How does Amazon make money?

Really, how does it?...

Amazon has long been seen as something of an anomoly in the business world. The company is all over the map when Wall Street attempts to guestimate its quarterly earnings, and when Amazon does manage to make money on razor thin margins, it reinvests all of it back into the business—a business that is nearly 20 years old and still laboring to stake its claim in the e-commerce land grab.

How does Amazon make money? Good question.

Amazon seems a little ADD when you break down all of its revenue sources. There’s the traditional e-commerce platform, its third party marketplace, Prime subscriptions, Web services, and hardware—which doesn’t actually make any money.

Once upon a time, Amazon sold books. Online. Ta-da! That was the jist of things. And then it expanded into other product categories. The overall goal was to be a convenience shopping service—you could go on Amazon and find that hard-to-locate book or lamp or whathaveyou, and have it shipped to your doorstep. But as more retailers like Target and Walmart began to move into the e-commerce space to keep up with changing shopping habits, Amazon’s “convenience” angle morphed into a “cheaper” angle.

Because Amazon is selling non-exclusive items, the only way to differentiate from competitors was to slash prices. So began the Great Showrooming Controversy, in which Amazon began encouraging customers to check out products in brick-and-mortar stores (like Target and Walmart) and then hunt them out on Amazon for a price comparison. Amazon even released its price comparison app Price Check in 2010 for that very reason. Sick of being used as showrooms, Target and Walmart subsequently kicked all Kindles and Kindle products out of their stores.

But taking the same bauble sold on millions of other e-commerce sites and offering it for less does not a winning strategy for high profit margins make. Sure, it helps with gaining market share, but how long will Amazon be able to keep that up? Amazon’s after-tax margin currently stands at a puny 1%--where it used to be 6.6% in 2004. But Bezos and company didn’t build Amazon into what it is today by being stupid. It’s likely that the company has a larger strategy in mind.

For now, let’s look at how Amazon IS making money. Let’s start with Amazon’s basic retail business.

General Retail

In 2012, Amazon’s net sales (all sales including AWS and commission from third party sellers) totaled $61.1 billion, accounting for 7% of the entire $900 billion global e-commerce market. The company’s retail sales totaled $51.7 billion, which is the equivalent of the sales of the next six non-auction based retail sites combined. Amazon’s Electronic and General Merchandise division accounted for $38.6 billion in 2012, a 35% increase over 2011.

Third Party Sellers

Amazon doesn’t reveal how many third party sellers it has in its marketplace, but some 40% of all goods sold on the site are via third party sellers, accounting for roughly 12% of Amazon’s total revenue. Amazon’s relationship with third party sellers has been a rocky one, with some sellers accusing Amazon of withholding payments for longer than the maximum holding period. There’s also the fact that some sellers find that Amazon becomes a competitor, selling the same item for less and with free shipping to boot. But for Amazon, third party sellers present a unique market research opportunity. Amazon can track purchases made through its marketplace, which means it can get CRM data on customers who have never actually purchased an item from Amazon.

Amazon Web Services

AWS doesn’t account for a large share of Amazon’s revenues, but it’s still nothing to sneeze at. In the third quarter of 2013, AWS generated $850 million in revenue, more than double that of Q3 2012. AWS is expected to generate $1 billion in the fourth quarter, at which point it will have generated an estimated $3.2 billion for the entire year. It doesn’t seem like much in the grand scheme of things, but when you consider the fact that Amazon’s revenues in 1997 totaled just $147.8 million (itself, an 838% increase over the $15.7 million the company made in 1996), $3.2 billion isn’t bad.

Kindle Family

Let’s be clear on this one: Amazon makes no money on the Kindle Fire itself. Jeff Bezos finally admitted as much this year, revealing that Amazon actually breaks even on each device. So what’s the point? The point is that each Kindle Fire is a content driver. Customers are more likely to buy books, magazines, and watch movies and TV shows via Amazon Instant Video, so Amazon can afford the loss in order to undercut competitors Apple and Google. Each Kindle Fire also comes with a free one-month Prime trial, the significance of which will be explained in a moment.

So why is content such a big deal? Because it accounts for nearly a third of Amazon’s revenues.

Media and Content

Amazon’s media revenues for 2012 were $20 billion, an increase of 12% over 2011. The division grew 15% in North America and 10% internationally. And the segment is likely to grow this year as Amazon invests more heavily in original content. The company has already moved into the publishing game, and now it’s producing its own TV shows, including “Alpha House” and the newly released “Betas.” There are lots more on the way, too.

One big way that Amazon is driving more content purchases is through its Prime subscription program.

Prime

Each Kindle Fire comes with a free one-month Prime subscription, which means newbies get a chance to experience the awesome sauce of free two-day shipping and a wide array of free movies and TV shows, including Amazon’s original programming (“Alpha House” and “Betas,” to start with). Once users get a taste of Prime, they realize that the sticker price of $79 a year is well worth it.

But Prime isn’t just a content driver like the Kindle Fire. Prime is actually a veritable revenue generator in itself. Earlier this year, a report by Morningstar analyst R.J. Hottovy estimated that Amazon had 10 million Prime subscribers by the end of 2012, up from four million at the end of 2011. The Kindle Fire played a big role in that growth, as subscriptions exploded after Amazon began offering the free 30-day trial with each Kindle Fire purchase. And while Prime subscribers only represent about 4% of Amazon’s 182 million active users, they represent 10% of all purchases. Prime subscribers also spend more than non-subscribers: $1,200 versus $500, respectively.

And that $79 annual subscription fee? Pure profit. Specifically, Amazon pockets $78. It breaks even on shipping and all of the other things it offers Prime subscribers, but that $78 per subscriber works out to make up one-third of Amazon’s consolidated segment operating income in 2012, according to the report.
Amazon is always growing and adding new sources of revenue. Its annual revenue has grown by an average of 32% every year for the last 10 years, and that’s due largely to Amazon’s ability to innovate and adapt (remember when the company used to take a loss on e-books in order to sell more Kindles? Now it’s the reverse). While Amazon started off as an online book retailer, it’s now an e-commerce company, media company, and a hardware maker. Who knows what it could be 10 years from now.