How 1 Little-Known Business Makes Almost All of Amazon's Money

Earlier this week, Amazon announced that its retail operations had another record-breaking holiday quarter, with millions of its own devices flying off the shelves and over one billion items shipping for free in the U.S. thanks to the company's Amazon Prime offering.

It would be easy to assume Amazon is raking in money thanks to its e-commerce dominance.

The truth is that Amazon does make some money with its marketplace, but it pales in comparison to how much the company's real cash cow makes.

In this video from our YouTube channel, we break down Amazon's business and explain how Jeff Bezos and company have attacked the online opportunity.

Those unable to watch may read a text version of the video below.

Dylan Lewis: This winter should be another record-breaker for Amazon (AMZN -1.65%) -- experts have estimated that the company will pocket 40% of online holiday shopping. That kind of activity might sound like the kind of thing that would mean big money for Amazon...but that's not exactly the case. 

I'm Dylan Lewis from The Motley Fool, and in this video, we're going to break down how retail doesn't actually make much for Amazon, where the real cash cows are for the online giant, and run through just how big Amazon's empire really is.

To do that, we hopped into "Bezos," a conference room here at Motley Fool HQ that's named after Amazon's founder. 

In the first nine months of 2019, Amazon did more than $100 billion in worldwide product sales -- $109 billion, to be exact. That may sound huge, but it's less than what Walmart (WMT 0.57%) sells in product in a single quarter.

Getting down to just how much Amazon actually makes on those retail sales is hard -- the company doesn't break out operating income for just its product sales, so we have to look at its various business segments.

The company breaks things out into three categories:

• North America
• International
• AWS (Amazon Web Services)

North America and International both include mostly consumer-facing e-commerce things like product sales, but they also include services sales, which is a catch-all for things like Prime memberships, content subscriptions, advertising, and other services. 

So far in 2019, Amazon's North America segment posted operating income of $5 billion on revenue of over $117 billion, and its international segment lost $1 billion on $50 billion in sales. 

That means the North America segment has about 4% margins, even when you include all the other non-product sales. Those "other" things include advertising, which is estimated to be about a $10 billion business for Amazon this year, and that revenue is way higher-margin than e-commerce sales. 

So, that 4% North America margin is being subsidized by other stuff, meaning Amazon's true e-commerce margins are likely in the very low single-digits, which kind of makes sense. 

Jeff Bezos is often attributed with the quote: "Your margin is my opportunity." Amazon's approach to retail has been to be a low-cost provider that can't be beat on convenience. 

The company made free shipping table stakes and is now pushing same-day delivery. It's great for shoppers, and it's totally in line with Jeff Bezos' plan from the beginning. Here he is in 1999 explaining Amazon's focus:

Sometimes people ask us, are you a book company or a music company, or now are you a toy company or...? And we're none of those things. We're trying to be a customer company. And you can sort of uniquely do that well on the internet because of the possibilities for personalization, and you know, putting each individual customer at the center of your universe. And if you can do that, you'll have something completely new.

This focus has gotten Amazon to the point where it owns about 40% of online sales, which has enabled it to build a nice complementary advertising business that could be a huge boost for the company down the road. But putting the customer first -- to such extreme lengths -- is expensive. You have to compete on price and invest heavily in your infrastructure and supply chain. So, where does the money come from? 

AWS. Amazon Web Services is a lesser-known part of Amazon's operations, but it does the heavy lifting when it comes to Amazon's finances. 

The segment is the one-stop shop for most of the tools and services that businesses need to start something online, and it has proven wildly successful. Based on estimates, AWS owns about 50% of the public cloud infrastructure market, leaving competitors like Microsoft's (MSFT -2.45%) Azure and Google (GOOG -1.96%) (GOOGL -1.97%) Cloud in the dust. 

And the segment has done $6.6 billion in operating income on $25 billion in revenue so far in 2019. Going back to our margins breakdown before, $1 in AWS revenue is worth about $6 of sales in the company's North American retail segment.

AWS was born from engineers at Amazon looking to standardize Amazon's IT infrastructure and make it more efficient. As the team was crafting a plan to do so internally, they also realized that infrastructure-as-a-service could be a very valuable offering, so they pitched it to Jeff Bezos. 

Bezos liked the idea. That's no surprise; it fit directly into his idea of how the company should be seizing the online opportunity. Here he is again in 1999 explaining his mentality. 

This is the one of the most unusual business events of all time, sort of what's happening as a result of the internet, this big dislocation it's caused, and our sort of insurmountable opportunity.

Bezos has always looked at all things internet as a green field of industries and segments whose value hasn't yet been realized and whose ownership is up for grabs. 

AWS is the company's most high-profile success now, but based on all of the company's other online operations, it's likely there will be more to come. If you name a market segment, chances are, Amazon plays in that space. 

The company has internally developed offerings in streaming, smart home products, logistics, and e-readers, but it has also acquired names that have immediately given the company huge market share in key spaces:

• Grocery? Amazon owns Whole Foods.
• Video game streaming? Amazon owns Twitch.
• Prescription drugs? Amazon owns PillPack.

On their own, all of these things are helpful. But together under the same umbrella, they reinforce the others' strengths. Prime members have access to free shipping options, but they also get access to Prime Video, Prime Music, savings at Whole Foods, etc. 

As Amazon's offerings grow, it can nudge Prime customers to use PillPack, or try Twitch Prime, and all of that means more money for Amazon.

Shoppers might be familiar with the idea of a loss-leader -- it's a product a store is willing to sell at a loss (or break even) in order to get people into the stores, where they'll also add other items to their cart. 

That's effectively what Amazon's retail operations do. They don't make a ton of money on individual sales, but they entice people to shop, which encourages them to get a Prime membership, and then they tread further and further into the Amazon ecosystem. And the deeper they go, the more money for Amazon.

Estimates from Consumer Intelligence Research Partners estiamte that Prime users spend twice as much as non-members on Amazon, and that gap has widened over the past few years.

You can call e-commerce the "gateway" for Amazon, and while we generally think of e-commerce as having "arrived" -- the reality is that it only makes up somewhere between 10% and 15% of U.S. retail right now. 

So, while Amazon is absolutely dominant, it looks like there's a lot more green field ahead for Jeff Bezos and company.