Big Tech Giants Get Even Bigger

Tech giants Microsoft (MSFT -2.45%), Amazon.com (AMZN -1.65%), and Alphabet (GOOGL -1.97%) (GOOG -1.96%) are all hitting all-time highs this week after reporting spectacular quarterly results.

In this week's episode of Industry Focus: Tech, analysts Dylan Lewis and Evan Niu take a dive into the numbers from Amazon and Microsoft's reports and explain how such massive companies managed to grow their top lines so much this quarter. Listen in to find out how Amazon is competing with Google, and holding its own against them; where and Amazon's ad business fits into the company's strategy; how the LinkedIn acquisition is working out for Microsoft so far; why both companies are so keen to get into the cloud space; and more.

A full transcript follows the video.

This video was recorded on Nov. 3, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Nov. 3, and we're talking about the tech earnings bonanza from last week. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist Evan Niu. Evan, I want to start out today's show by apologizing to you, because I'm going to be out of the office Wednesday through Friday of this week and we had to pre-tape and cover some earnings that were already out. Because of that, you and I will not be doing one of our favorite episodes for the quarter, the Apple (AAPL 0.52%) earnings show. I hope you're OK with that.

Evan Niu: I'll have to be. I'll just talk to myself on Friday morning.

Lewis: I'm just picturing that's what you're normally doing in your home office, frankly. [laughs] 

Niu: [laughs] Yeah, when Apple reports, I just talk to myself.

Lewis: If something is truly blockbuster in the Apple earnings report, we will hit it the following week. But if there's something more interesting to talk about, and something, perhaps, a little bit more timely, we will touch on that then. That said, if you want some Apple earnings coverage, you can go to fool.com, where all of Evan's stuff lives. He does an excellent job covering the company. But, looking at what has already happened as of the time that we're taping this, it's been a pretty good week for tech stocks. You look back to last week ... right, Evan?

Niu: Yeah, a lot of them hit all-time highs. Microsoft, Amazon, Google, everyone just went nuts last week, all these fresh all-time record levels.

Lewis: Yeah. It's not too often that you see companies that size move more than 5%, and we saw several instances of that. To kick things off, why don't we talk about Amazon's report? The company generated $43.7 billion in revenue, which was good for 34% year-over-year growth. That resulted in net income of $256 million, roughly $0.52 per share. I mention that growth rate. If you exclude the impact of Whole Foods, the company actually grew at 29%, which is better than what they posted in Q2. So, we saw an acceleration of growth this quarter.

Niu: Yeah. It was a pretty strong quarter all around. This was actually an all-time record for them, too, in terms of the top line revenue. Which is interesting, because they didn't brag about that. You would think they would point that out or call attention to the fact that they just had an all-time record quarter. I mean, it's by a few million dollars, but still it's a pretty meaningful accomplishment. And then, as we're heading into the fourth quarter, sales will be up even more, accelerating even more into the busy holiday shopping season.

Lewis: I guess that's just a testament to how good things are going at Amazon right now, the fact that they don't even feel the need to point that out. [laughs] 

Niu: Yeah, they just left the numbers speak for themselves.

Lewis: Two things that they did point out though, for the strong performance. AWS, one of them, Amazon Web Services. We're certainly going to talk about that. And, Prime day, as well. They said they had an incredibly successful Prime day, and that drove a lot of traffic and a lot of transactions on the site. Looking at the business by segment, I think the story is more of the same from what we've come to expect from Amazon. You look at the breakouts here, and North America is doing pretty well at a super low margin. AWS is a fifth of the size and generating a ton of operating margin.

Niu: Yeah, it's kind of the same story you see every quarter. North America is the bulk of revenue, slightly profitable. International is catching up, but they're still messing really heavily structure. I think right now they're focusing really heavy on India and Japan. And speaking of Prime day, they did say that Prime day was especially successful on the international front. They had a record day in terms of sign up for free trials. I think Prime's value proposition is so strong, and investors can expect a lot of those people to convert to paying members, not that Amazon will actually disclose any of these numbers.

Lewis: Of course not.

Niu: But I think it's safe to assume that you're going to get a lot of these people converting to paying members, because Prime is just such a good deal. It's really hard not to justify it, it's such a good deal.

Lewis: Yeah, the value prop is almost silly with how much they're giving you. You touched on the international markets. As of the most recent quarter, that was $13.7 billion in revenue for them, and they are operating at a 7% negative margin for those markets. One market in particular that they highlighted was India. The company launched Prime in the country a year ago, and they have seen more members join than in any other country in the first 12 months of operation. Perhaps not shocking, given the size of the Indian market. But, obviously a good sign for their international efforts.

Niu: Yeah, absolutely. And one of those other quarters in the past year, all they talked about was India and all these little accomplishments they were doing. So, I think we're starting to see the fruits of those efforts. India is humongous. It's the second most populous country on Earth. So, there's definitely a huge opportunity there.

Lewis: And you look at what's going on with their business. We've spent so much time talking about it in the past, but it's worth harping on again here. North America contributed a $25.4 billion in revenue, primarily e-commerce. International, $13.7 billion. AWS, $4.6 billion. So, AWS was a fifth of the size of the North American e-commerce market for them, and yet it generates so much money that it allows them to invest in all these side projects. It allows them to build out the ecosystem for Prime, and it allows them to make all these experimental bets in the hardware space.

Niu: Right. I had an article on this, I think it's really under-appreciated by investors in terms of, everybody knows how much more profitable AWS is. But I think when you combine that with Amazon's characteristic willingness to invest in itself, and they don't really care about profitability in the current period or the near-term. The fact that AWS is so profitable gives them so much more room to work with in terms of flexibility and reinvesting into their own business. Consider the alternative -- if AWS was not here and they had to pay for all these side bets and side businesses with e-commerce profits, the rate at which they could be investing in themselves is really nothing compared to what they do today. So, I think it's this huge thing that really accelerates their ability to reinvest in themselves.

Lewis: And one of those little side investments, less of something that's a long time built out and more of them experimenting within their platform, is their advertising business. This is something that is very tiny in the grand scale of Amazon's total business, but I think worth touching on. The Other Revenues segment for them was up 58% year-over-year, and that segment is where Amazon puts its advertising revenue. Management had actually noted that ad revenue had outpaced revenue for the whole segments. So, it's growing very quickly. That's a nice business that's doing pretty well for them, and I think could become increasingly important down the road.

Niu: Yeah. I recall this quote from Google's chairman, Eric Schmidt, a couple of years back. I forget where he was. Someone asked him, who do you see as Google's biggest competitor? And most average people would say Apple, because Android vs. iOS. But Schmidt's argument back then a couple of years ago was, Amazon is actually Google's biggest competitor. And his reasoning was, a lot of the time, when people go to Google and plug something into the search box, you're looking to buy something. Of course, Google serves us ads that are very targeted, very relevant, and knows exactly what you want. But the point is, a lot of times, you go there when you're looking to buy something. But if you already know that that thing is going to be on Amazon, you don't go to Google at all, you just go straight to Amazon's website, search on their website for what you're looking to buy. And when you have that purchase intent, it's a really hugely valuable thing in online advertising. So, to the extent that Amazon continues to grow, and you can find literally anything on there, and that does have the potential to take away some of those traffic and engagement away from Google's core search engine and ad business, because everyone is going to go straight to Amazon and search for what they want there. More recently, eMarketer last week estimated that Amazon's ad revenue should be about $1.6 [billion]-1.7 billion this year, which would make it the fifth largest in the U.S. Of course, still nowhere near Facebook or Google in terms of the size of the advertising business. But like you mentioned, it's growing, it's becoming more important. That would be more than Twitter or Snapchat, which is kind of a crazy data point.

Lewis: I think that's good context there, because the Other Revenue segment itself for the quarter was about $1.1 billion. So, you think about the scale that everything else is operating on for Amazon, and yes, this is high growth for them, and it's a super high margin business to be in. So, it's nice that they're getting something there. But it's still pretty small in the grand scheme of things. Still worth pointing out, though. One other thing I wanted to touch on with Amazon was the fact that, this is the first quarter that we have Amazon reporting Whole Foods numbers on their books. Moving forward, you'll see Whole Foods operations being tucked into Amazon's Physical Store segment, which generated $1.3 billion in revenue for the quarter. So, if you're looking for how that's doing, that's where it's going to be. I personally think it's kind of interesting that they are classifying it as Physical Stores. It might speak to the company's ambitions a little more broadly.

Niu: Yeah, I definitely agree with you there. I think the fact that they're disclosing physical retail sales now is potentially meaningful, because it could be indicative of where they want to go in the future. If they're starting to break this out, and right now, it's all Whole Foods, but if they're starting to break this out now, it really does underscore this idea that Whole Foods is really a starting point for their ambitions for physical retail. They have so many other things they can do beyond local on-demand grocery delivery. There's now talk about them getting into the prescription drug business, pharmacy business. They wouldn't talk about it, which further stoked speculation. But there's so many things they can do which is, of course, ironic, because they've helped put a lot of physical retailers out of business. I do think they're going to add a lot more up to their sleeve in the future.

Lewis: I'm sure there will be plenty of surprises from Amazon down the road. One surprise, frankly, for me, was looking at Microsoft's results. It's insane for me to see something where Microsoft moved 7%. You think of them as a tried-and-true, chugging along company. But when a company handily beats on earnings and revenue, that's exactly what happens. The company put up $24.5 billion on the top line, 12% growth. They posted $0.84 per share in earnings. I think they beat estimates by $1 billion on the top line.

Niu: I think it's really a testament to what a good job Satya Nadella is doing and executing as CEO. I've always had a lot of faith in him, since he became CEO three years ago. I think, he really has a much more cohesive vision for the company compared to Steve Ballmer. He had plenty of mistakes throughout his long tenure. But, Nadella is really focused on cross-platform compatibility and the cloud, and they're executing and killing it.

Lewis: Their rallying cry when he first came on was cloud first, mobile first. And it seemed like it's been like, cloud definitely first.

Niu: [laughs] Yeah, they kind of backed away from the mobile, particularly on the phone front.

Lewis: And you can see that emphasis even in the conference call. You look through the order of operations for what management decided to talk about. I think they made it about 30 seconds into the call before they start talking about Microsoft's commercial cloud business. So, that's obviously a priority for them, and I think that's part of the reason why the market was so excited with these results.

Niu: Right. The big achievement this quarter was, they hit $20.4 billion in annualized run rate for the commercial cloud. Speaking of how they had to present their information, if you look at all their earnings releases over the past couple of years, that's literally the very first thing, that's the little subtitle to their earnings release is basically what this commercial cloud revenue run rate is. So, they've been emphasizing this very clearly for a few years now. Back in 2015, Nadella basically predicted, "We want to get this to $20 billion." And back then, it was about $6 billion or so. That's a pretty big, ambitious goal, to say, we want to triple this business in a few years. And he predicted that would be able to do so by mid-2018. So, they're just now kicking off fiscals 2018, but we're still 2017, so, they're ahead of schedule and they've now hit $20 billion, which is a huge milestone.

Lewis: And I think, seeing that $20 billion figure, and having just talked about Amazon's AWS run rate of roughly $18 billion, it would be easy to make the mistake to think that Microsoft is the leader in cloud infrastructure, but that isn't quite true. I think it's worth working through why that's the case.

Niu: Right. Microsoft's commercial cloud includes tons of these cloud-based, subscription-based offerings, most notably Office 365, which now has, on the commercial front, 120 million monthly active users, that's all enterprise customers. On the consumer side, they have 28 million subscribers. So, total Office 365 is about 150 million users, which is pretty strong. With Office 365 Commercial, that's obviously a huge business and one of the biggest cash cows. They also have things like Dynamics 365, which is their CRM platform that's all so deeply integrated with LinkedIn. Those are things that aren't directly related to cloud infrastructure in the way that you think of AWS. It's really just Microsoft Azure alone, which is also part of the commercial cloud. Azure is really what competes with AWS. They don't break out its revenue directly, but they did say it was up like 90%.

Lewis: Not too shabby. But, not on the scale of Amazon's AWS, at least for the cloud infrastructure side of what they're doing. Still a lot of really good cloud stuff going on at Microsoft. One of the things that I wanted to hit, too, with this earnings release was the update that we got on LinkedIn. Just as a reminder, Microsoft bought the professional social media platform for $26 billion in 2016. Management mentioned that LinkedIn is contributing positively to EPS, which is something, frankly, I was a little bit surprised to see. That's, of course, ex-purchase accounting. But, it does seem like the platform seems to be doing pretty well. It just had its fourth consecutive quarter of over 50% sessions growth, 65% year over year growth in jobs. So, there's clearly some engagement happening there. It's clearly a place that people are going. And we are starting to see a little bit more on the integration side with Microsoft products.

Niu: Yeah. This is going to be exactly what they outlined in their vision when they bought LinkedIn, which was the biggest acquisition ever, by a lot. Right now, there are about 530 million LinkedIn members. And yeah, they really helped to grow this Dynamics 365 business. If you remember before they bought LinkedIn, LinkedIn was talking a whole lot about this new sales navigator product, this whole idea of social selling. And I think, they had this vision for it, and then Microsoft buys them and now they're integrating this idea of really being able to leverage your social and professional contacts for sales people to grow their businesses. And that's where Dynamics 365 comes in.

Lewis: I'll admit, I was a little bit of a skeptic when I saw this acquisition, the purchase price and the premium that was being paid for it. I'm generally wary of huge acquisitions, especially in the tech space, because you always hear about these integrations or efficiencies that are going to be gained, all these cost-cutting measures that can be realized. 

Niu: And especially for Microsoft, too. Bad track record.

Lewis: Especially for Microsoft. But when you're dropping $26 billion on something, that can be a lot of goodwill to carry, and that can be kind of dangerous as a business. It's nice to see that this seems to be working out for them.

Niu: Yeah. They have this horrible track record. But, again, I think it comes back to all of those terrible acquisitions they bought over the years were mostly Ballmer, and now they have Nadella in charge with a much stronger vision and ability to execute. LinkedIn, the big thing is going to be the data. The data that LinkedIn has can really jump start a lot of these areas that Microsoft wants to get into, or can continue expanding into. But, yeah, it's kind of crazy how much they spend. But for now, considering the numbers they're putting up and the way they're really being able to integrate it, I'm willing to give Nadella the benefit of the doubt here, because he's really proving himself in a lot of ways, including LinkedIn.

Lewis: Well, it's nice to see a steady hand guiding the ship for Microsoft. They certainly need it. Anything else before I let you go, Evan?

Niu: I think the Surface business is interesting, too. Right now, Surface revenue last quarter was about $1 billion. All these tech giants keep pushing deeper and deeper into hardware, including Amazon, Google and Microsoft. For Microsoft, it's really about Surface. The Surface laptop just came out a few months back, and that's really what's driving sales right now. So, I do think this is another interesting area where you're going to see a company continuing to come out with some interesting announcements since going forward as they continue to bet big on hardware.

Lewis: I think it's safe to say this is not your father's Microsoft.

Niu: It's funny, because Microsoft is my dad's largest position, because he's held Microsoft for 30 years.

Lewis: So, he's probably doing alright. [laughs] 

Niu: He bought in in 1987, and literally still has it. And as you can imagine, Microsoft in 1987 was tiny, and it's humongous now. So, he loves Microsoft. [laughs] It is my father's Microsoft.

Lewis: I'm talking to the wrong Niu here. I should really have your dad on the show. That's what I'm hearing.

Niu: [laughs] He has some good stories about weathering the ups and downs, particularly in the tech bubble. But he held on. He's a classic long-term investor. 30 years. It's kind of crazy to think about. But that's how long he's had his position.

Lewis: It's a great holding period. He's going to enjoy the long-term capital gains tax rate there.

Niu: And the dividend, he loves the dividends. [laughs] 

Lewis: [laughs] The dividend, especially if you're DRIP-ing it over that long time.

Niu: Oh, yeah. The dividends he gets per year are 3 times his initial cost basis. His annual dividend is 3 times what he originally paid back then. So, he considers it all free money. [laughs] 

Lewis: Why not? It sounds like he's doing alright. Well, say hi to him for me, Evan, and give him a shout out next time you chat.

Niu: Will do.

Lewis: Listeners, 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 over at [email protected], or tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over 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!