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Why Amazon is not making money

The world’s largest online retailer, Amazon.com  (NASDAQ: AMZN ) , posted great third-quarter results in terms of revenue and user metrics. From a revenue perspective, with US$17.09 billion in net sales for the third-quarter, Amazon’s business is doing great. Total units sold were up 29%, while third-party units sold increased 33%. In terms of user metrics, Amazon is on its way to becoming a major global hub for online activity, together with Facebook and Google. Active users increased 19%, reaching 224 million.

However, the company is barely making money. Although gross margins slightly improved thanks to third-party sales, the company converted less than 2% of its revenue into operating income. Amazon’s net loss was US$41 million in the third quarter, or US$0.09 per diluted share. Why is Amazon not making a profit?

It’s all about long-term growth

Amazon isn’t making profits simply because it is in investment mode. This may sound surprising, considering that 19-year-old Amazon is the world’s largest online retailer, not a new start-up.

Source: Statista

However, for Amazon’s CEO and founder, Jeff Bezos, the company is only at the beginning of a long journey. Few managers have a longer vision than Bezos, who isn’t afraid of going beyond retail. Amazon has successfully created a cloud server farm, established its Kindle as a best-selling tablet, entered into the online streaming market with Amazon Prime, and is rumored to be working with HTC on a smartphone.

Therefore, although Amazon may be a veteran in the online e-commerce field, it is a start-up in the online streaming market, cloud server business, and educational software segment. This explains why the company spends so much of its revenue. It is investing in every segment that management identifies as having growth potential. Because Amazon is present in many markets, it’s normal to see low margins. Remaining competitive in multiple markets requires heavy investment.

As Amazon gains market share in new markets, consolidates its position as the standard cloud server choice, and expands its e-commerce business in emerging economies, profitability should improve. Meanwhile, its US$166 billion market valuation is safe, as companies are not worth the present value of current cash flows, but the present value of their future cash flows.

The curse of being too profitable

Usually, investors tend to focus on high profitability when looking for investment opportunities. However, in order to protect current high margins, sometimes a very profitable company may avoid entering into low-profit segments that have high future growth potential. This could be a huge mistake in the tech world.

With US$41.7 billion in net income generated last year, Apple (NASDAQ: AAPL)  became the second most profitable company in the world, according to Forbes. The ability of Apple to sell its devices at a high premium allowed the company to accumulate more than US$150 billion in cash and cash equivalents.

However, Apple also generated an addiction to high margins. The company maintains an unsustainable premium pricing strategy in an increasingly competitive smartphone world. Furthermore, considering the low end of the smartphone market is expected to grow faster than the high-end segment, Apple’s market share is in danger.

Future profitability is more important

The king of retail, Wal-Mart  (NYSE: WMT) , made almost US$17 billion in profit last year. However, the company faces a strong trade-off relation between keeping its margins at decent levels and pursuing sales growth. In order to keep comparable-store sales growth in the 2% range, the company needs to invest its gross margins to lower prices. Considering there’s a heavy and unsustainable reliance on price cuts to attract customers, future profitability remains uncertain.

Final Foolish takeaway

Amazon’s poor profitability is not a problem, as the company is using most of its revenue to aggressively invest in new products. It is investing in warehouses and data centers. It is selling its Kindle fire at cost price, and giving one-year free Amazon Web Services subscriptions to developers. Amazon is investing for the future.

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A version of this article, written by Adrian Campos, originally appeared on fool.com.

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