How Amazon Makes Money - YouTube

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.