On this tech episode of Industry Focus, Motley Fool analyst Dylan Lewis is joined by senior tech specialist Evan Niu to dive into both companies' earnings reports and key investor takeaways. Tune in to find out the most important numbers from each report, what Twitter's biggest concerns are going forward and how it's addressing them, which unlikely segment is accounting for the majority of Amazon's profits, how Amazon is investing in the long game in international markets like India, and more.
A full transcript follows the video.
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This podcast was recorded on April 28, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 28. Welcome to earnings season, folks! I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist Evan Niu. Evan, it is the most wonderful time of the quarter. How's it going?
Evan Niu: Pretty good. Ready for the weekend. It's been a busy earnings week.
Lewis: Yeah. A lot to catch up on this week, and obviously, looking forward to next week as well, with a lot of big tech companies, namely Apple, reporting. But, this most recent week, two big names, Amazon and Twitter, both reported. We're going to go through their quarterly reports today. Evan, why don't we start out with the e-commerce giant?
Lewis: Looking at Amazon's report here, they put up $35.7 billion in revenue. A year ago, $29 billion. That's a 23% increase year over year. That's pretty incredible given the size they're working on with that denominator for year-over-year changes. Down to EPS, $1.48 per share. Based on last year, $1.07, good for 39% increase year over year. When it comes down to it, the company really crushed Wall Street's expectations and their own estimates.
Niu: Yeah, I think it was a pretty strong quarter. The same thing we've been seeing play out over the past year-plus. Amazon Web Services continues to really crush it. This AWS segment is so important at this point financially, because it's so much more profitable than the e-commerce businesses. Plus, on top of that, operating margins for AWS is expanding, so they're starting to see some operating leverage kick in. Whereas the e-commerce businesses, both North America and international, saw operating margins decline a little bit. AWS is now approaching 25% operating margins, compared to 2% to 3% in North American e-commerce, and negative in international. And that's only going to get more pronounced over time as AWS continues to grow, continues to scale, and continues to be even more and more increasingly important, financially speaking, to their bottom line.
Lewis: A couple numbers on the company's cloud computing division, AWS. Sales were up 43% year over year. AWS accounted for 10% of Amazon's total sales in the quarter, which was up from just under 9% in the year-ago period. Like you were saying, investors should be thrilled to see AWS continue to become a larger part of the company's top line, because it is a much higher-margin business than the company's e-commerce efforts. E-commerce is, by nature, razor-thin, particularly the way that Amazon does it. So, when you have a cash cow business like AWS, to highlight the margin differential here, that segment produced more operating income than Amazon's North American division on roughly one-sixth the sales. Which is insane.
Niu: Yeah. I think it's funny. Amazon has always been considered a tech company, but I would argue that's only recently become an appropriate description. E-commerce, yeah, you're doing online, but the cost structure doesn't scale in the way that most tech companies do scale. That's one of the big advantages for a lot of tech companies, that they can really scale up into these really high levels and profits just start expanding. But when you have e-commerce, it's just not that way, because the infrastructure investments are massive, the margins are, like you mentioned, very small to begin with. I think when they jumped into this AWS thing a few years ago, obviously cloud infrastructure is pure tech, and it's also very scalable, which is also another thing that's common in tech. I just think it's interesting how, historically, they've always been considered a tech company, when their operations have been less tech-focused, especially in terms of the cost structure compared to this new cloud business, which is just exploding and blowing up everywhere.
Lewis: And that cloud business has really allowed them to invest in other parts of the business. We mentioned the losses that are going on in the international side right now. That segment posted 16% year-over-year growth. It's still operating at a loss. The reason for that is, they're sinking a ton of money into long-term investments on that side. You can think about what they're doing with e-commerce and building out warehouses, that fulfillment infrastructure. They're investing in content and having original programming that's bespoke to all the markets they're entering, launching Prime in India, all these different things that are long-term plays, that's all enabled by the fact that AWS is creating a ton of money for them.
Niu: Definitely. Speaking of India, I think that was a big contributor. International operating margins declined from -1% to -4%. So, you see losses widening on the international side. In the earnings release, they talked a lot about India. They mentioned India many times. They mentioned they're making localized content and TV shows for the Indian market. I think they invested, at this point, somewhere in the neighborhood of $5 billion in infrastructure in India. Jeff Bezos even said, it's still "day one" for e-commerce in India. So, clearly, Amazon sees a lot of potential in the Indian market, and that's where they're directing a lot of their investments. But, they did talk about it an awful lot in the press release, so you can certainly see that it's at the top of their mind.
Lewis: Yeah. We talked about that "day one." That was something that also came up in Jeff Bezos' annual letter to shareholders -- if any Fools haven't read it, I highly recommend it, it's great insight into the leadership of Amazon and how the company is thinking about things. You see a lot of that reflected in how they're handling that international segment. Pulling back and looking broadly at the company, and looking for investor takeaways here, I think you have to chalk this up to a killer quarter from a great company. A lot of stuff that we expected. AWS, it's great to see it continuing to grow and become a more important part of the business. We love that. But what we're seeing on the international side, yes, would it be nice if it wasn't operating at a loss? Yeah. But the long-term investments are probably going to bear fruit for the company in the future. Anything else on Amazon for you, Evan?
Niu: I remember a few years back, I was having a conversation with Eric Bleeker, he used to be a general manager at Fool.com and has moved to a different part of the company. Bleeker was telling me, we were having this conversation a couple years ago and he was saying it might be worth it to invest in Amazon purely just for AWS. This was at a time when AWS was much smaller, and Amazon wasn't even disclosing their results yet, so it was hard to know how important it was. But I wish I had taken him up on that. The stock has more than doubled since that time, largely driven by AWS. So, it is pretty breathtaking how AWS has become so fundamental to the investing case. It would have been hard to predict five years ago, but it's so important now.
Lewis: Yeah. I mentioned Jeff Bezos' annual letter before. Actually, we had a writer, Seth McNew, look at Jeff Bezos' annual letter from 10 years ago, and he talks about AWS. So, I mention the importance of reading these letters as getting a lens into how management thinking, and what eventually might become very important parts of the business, and why they're funneling money into these different projects. I think that's an example where Bezos had the vision a long time ago that this was going to be super important for Amazon. Bleeker caught on at some point, too. But, it wound up being huge for investors, huge for the company, and it's really fueled a lot of the growth that they're looking for in other segments.
Niu: Yeah. I wish I could have invested in just the AWS business.
Lewis: [laughs] Gotta love those margins.
So Evan, flipping from a company that has been on fire for years in a positive way to, maybe, a company that's been on fire in more of a negative sense, let's talk a little bit about Twitter and their most recent report. Revenue came in at just under $550 million, which beat expectations. But even with that beat, the top line was still down from nearly $600 million that the company brought in at the first quarter a year ago. Looking over at the bottom line, non-GAAP EPS came in at $0.11. Of course, if you're looking at the generally accepted accounting principals side of the financials, the company lost $0.09 per share. I think in some ways, this is the quarter that Twitter desperately needed. It was the first set of good news for the company in a while. They had the beat on some financial numbers, and they also had some core business numbers that looked pretty rosy. The stock is up over 10% since the report. Obviously a lot of people like what they saw. Looking at the results, Evan, what stuck out to you?
Niu: I think the key theme for this quarter was cost-cutting, which really helped profitability. Not that they're profitable on a GAAP basis. But in general, it certainly helps their financial position. If you remember, they announced in late 2016 that they are restructuring and laying off 9% of their staff. That's certainly a big driver of these big cost reductions. For example, revenue is down 8%, but total costs were down 10%. You can see that translates into a little bit of margin expansion, which is funny, it's almost like reverse operating leverage, if you can get margins to expand while revenue is going down. But, I think it's an interesting thing. This is an argument I've been making recently. Before Q1, this quarter, Twitter has been operating unsustainably because they have consistently large net losses, deteriorating operating metrics, most notably around users. But meanwhile, revenue has been growing for most of the time, so it makes it more acceptable. But if you have net losses, declining sales, and poor operating metrics, that's just a really bad recipe. This quarter being the first-ever revenue decline, but the silver lining is they helped their profitability a little bit. I think of it kind of like inflection points. Sales went down, but this is their highest EBITDA margin they've ever posted.
I think, in a way, Twitter has to accept what it is, and more importantly what it isn't. It's definitely carved out place for itself at the intersection of social media news, microblogging, and interacting with people or public figures that you might not know personally. But there are limits to how far that usage can take Twitter in that role. Frankly, overinvesting in future growth could be a waste of money because I think the platform does lack some mainstream appeal, which is what we've seen manifest itself over the years, in terms of poor user growth. This quarter was the strongest user growth they've had in two years, so there are things that are turning up, and engagement is improving. They're stabilizing their financials and right-sizing the cost structure. I think they're more surgically investing in product improvements. And, obviously, the goal of that is to improve user engagement and growth. But I think what they're doing really bodes well in terms of financial sustainability, because they can support themselves. They brought in $550 million in sales. You can sustain a business on that, if you're bringing in that much money each quarter, so long as you have some cost discipline, you're not overinvesting and chasing things that won't ever materialize. So, I do think this was an important quarter for them.
Lewis: Yeah. Looking beyond those financial numbers, you mentioned what's going on with users. They're now at 328 million monthly active users worldwide, which is up 9 million sequentially. That's really great to see. We've been looking at this stagnating user growth for quite some time, so it's great to see them notch what amounts to a meaningful bump here. I think it's the strongest sequential addition they've had in two years, back when they reported something like 14 million in Q1 2015. What do you think is really pushing those gains, Evan? Because they've been doing so much on the platform to improve engagement and get people logging in more often and engaging with the platform more. They've been doing a huge push with live-streaming and getting some programming there. They've been experimenting with push notifications. They've been rethinking the company's timeline approach. Rather than having it be just sequential and based on recency, they try to curate content a little bit more. Do you think there's any one thing that's really getting people more engaged?
Niu: I think it's a combination. They mentioned on that call a couple of factors. One is, in the U.S. particularly, there's been a big rise in political engagement, so people following and interacting with political-related content. Which makes sense, given the current political climate. It's kind of a crazy climate, so people are getting more engaged. But the hard part is, it doesn't seem like that's translating into ad sales, necessarily, which is the next step of that equation. And like you mentioned, the algorithmic curation. It's funny, they announced that a year ago, and Twitter users freaked out, they were like, "You're just trying to become Facebook."
Lewis: Yeah, that was not a popular decision, when they decided to do that.
Niu: Yeah, they got so much backlash. I don't understand why these really enthusiastic Twitter users were so upset about this. Compared to a strictly unfiltered reverse chronological feed, which is hard to use unless you're literally constantly on there and you'll see everything in real time, which, no one does that --
Lewis: And, also, because of Twitter's platform, there's so much noise. Having a reverse chronological feed sets you up to look at a lot of stuff you just don't want to see.
Niu: Exactly. Thinking about it fundamentally, the point of having algorithmic curation is to unearth content and tweets that are more relevant to you as a user, based on your behavior and data around what you interact with. Shouldn't any social media user of any platform want more relevant content? I just don't understand how that is some terrible thing to some of the people who really spoke out against this. I mean, it's very likely that it's just a very vocal minority that was making a big fuss about this. It's obviously helped. More relevant tweets helps engagement. You don't have to waste as much of your time trying to find the information or content you're looking for, if Twitter is going to help you with that process and showing you information you might be interested in. And they've introduced a lot of features with that idea in mind. It's definitely helping, clearly.
Lewis: One of the numbers we can look at for that -- and they don't break it out specifically for us, but we can glean it from growth rates -- is how daily active users compare to monthly active users. I know this is something that you've written a little bit about on fool.com. Seeing daily active rise 14% year over year, while monthly actives were up 7% year over year, that says that people are generally coming back to the platform more, even as monthlies are growing.
Niu: Exactly. This is the fourth or fifth quarter of daily active user growth accelerating. The growth rate has been trending higher over the past year. Again, over the past year is when they've been innovating these product changes, particularly with the algorithmic curation. I don't know if they're making much progress on the whole abuse side of it. That's always been a big problem, and they always say they're doing stuff to help, and they always say they're making progress. And there's no really good way to measure this. It's not like there's metrics around abuse. [laughs] At least, maybe internally they have some metrics they follow. But as far as public investors go, it's not like we can look at some hard number and see that abuse is going down. So you just have to take their word for it. But their word on this topic doesn't really have a lot of weight because they've had this long history of being way too passive when it comes to abuse and harassment on their platform. They said that making progress there has also helped engagement. But, again, I think it's probably more about the other factors, because I don't give them too much credit about actually fighting abuse, because they seem a little too complacent there.
Lewis: Right. Beyond the user side, switching over to the ad side of their business, I think on first glance, one of the things that was a "yikes" moment in the results was, even with all these positive trends -- more daily actives outstripping the monthly active growth, and general positive growth trends in monthly actives -- cost per ad engagement was down 60% year over year, and that's on the back of a 50% decline a year ago. Generally, in the past, the company has been able to make up for those declines based on the volume of ad engagements. Even with ad engagements up 140% year over year in this most recent quarter, they still posted the revenue decline, because that price is coming down and down. This is something that you have to be a little bit concerned about. At the end of the day, the user growth is only so good as long as they can monetize those users.
Niu: Yeah, exactly. I think that's exactly the challenges they face now. Jack Dorsey has certainly always been a more product-focused CEO. The product improvements are helping the user numbers, but as far as financials go. For example, they mentioned that engagement had the biggest gains in the U.S., in part because of the political stuff we mentioned. They're seeing the biggest gains and engagement in the U.S. But ad revenue declined the most in the U.S. So, there's a big disconnect there between these things. These things are diverging. Growth is down, engagement is up. How do you reconcile those two things? That's what they're trying to focus on next. "Once we stabilize the user number, then we focus on the ads." And they're trying to streamline their ad products, because I think they had a little bit too much going on. They're trying to be more efficient and targeted with how they're approaching the ad business. It's definitely what they need to hit next. Right now, there's a big discrepancy between engagement and ad sales. So, whether or not they could do that, that's a pretty big, open-ended question, in terms of results going forward.
Lewis: To a certain extent, I think that's just the dynamics of the ad business. In the quarterly call, CFO Anthony Noto tried to explain what was going on here by saying, "Current revenue trends we are reporting reflect budget decisions based on trends in audience and pricing of 6-12 months ago, and we're not seeing significant acceleration in user growth." Really, what he's getting at here is, ad budgets are planned out, so any increase in ad spend or anything that would impact the rates that people are paying on Twitter or the number of impressions, anything like that, it's going to be a reflection of what user growth looks like six months prior, basically. In the company's PR, in their guidance, they said Twitter continues to expect advertising revenue growth to continue to meaningfully lag that of audience growth in 2017. Including into the second quarter. So, if you're looking for a period where we might start to see these metrics sync up a little bit more, and start seeing what people are paying for ads on Twitter reflect what's going on with the audience growth they're experiencing, it probably happens sometime in the fall of 2017. That's the mark-your-calendar period for investors if you're watching these two metrics.
Niu: Yeah, I definitely agree with that. There's a little bit of a lag time there. But, hopefully they can actually start executing better on the ad side. But even beyond that, the cost bit is pretty important. I think they've been a little too generous with things like stock-based compensation, for example. They're expecting stock-based compensation in 2017 to be down about 20% to 25% versus 2016 levels, which I think is an encouraging sign. That's certainly one of their largest expenses. It's a non-cash expense, but it's still one of the biggest expenses on a GAAP basis, and they're still trying to hit GAAP profitability. They're still putting non-GAAP net income, but of course, investors prefer GAAP profits.
Niu: They have a lot of pieces of the puzzle to work on at the same time. And they're making progress on the user side and the product side and on the cost side. But they do need to be doing better on the ad side, on the revenue side.
Lewis: We talked about some of the progress we're seeing here. Evan, are you buying into Twitter's turnaround story? A lot of the numbers here seem to be moving in the right direction. But I also see a lot of reasons for pause.
Niu: I'm not really interested in Twitter as an investment. I do think they can become a sustainable business with a place in the world, and provide a service that provides value to people. But that doesn't necessarily mean they're going to be a good investment for public shareholders. You can have a solid company that can operate and be sustainable and still underperform the broader market. Those two things are certainly quite common and not mutually exclusive. I think Twitter is on its path to becoming more of a long-term company, in terms of how it's being run, and holding down its place that it's carved out for itself. And while a lot of these metrics are improving and heading in the right direction, it's just one quarter. I still don't think Twitter is going to be an outperforming investment, in which case, I'm not interested.
Lewis: I'm kind of thinking along the same lines here. For me, this is a company that has been poorly managed for such a long time. There's been that revolving door of CEOs. They've gone through so many different platform identity crises. There was a period half a year ago when management was looking for a buyer for the business. Given all of that dysfunction, I think I need to see more before I'm really thinking about this as serious investment opportunity at all. It's great to see some of these metrics trending the right way. But I also really want to see if they can continue to sustain this user growth. We talked about how, to a certain extent, the current political environment is something that is helping out the business a ton. Is that going to be short-lived? Long-lived? Will major changes to the platform continue to fuel what they're seeing on the user side? There are a lot of questions, and I need more solid answers and metrics to hang my hat on before I give them a serious look.
Niu: Right. And something you mentioned a minute ago, in terms of the changing product direction and revolving-door CEOs, I think if you haven't already, and any listeners also, you should check out Hatching Twitter by Nick Bilton. It came out a couple years ago in 2013 or 2014. It's not a new book. But it gives a really good account of Twitter's founding and the early days and how much in fighting and backstabbing and betrayal there was in those early days. Between Jack Dorsey and Evan Williams, two of the co-founders who had a constant power struggle. But, to your point, they each had different vision for the products. I think if you read the story, it really gives you some context into why Twitter has always seemed to lack direction as a company and a product. It's really useful, really good for investors to get that context of the culture that Twitter grew up in, which kind of explains why it's still been so hard for them to figure out exactly where they fit in the world, because of these conflicting visions about the product very early on. I don't know if those types of culture concerns persist to this day. But it's a really interesting story, and I think some very useful context. I would highly recommend anyone who's interested in Twitter as a company, stock, or service, should go read the book. It's a pretty good book.
Lewis: It's always nice to send the listeners home with some homework. That's the book on Twitter, Hatching Twitter, you said?
Niu: Yeah, Hatching Twitter, it's written by Nick Bilton, who is a really prominent New York Times journalist, now rights for Vanity Fair. He did a really good job, and he had good access, too, he had access to all the co-founders, so really good first-hand accounts of how everything went down. A lot of betrayal and power-grabbing.
Lewis: So, for more color on what we were talking about today, listeners, check out Hatching Twitter. I would also highly recommend checking out Jeff Bezos' annual letter to shareholders if you haven't already. Awesome discussion. Evan, anything else before I let you go?
Niu: No, I think we covered it all.
Lewis: All right. We'll definitely be back next week to talk some major tech earnings. But, until then, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus too. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!