Has Amazon Uncovered the Secret to Increased Profitability?

Amazon’s (NASDAQ:AMZN) Chief Executive Officer Jeff Bezos has told investors time and again that the focus of the company is on creating new opportunities and growing its business, not generating massive profits. Evidence of this ethos is very clear in the company’s recent quarterly results; the e-commerce behemoth reported slowing revenue growth and lower-than-expected profit Thursday, while giving a disappointing guidance for the current quarter. For analysts, these results only further exacerbated concerns about the health of the company’s business beyond the United States. Ever since last quarter, the company’s razor thin margins — which have held back profits — have been under their microscope.

However, a transformation is underway. As Reuters reported, Amazon seems to have discovered the secret to being more profitable: sell less physical goods. This fundamental shift — from physical goods to digital goods — is taking place in the United States. The Internet retailer built its business on shipping books and other physical items quickly, and now the company is attempting to implement the same idea but in the digital world, where profit margins are higher.

With its fast-expanding third-party merchant business, where Amazon takes a cut of sales from seller listings on its website, its operating margins will also likely improve. “Over the long term it does help margins,” Macquarie analyst Ben Schachter told Reuters. “You don’t have to put these things on a truck and ship them.”

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Amazon’s results show evidence that the shift in its business has begun to help the company’s numbers. In the first quarter, net shipping costs were 4.7 percent of sales, a decrease from 5.1 percent in the year-ago quarter. The company has followed all the strategies usually employed by retailers to boost margins; it has placed its distribution centers closer to customers and charged its partners more to ship goods. But Amazon has also diversified into other revenue streams, including digital content, advertising, and the Amazon Web Services cloud computing business…

Digital is clearly becoming a top priority; in Amazon’s Thursday earnings press release, the company outlined 14 highlights from the first quarter and all but one was related to its digital business. Even more telling, the Internet retailer’s top-10 selling items during the first quarter were digital goods or Kindle gadgets, as Chief Financial Officer Tom Szkutak told analysts during a conference call. “That is the first time that we have seen that,” he said, according to Reuters.

However, there are challenges ahead. Amazon’s business faces pressure from sluggish economic growth in Europe and difficulties breaking into emerging markets like China, where competition is intense. Still, analysts believe that the company’s focus on pushing digital content — by selling Kindles at close to cut and undercutting much of the competition — is a winning strategy. Using the Kindle enables Amazon to get its content in front of more customers. The company has even begun gaining on Apple (NASDAQ:AAPL) in the digital music arena, tripling its market share over the last five years.

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Amazon Web Services, which provides data services to a wide range of companies, will be an important revenue driver in the future as well. AWS generated $1.8 billion in revenue last year, and in the most recent quarter, net sales in Amazon’s “other” line, which includes AWS in North America as well as advertising services, increased 59 percent.

“What we’re seeing is that Amazon is really getting leverage from shipping costs. AWS is becoming a big part of their mix. They are also benefiting from a greater mix of advertising revenues. We’ll continue to see that improve,” Topeka Capital’s Victor Anthony told Reuters.

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