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How Amazon Makes Money


Amazon reported record profits in 2018,
earning $10.1 billion in net income compared to just $3 billion in
2017. Considering the company hardly had any annual profit until
2016, this represents major growth. Whether that’s gap earnings, operating
income, free cash flow, this company hit an inflection point at the beginning
of 2018. It’s one of the reasons that the stock
materially outperformed the market. Traditionally, Amazon has funneled most of
its money straight back into the company itself, leading to meager
earnings compared to other tech giants like Apple or Google. But in
spite of this strategy, Amazon has been making enough lately that there’s still
money left after all of its expenses on inventory,
fulfillment centers and people. Amazon still doesn’t have the types
of profits that other big tech companies do, say a Google or
an Apple or a Microsoft. But significantly more than they ever have in the past
and it really allows them to do much more experimentation with
the core business. So what’s changed? Though Amazon has long dominated
the U.S. e-commerce market, online sales are not actually the biggest
moneymaker for the company. Its e-commerce division isn’t even profitable
internationally. Instead, Amazon Web Services, or AWS, has generated
the majority of the company’s operating income since 2016. AWS is Amazon’s cloud computing division,
comprised of a huge network of servers providing processing and
storage solutions for companies, government agencies and individuals. What that did for Amazon is it
turned Amazon into a technology company as well as being
an e-commerce and retailer. Its clients, which include Netflix, Airbnb
and Yelp, are charged for their volume of usage, the features they
subscribe to, and the services they use. AWS really started to grow about four
or five years ago and became a significant force in computing. Amazon Web Services continues to get
bigger as a percentage of overall revenue and it’s a highly profitable
business by Amazon’s standards but by most corporate standards. It’s doing
something like 30 percent operating margins. In 2018, AWS brought in 7.3
billion dollars in operating income and 25.7 billion dollars in revenue which,
for reference, is more than both McDonald’s and Macy’s. In this last quarter, AWS was
58 percent of total operating profit for Amazon. So it’s still clearly the
profit driver for the overall company. In fact in 2017, AWS was
actually more than 100 percent of Amazon’s operating profit. So without AWS, Amazon
would not have been making any money. But though it’s a huge
reason behind Amazon’s recent profitability, other areas of the company are seeing
major growth as well. The fastest growing division of Amazon is its
other category, comprised mainly of its advertising business. It grew 95 percent
in the fourth quarter of 2018 and brought in $10.1 billion in
revenue for the year overall. As Amazon has become the center of
commerce for a lot of businesses, it’s becoming a huge
advertising play as well. They don’t break out the profits
of this, but looking at comps like Facebook and Google, it’s almost
certainly also in that 30 percent operating margin range. If advertising continues to grow at
this rate, some analysts even predict it will be more
profitable than AWS by 2021. The last segment experiencing major
growth is the third-party marketplace. While Amazon traditionally buys products
in bulk from wholesalers and sells them at a slight
markup, in the third-party marketplace outside companies pay Amazon to sell their
goods using its platform. Amazon takes about a 15 to 20 percent cut
of the sales, while also collecting fees for things like storage and
shipping. While Amazon generates significantly less revenue from third-party merchants
than from products it sells, margins are much higher, making
it more profitable than the traditional model. If you assume even a small
5 percent margin, you’re talking about potentially two billion dollars
in profit just from third-party contributing to overall Amazon. Today, more than half of all
goods sold come from third-party sellers, and more and more businesses are
signing up. Sales of third-party seller services rose 34 percent in
2018 to 42.7 billion dollars. You really have to be on Amazon,
unless you are going to go it alone. Amazon is the only place where
you can instantly get scale without having to do all of the marketing yourself. Amazon smart speakers
also have analysts excited. The last thing I find really interesting
is Alexa. So you now have an installed base of over 100
million of these voice-activated devices. Over time, you’ll find yourself increasingly
turning to Alexa, and say “Alexa, order more coffee.” And it’s one
of those things that will accelerate the move of Amazon into two places,
the pantry and into the refrigerator. The boom in all these
categories, from Alexa to cloud computing, advertising and third-party seller divisions,
raises the question of how the company should be valued. At the size of the company now,
well over 200 billion dollars in annual revenue, it’s just really hard to grow
at 20 plus percent. So that means these investors who have expected
high growth repeatedly every quarter are now looking at a company with
slowing growth but lots of profitability. There’s clearly some consternation in the
investor community as to how to value Amazon today.

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