Thank you for standing by. Good day, everyone, and welcome to the amazon.comq32016 Results Teleconference. Today's call is being recorded. For opening remarks, I will be turning the call over to the Director of Investor Relations, Darren Manny. Please go ahead.
Hello, and welcome to our Q3 2016 financial results conference call. Joining us today to answer your questions is Brian Othosky, 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 27, 2016 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 ks 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 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 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, investment, restructurings or legal settlements. It is not possible to accurately predict demand for our goods and services, and therefore, our actual results could differ materially from our guidance. With that, we will move to Q and 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. 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. So if you could provide some of the key drivers there in terms of the drag and any color on how to think about the 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 fulfillment network increases. We're also investing in digital content and additional Prime benefits, fresh location, Prime Now. But 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.
So 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 twenty fifteen and kind of the flat lining of overall margin at this point excluding AWS. I guess should we think about this as being a temporary kind of plateau that will at some point resume once you start leveraging your fulfillment build out? Or is there something, structurally 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. And the things I'm about to mention fall into that category. But the largest individual reasons for the ramp up in investment between first half and second half of this year and 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 both Q3 and Q4. In the quarter, in Q3, we added 18 fulfillment centers and we've added 5 more in October. For the year, we'll add 26. Most of those are in North America, but that compares to 14 last year. And I would look looking back, there's the last time we had double digit increase in fulfillment centers was in 2012 when we added 11 in the Q3.
So 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 FDA, is significantly higher than even that. So we're continuing to build for high AFN or Amazon Fulfilled Network demand, including both retail and FBA. The number of warehouses that we added represents a 30% increase in square footage year over year. Last year we increased square footage by 20 just under 20%. The definition of square footage in this case is all of our warehouses, plus our sortation and delivery centers.
So it's pretty much our and customer service centers. So it's pretty much our full square footage of support to operations. So those will dissipate as we 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. And there's a number of transportation costs also related to the startup of a new fulfillment center, both inbound and outbound.
And they're inherently less efficient than more established mature buildings. So 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. So, what you're seeing essentially in the second half of this year is a step up investment primarily around digital content and 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 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 2. 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 kind of get the fulfillment centers to peak efficiency. So with these new FCs opening, can you just talk about it, you become more efficient, so if you get into a lower volume quarter next year, there's less risk of deleverage or should we still kind of think about it's going to take time to get up to peak efficiency?
And then 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. So 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. So 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 build that space 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 Prime then the Prime's success attracts more sellers. So 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 Darren. On the AWS question, yes, we continue to invest in AWS on behalf of our customers. In addition to the technologies that make integrations easier and 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 to from on premises to the cloud with virtually no downtime.
And also 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 on to AWS. And so 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. So yes, 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 2 categories, in particular groceries and fashion and apparel? And particularly on groceries, I know when they released just a couple of data points about Fresh rolling out into newer areas like Maryland. Great to see that. But could you just talk about that in the investment horizon? Is that kind of moving the needle for you?
And how big that any way to help us quantify how big that how big that already is to your to the revenue growth that you're seeing, particularly on groceries and any particular comments on fashion apparel, same line of thinking? Thanks.
Okay, sure. Thanks, Mark. I will start with Fresh and groceries in general. So 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. And 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's 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 smaller list of items available in 1 to 2 hours. But there's certainly a lot of people who are using that for groceries and consumable items. And that is now up to 40 cities across 7 countries versus 17 this time last year. We're also adding restaurant Amazon restaurant delivery to the Prime Now offer in 19 metropolitan cities in the U. S.
And that's up from 2 last year. So 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. So we're very happy with the Amazon Fresh and we've now expanded quite a bit as you've seen this year. And Prime Now, we're also very happy with, although obviously the economics in that business are even tougher, but we do feel that our scale makes that even possible because of our geographic footprint and how close we already are to customers.
And hi, Mike, Mark, this is Darren. On fashion, 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 traction we're seeing with those brands. And 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 goes behind making it easier to shop for fashion on our site, as well as increased selection by adding the brands.
Sorry, and to answer your question about whether that's part of investment, yes, it's certainly part of our investment. But 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 kind of being expensed? I'm particularly looking at your COGS as a percent 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 kind of better understand that. And I think also you've been changing around and this is happening very 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 kind of 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. So 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 who around holiday. And 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. So we are trying to incentivize that behavior. We're also trying to incentivize getting inventory into the warehouse quicker.
So yes, the formulas were excuse me, the changes to the pricing formulas were really with that in mind to help the flow and the space utilization in Q4. Yes. Hi, Mark.
This is Darren. On the capitalization point, I'd say the things that get capitalized are the core buildings and leasehold improvements in the buildings. But the things that we're seeing hit the P and L are the fixed and variable expenses that it takes to run the building. And I think that's what Brian is pointing out most pointedly in terms of what is impacting our the profitability of second half. So yes, the capitalization is relatively small in terms of other than the buildings 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. 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? And then do you I know you're not guiding to 2017, but just looking at the capacity increase that you've had for 16, should we expect kind of that as an ongoing kind of expense going forward?
Or is the current buildup enough to maybe give you some spare capacity to kind of cool that down for 2017? Thanks. Sure. So, first on your video comment. We're in 4 countries right now, the U.
S, U. K, Germany, Japan. And we have stated that we will be in India soon. So 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. And the cost of that then gets amortized to the countries, become part of the international segment results.
So, yes, we consider that to be very valuable as opposed to Versace licensing many times by country, the 3rd 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. But I would say we are 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 facility units. So really our forecast for additional capacity additions and the rate of additions will be tied to that those growth factors as well.
So 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 1 quarter and another 5 in the 1st 3 weeks of the next quarter. So, and 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 FTE question. And I guess more specifically, it sounds like you have enough capacity in terms of fulfillment centers for the holidays, but also wondering what your comfort level is in terms of your shipping partners to manage those deliveries. And then 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. So yes, we are looking forward to a great holiday and 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. But with all of our partners, we work well in advance of the holiday to get our plans in place. And 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, but you'll have to fill me in on that later.
The thing I can tell you about pricing is that our pricing is price reductions are a core part of our philosophy. Of course, we had a price decrease in Q3 and that was our 50 seconds since we started this business. So, it's we are comfortable with price decreases. Not only do we lower the prices of our products, but we also create new services that are cheaper that customers can switch to, So they can also benefit from that as well. So 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 new more new significant features and services this year already than we had all of last year when we added 722. We have partner and customer ecosystem. You've read about the VMware deal that we signed this quarter.
So we continue to extend with partners and build ecosystems that better support customers. And finally, experience. We've been in this business a long time, longer than anyone else, and we've used that time to make our products and services better. So there is going to be a lot of winners in this space as we said, but 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 Q4 guidance and you back out AWS, it suggests that margins are 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? And then 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 difference is in the U. S. For the core retail business? Thank you.
Sure. Yes. As far as the continuation of the investment and into next year, I cannot give you as 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 AWS excuse me, the fulfillment center and spend and also the video content spend. So we will continue to invest in video content. We'll continue to invest in fulfillment space to handle higher and higher paid unit volumes than ship 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 2 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 business 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. So that's still our mission.
We have pillars of the business right now with marketplace AWS and Prime and we're actively looking for a 4th and 5th 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, how could you quantify a little bit more how you would compare this investment cycle to that most recent one? And to the extent that we are in the midst 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 last half, the second half of last year, which I mentioned.
But we have said investments are going to be lumpy. They are going to be high sometimes and they'll be moderated 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. But again, it's all areas that we will continue to invest in, some of which I just actually went through the laundry list. So 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. Just two questions. It seems you're increasing your efforts in the auto vertical with the recent launch of Amazon vehicles. Just 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?
And also wondering if you had any plans to work directly with auto shops, just given your ability to service most areas in 1 to 2 days? And 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.
Hi, John. This is Darren. On vehicles, Amazon vehicles is really a car research destination and build 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 in the garage and which makes it actually easier to shop for parts and accessories for your particular vehicle. And so, 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 and the selection that we have in our parts and automotive categories are certainly open to that channel. But I wouldn't speculate on anything we might do in a particular vertical for those business customers.
Sure. And your comment on your question on grocery and physical stores, I can't comment on any rumors or speculations there might be regarding that. But what I will tell you is, we have experimented with physical stores. As you may know, we have 3 physical bookstores, 1 in Seattle, 1 in San Diego and in Portland and 2 more coming, 1 in Boston and 1 in Chicago. And what we're finding is, there are great places for customers to browse what ends up being a curated selection of books.
And they also get to try out our devices, which is very beneficial. So they get to touch and try our e readers, tablets, Fire TV and Echo. So, we like what we see with that connection. And we also have pop up stores that you may see and also college pickup points. So 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? And are you seeing overall wage pressure in the fulfillment centers? And then 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.
Yes. So 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. So 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 fresh locations, Prime Now, but also a lot of hiring in our tech areas, particularly around AWS and also the Echo, Alexa areas.
And the second question.
Sorry, go ahead. Okay. And our final question will come from the line of Neel 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?
Yes, sure. So 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. India.
And so it's very 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 3rd 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 created themselves, whether that's from delivering stations to working with small merchants to you name it. So we're very happy with both the customer engagement that we're seeing and also the seller engagement, which is very important in India, and very pleased with the team that runs it over there and the way they work with teams throughout the world.
And Brian, to step back to Ben's other question on units. Ben, this is Darren. 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 Filled units, which include our 1st party units as well as FBA units that go through our warehouses are continuing are certainly higher than that 28%. And that's a result of the traction we're getting with our FBA sellers.
So 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.