1 Change Could Make Amazon’s Profit Explode

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If there's been one knock against Amazon.com (NASDAQ: AMZN) as an investment, it's been the company's lack of substantive profit. Still, investors have been willing to afford the company nosebleed valuations based on its considerable growth.

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Amazon produces most of its revenue, 91% as of fiscal 2016, through its low-margin retailing business (international and North America). Founder and CEO Jeff Bezos is hell-bent to compete on price with a mantra "Your margin is my opportunity." The company has not only survived in this notoriously cutthroat industry, but has thrived thanks to its aggressively low prices (even when it meant sacrificing margin).

After decades of producing losses, the company has recently become reliably profitable on the back of its higher-margin Amazon Web Services (AWS) division. However, it's another division that Bezos could focus on if the company wants to see its stock push higher, at least in the short term: international retailing.

Axing international retail could make Amazon significantly more profitable

In the company's annual report, Amazon reports revenue and operating income from three business segments: North American retail, international retail, and AWS. Below are revenue, operating income, and operating profit margin attributable for each segment for the last three reported years.

Metric 2014 2015 2016 CAGR
North America Revenue $50,834 $63,780 $79,785 25.3%
North America Operating Profit $360 $1,425 $2,361 156.1%
North America Operating Margin 0.7% 2.2% 3.0%
International Revenue $33,510 $35,418 $43,983 14.6%
International Operating Profit ($640) ($699) ($1,283)
International Operating Margin (1.9%) (2%) (2.9%)
AWS Revenue $4,644 $7,880 $12,219 62.2%
AWS Operating Profit $458 $2,233 $4,186 202.3%
AWS Operating Margin 9.9% 28.3% 34.3%

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Although Amazon's AWS division produced only $12.2 billion in revenue in 2016, the division produced the bulk of the operating profit due to its 34% operating margin. While the company is mostly known for its e-commerce business, Amazon's North American retailing contributed approximately 50% less to operating income than AWS with significantly higher income due to its much lower profit profile. At these profit margins, North American retailing would need to produce 11 times more revenue than AWS to surpass its profit.

Which brings us to international retailing: Despite generating $44 billion in revenue, international retailing remains unprofitable. Even worse, the company's operating margin continues to deteriorate even with sales growing at a rapid clip, growing losses in the division and pointing to dis-economies of scale. If this segment wouldn't have existed, Amazon's operating income would have been 31% higher in 2016.

In fiscal 2016 (the company hasn't reported full-year 2017), Amazon reported $2.4 billion in net income, or $4.90 per share. Using back-of-the-envelope math, and keeping all other below-the-line items equal, EPS without international retailing would have been approximately $6.40 that year.

Here's why Jeff Bezos should ignore this advice

For a Wall Street myopically focused on short-term results, any action by Amazon to ax its international retailing division to produce more profit could lead to a short-term, perhaps aggressive bump in the stock price. As previously stated, the knock against the company is the lack of significant profit. Killing this division would immediately improve operating and net income margins.

While astute investors may note Amazon is afforded nosebleed valuations on account of top-line growth, I'd counter with the fact that international is the lowest revenue growth segment over the prior two years, trailing North America by 10.7 percentage points and AWS by nearly 50 percentage points.

However, for long-term investors, this would be a mistake for a few reasons. Amazon's investing thesis is predicated on having the company eventually become the worldwide e-commerce leader, which will not happen if it operates in only three countries. Additionally, international retail establishes a relationship for future services like AWS. Finally, like its North American retailing operations, Amazon is more focused on the long term than immediate profit. In an interview at the Internet Association's gala, Bezos responded to a question about time frames:

When somebody ... congratulates Amazon on a good quarter ... I say thank you. But what I'm thinking to myself is ... those quarterly results were actually pretty much fully baked about 3 years ago. Today I'm working on a quarter that is going to happen in 2020. Not next quarter. Next quarter for all practical purposes is done already, and it has probably been done for a couple of years.

Could Amazon maximize short-term profit and most likely get rewarded by axing its international retail business? Probably. Should it? Not a chance.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jamal Carnette, CFA owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.