Why the Amazon of the Future Could Be Much More Profitable Than It Is Today

MarketsMotley Fool

Amazon (NASDAQ: AMZN) began life as a humble bookseller before branching out into all corners of retail. Today the company is best known as an e-commerce giant, with online retail sales set to top $100 billion this year.

But Amazon is much more than just an online retailer. In fact, Amazon's financial reports reveal a company that is playing by different rules than its competitors. Rather than driving profits with online retail, as its peers do, Amazon is using e-commerce business to draw in customers and create a massive ecosystem, which it then leverages to generate profits in a number of other ways, including subscription services like Prime, third-party services through its marketplace, and advertising.

Continue Reading Below

A shifting business

Amazon's business is built on its e-commerce operations. Its hundreds of warehouses in the U.S. and around the world give it the ability to stock a wide range of inventory and achieve the two-day delivery promised by its Prime loyalty program. However, growth in direct sales -- meaning transactions that Amazon handles entirely itself -- have slowed recently. In the last two quarters, Amazon reported sales growth from online stores, excluding foreign exchange, of just 13% and 12% respectively, its two slowest quarters since it started reporting results in 2016.

That pace is notably behind e-commerce growth nationwide, which stood at 15.8% over that time period. It also signals that Amazon is losing market share to rivals like Walmart and Target.

However, rather than being a sign of the company's challenges, that slowdown seems representative of its success. Online retail is a notoriously low-margin business, often yielding lower margins than traditional brick-and-mortar retail as online sellers have to deal with shipping costs and process returns. Therefore, it's not a great way to generate profits.

Amazon now controls about half of online sales in the U.S., but the businesses enabled by its e-commerce success are growing much faster and generating significant profits along the way. Subscription services, which include Prime along with Kindle Unlimited, Amazon Video, and Amazon Music, jumped 57% last quarter to $3.4 billion. Prime recently reached 100 million members, showing how successful the loyalty program has been.

Third-party seller services, which include commissions, fulfillment, shipping fees, and payment processing, may eventually be the company's biggest business, as sales in the category jumped 39% in the most recent quarter to $9.7 billion. Since Amazon's marketplace business relies on infrastructure already in place to support the company's own e-commerce operations, it is likely highly profitable, especially given that marketplace businesses like eBay tend to generate significant profit margins.

Finally, advertising may now be Amazon's fastest-growing business, and one made possible by its strength in e-commerce. In its most recent quarter, other revenue, which is primarily made up advertising, jumped 132% to $2.2 billion. Over the last year Amazon has doubled the number of sponsor ads in its searches, unlocking a potentially huge revenue stream, one that has driven tens of billions in profits for tech giants Alphabet and Facebook.

Amazon doesn't report profits in those individual segments, but the bottom-line growth from those businesses can be see in North American operating profits, which jumped from $436 million to $1.8 billion in the second quarter. Though the Whole Foods acquisition contributed to that improvement, it likely only added $250 million in operating income at most during the period.

Don't forget AWS

Meanwhile, Amazon's cloud computing division, Amazon Web Services, continues to put up blockbuster growth, along with much of the cloud computing industry. In the most recent quarter, sales jumped 49% to $6.1 billion, and operating income surged 79% to $1.6 billion. More blockbuster growth should be on the way in the cloud segment as businesses continue to tap its scalable service to meet their needs. In fact, one analyst sees AWS revenue tripling to $60 billion by 2022.

Add it all up and you have a much different Amazon than even five years ago. It's a unique business with a huge economic moat that can leverage its giant e-commerce operations to generate wide margins in areas like third-party seller services and advertising.

That's one big reason why Amazon just topped $1 trillion in market value, and why it could soon be the most valuable company in the world.

10 stocks we like better than AmazonWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Amazon wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 6, 2018

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Facebook. The Motley Fool recommends eBay. The Motley Fool has a disclosure policy.