast that for our AWS business either. We are, again, working on two fronts. We are honing the businesses that we're in and making them as efficient, as profitable as possible, while also investing very pointedly and very wisely, we believe, in things that will enhance customer experience and create lasting businesses for us down the line. We've said we want things that customers will love, can grow to be large, will have strong financial returns, and durable and can last for decades. That's still our mission.
We have pillars of the business right now with Marketplace, AWS, and Prime. We're actively looking for a fourth and fifth pillar.
Thank you. Our next question comes from the line of Heath Terry with Goldman Sachs. Please proceed with your question.
Great. I was just wondering, there have obviously been some headlines since the call that you did earlier with the press on the scale of this investment cycle relative to other investment cycles that you've been through. With the 2014 cycle sort of being the most recent, could you quantify a little bit more how you would compare this investment cycle to that most recent one? To the extent that we are in the midst of this investment cycle, would you say we're in sort of the earlier or later stages? Any sort of clarity around that would be useful. Thank you.
Sure, yes. The word cycle, if I mentioned that, was a mission. It was a misspeak. The investment that we are seeing is a step-up versus what we have experienced in particularly the first half of this year and the second half of last year, which I mentioned. We have said investments are going to be lumpy. They are going to be high sometimes, and they'll be moderate at other times. We are right now, the second half of this year looks like a big step-up compared to the first half, and it is. Again, it's all areas that we will continue to invest in, some of which I just actually went through the laundry list. I would not characterize it as a cycle. I would characterize it as continued investments.
We make investments with the idea that they are going to pay off, and they pay off either directly in the business they're in or in their contribution to the total business, many times as a part of the Prime program.
Thank you. Our next question comes from the line of John Blackledge with Cowen and Company. Please proceed with your question.
Great. Thanks. Two questions. It seems you're increasing your efforts in the auto vertical with the recent launch of Amazon Vehicles. Also wondering if you could discuss some of the dynamics of the auto industry that make it attractive, and maybe how it aligns with the Prime value prop. Then just the second question, on grocery, would you consider physical locations in an effort to kind of expand and/or accelerate the growth in that vertical? Thank you.
Yeah. Hi, John. This is Darin. On vehicles, Amazon Vehicles is really a car research destination, and built the automotive community for customers, and gets information they need when shopping for vehicles off-site or shopping for parts and accessories on-site. The features include research tools, community engagement, where you can talk to other customers, and certainly we try to build a one-stop shop for vehicles as an extension to the automotive store, which engages customers to add information about their cars and a garage, which makes it actually easier to shop for parts and accessories for your particular vehicle. We think there's a lot of opportunity there to add convenience for customers. On the B2B side, certainly, we do have an Amazon Business offering.
Businesses of all shapes and sizes can sign up to be a B2B customer. The selection that we have in our parts and automotive categories are certainly open to that channel. I wouldn't speculate on anything we might do in a particular vertical for those business customers.
Sure. Your question on grocery and physical stores, I can't comment on any rumors or speculation that there might be regarding that. What I will tell you is we have experimented with physical stores. As you may know, we have three physical bookstores, one in Seattle, one in San Diego, and one in Portland. Two more coming, one in Boston and one in Chicago. What we're finding is they're great places for customers to browse what ends up being a curated selection of books. They also get to try out our devices, which is very beneficial. They get to touch and try our e-readers, tablets, Fire TV, and Echo. We like what we see with that connection. We also have pop-up stores that you may see and also college pickup points.
We will try different delivery methods or pickup points or ways of getting product to customers, but nothing specific to point out on the grocery side right now.
Thank you. Our next question comes from the line of Ben Schachter with Macquarie. Please proceed with your question.
Given the low unemployment rates that you're seeing in the U.S., do you expect any unusual impact on wages for seasonal workers this year? Are you seeing overall wage pressure in the fulfillment centers? Separately, if you could just talk about trend lines you're seeing in paid units versus shipping units. Are they diverging meaningfully versus past? Thanks.
Yeah. On wages, nothing to point out for this holiday. Our challenge generally is the volume of headcount that we're looking to hire, and we work well in advance with agencies to help to get seasonal employees, and many of them turn into full-time employees after the holiday. Nothing specific on the wage pressure front. As you probably saw, headcount is up 38% year-over-year in Q3, and that is a continuation of a lot of ops roles that are supporting this high demand, the opening of the fulfillment centers we talked about, new Amazon Fresh locations, Prime Now. Also a lot of hiring in our tech areas, particularly around AWS and also the Echo/Alexa areas.
I'm sorry, the second question?
Sorry, go ahead. Okay, our final question will come from the line of Neil Doshi with Mizuho. Please proceed with your question.
Great. Thanks. Can you guys provide a little more color into the investments that you're making in India? What's driving that growth, and what stage is India in today relative to some of the other large international markets that you've launched in the past?
Yeah, sure. We are very encouraged by what we're seeing in India, but it is certainly very early on still. Most recent highlights would be the launch of the Prime program in India this past quarter. It's now one of the top-selling units based on amazon.in. It's been well received by customers. It's hard to compare India to any other country. It's very different in its stage and structure. Being a third-party market has caused a lot of invention on our side. We're being creative. The team there in India has been very creative on whenever they find a roadblock or something that has not existed in another country, they create it themselves, whether that's from delivering stations to working with small merchants to you name it.
We're very happy with both the customer engagement that we're seeing and also the seller engagement, which is very important in India. Very pleased with the team that runs it over there and the way they work with teams throughout the world.
Brian, to step back to Ben's other question on units. Ben, this is Darin. I will say paid units grew at 28% again this year, as it did in the prior quarter. As Brian pointed out earlier, our AFN units, our Amazon Fulfilled units, which include our first-party units as well as FBA units that go through our warehouses, are certainly higher than that 28%, and that's a result of the traction we're getting with our FBA sellers. Thank you for joining us on the call today and for your questions. A replay will be available on our investor relations 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.