Why Amazon is not making money

Although gross margins slightly improved thanks to third-party sales, the company converted less than 2% of its revenue into operating income

a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

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.

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

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »