Amazon (AMZN -1.25%) is practically synonymous with online retail. A growing majority of Americans start their online shopping searches at Amazon.com. It recently made a big expansion into the brick-and-mortar world with the purchase of Whole Foods Market.
But comparing Amazon's business to Wal-Mart Stores (WMT 1.08%) or other big retailers doesn't do it justice. In fact, it completely misses the mark on what kind of business Amazon is.
Understanding Amazon's business is important for investors in order to evaluate its decisions like its Whole Foods purchase or its reported delivery service.
Amazon isn't a retail company. It's a services business. And the key to Amazon's services is that Amazon is its biggest customer.
A summary of Amazon's services
- Amazon Web Services: AWS is Amazon's cloud computing division. While trying to build its own infrastructure, Amazon realized it could offer Infrastructure-as-a-Service (IaaS) to other companies as well, and is now Amazon's most profitable business.
- Fulfillment by Amazon: FBA allows small merchants to use Amazon's warehouse capacity, order fulfillment operations, and its customer service team. FBA stemmed from the growth of Amazon Marketplace, the fixed-price online marketplace that allowed third-party merchants to sell items on Amazon. Amazon taking control of the operations allowed it to provide a better customer experience for shoppers as well as solve pain points for merchants.
- Amazon Prime: Prime is Amazon's loyalty membership program, which started with a flat fee for two-day shipping. Amazon has slowly added more and more benefits to the program such as video and music streaming, free e-book rentals, exclusive products, and more. With the acquisition of Whole Foods, Prime will become the loyalty program for the grocery chain as well.
- Amazon Prime Video: A video-only offering of Prime available in markets without Prime shipping benefits as well as the United States.
- AmazonFresh: AmazonFresh is Amazon's online grocery ordering and delivery service. The rollout of the service has been very slow, reaching just a few cities in the decade since its initial launch.
- Amazon Advertising: Amazon's digital advertising platform for selling more products, boosting online traffic, and/or increasing app downloads. The platform has quietly turned into one of the largest online advertising businesses in the world.
- Amazon Pay: A system that allows other online merchants to authenticate customers and use the shipping and payment information on file at Amazon to check out quickly.
- Amazon Kindle Store: Amazon's e-book store built into all of its Kindle devices.
- Amazon Music and Amazon Video: Amazon's digital media stores for downloading movies or music for devices like Fire TV or Echo speakers.
- Amazon Music Unlimited: Amazon's subscription music service. There's a low-priced Echo-only option.
- Amazon Prime Air: Amazon's experimental delivery service, in which it's developing a network of manned and unmanned cargo carriers.
Amazon makes itself its biggest customer
Amazon uses the same cloud computing infrastructure as its AWS clients. It uses the same warehouses and shipping and fulfillment capacity as FBA users. Most of Amazon's advertising supply comes from Amazon itself. Amazon uses the payments processing software behind Amazon Pay for every transaction on its websites.
This is more than just vertical integration, though. Apple (AAPL 1.55%) has done an excellent job of using vertical integration from design (in-house chip and software design), to production (owning its own laboratories), to retail and customer service (the Apple Store). But Apple's efforts go toward supporting its own products.
Amazon, on the other hand, is in the business of developing services for itself and then expanding them to the rest of the market -- even its competition. These markets are usually massive, too. In this way, Amazon has built-in demand for its products (itself), allowing it to instantly reach scale and provide competitive rates.
Putting it in context
If we look at Amazon as a customer, the Whole Foods acquisition wasn't an expansion into brick-and-mortar retail. It was an expansion of AmazonFresh.
Whole Foods is going to become AmazonFresh's largest customer.
AmazonFresh could eventually provide food delivery for numerous small grocers across the country, helping them compete with larger nationwide brands like Wal-Mart. That would also give Amazon the scale to make it economical for it to deliver groceries right to people's doorsteps.
Likewise, Amazon's efforts to develop its own delivery service aren't just a means for Amazon to cut down on its fulfillment costs. Amazon will become a full-fledged competitor to UPS (UPS -1.77%) and FedEx (FDX -1.85%). Amazon is already one of their biggest customers, so it instantly has scale. It can sell any excess cargo capacity to other retailers for competitive prices.
Amazon Prime Video -- a globally available video-streaming service -- stems from unused global rights for a lot of video content on Amazon Prime (the biggest customer of Amazon Prime Video). That went to waste in markets where Amazon doesn't have the infrastructure to support basic Prime benefits like fast shipping. Opening the video service globally allowed Amazon to price the service below Netflix and still produce a marginal profit.
Why investors need to see Amazon through the services lens
There are a couple of major implications of viewing Amazon through a services lens.
First, the profit margin on services is generally higher than on retail. Wal-Mart's operating margin last year was just 2.8%. Even UPS and FedEx -- services with relatively high operating expenses -- posted operating margins of 9% and 8.4%, respectively. Netflix's contribution margin in the mature U.S. market was 36.2%.
Amazon's AWS produced an operating margin of 30.3%. The company's retail operations in North America and internationally produced operating margins of 5.1% and -1.1%, respectively. If any other services can reach their potential scale like AWS has, the profit potential is clear.
Second, as a services business, Amazon's addressable market is much bigger than global retail. Amazon is also in the cloud computing market, the digital advertising market, the package delivery and fulfillment market, and the digital media market. These markets are all massive.
Viewed through a services lens, Amazon's market cap of around $470 billion -- one of the biggest companies in the world -- makes sense. It's one reason why it's worth more than practically all other major retailers combined. Amazon's not only their competitor; they could eventually be Amazon's customers.