Walmart (NYSE:WMT) continued its strong e-commerce sales growth in the fiscal third quarter with U.S. online sales climbing 79% year over year. While that's a slowdown from the 97% growth the company reported the previous quarter, management provided some upbeat comments during the earnings call.

During the third quarter, Walmart saw "significantly reduced operating losses in e-commerce." That's extremely promising considering it was looking at losing $1 billion in its online operations just a year ago.

Here are three factors leading to improved profitability for its online business.

Walmart.com boxes coming down a conveyor belt.

Image source: Walmart.

Third-party sales

Third-party sales were by far the biggest factor impacting Walmart's online operating profits in the third quarter. Management said sales from its third-party marketplace increased by a three-digit percentage, considerably faster than its overall sales.

Walmart's marketplace carries much higher margins than its first-party sales. Walmart simply charges a service fee for listing items on its website, and its marginal cost of sales is minimal. It's the model that's led Amazon's (NASDAQ:AMZN) retail operations to start producing significant operating margin after years of losses. Third-party seller services grew 55% year over year for Amazon in the third quarter as its marketplace continues to grow faster than its first-party retail operations.

Walmart is also working to copy one of Amazon's most successful third-party services by fulfilling orders for its marketplace merchants. The company introduced Walmart Fulfillment Services in February, and management sees it as an integral part of the e-commerce strategy going forward. A robust fulfillment service similar to Amazon's could attract more merchants to its marketplace, further growing third-party sales.

Advertising

Another key component to Walmart's push toward profitability is its online advertising business. While it's still small, digital advertising also has a very high profit margin for Walmart.

Management didn't break out any details of its advertising business, but as more sales move online, marketers have shifted their ad budgets. E-commerce channels like Walmart and Amazon have been some of the biggest winners with the former set to bring in a total of nearly $850 million in digital ad sales this year, according to an estimate from eMarketer. That's up 73.4% year over year -- faster growth than any other e-commerce company. Walmart's market share is set to continue expanding over the next few years, reaching 7% of the e-commerce channel advertising market by 2022, up from 4.9% this year.

It's worth noting, however, that Walmart's online ad sales may cannibalize its in-store advertising in the future. If the shift to online sales is permanent, as management suggests, and people return to their previous shopping habits as restaurants and other smaller retailers reopen, in-store traffic will drop, decreasing the value of in-store advertisements. Last quarter, Walmart's total transactions in the U.S. fell 14.2%, suggesting lower foot traffic as shoppers consolidate their trips.

Limiting fulfillment center build-out

Another factor that's worth pointing out is Walmart's ability to grow its online sales without a massive build-out in fulfillment centers. Walmart has opened just three e-commerce fulfillment centers in 2020, according to MWPVL International. It has just three more in the works, which would bring its total to 28.

By comparison, Amazon is opening dozens of warehouses, fulfillment centers, and delivery stations every month. The effort is capital intensive but quickly enabling it to expand its next-day fulfillment capabilities and cut down on ongoing shipping expenses.

Instead of using more warehouses, Walmart is leaning on its existing stores for fulfillment. It fulfilled orders from 2,500 stores in the fiscal second quarter but pulled back in the latest period as it was able to open more fulfillment center capacity. The ability to use its stores will cut down the overhead that comes with running a huge number of warehouses. That said, Walmart has hired extra workers to help pick products from the shelves in stores, but it's also using artificial intelligence to help make them more productive.

In the long run, Walmart will need to build out additional warehouse capacity if it wants to fulfill orders for third-party merchants. And as online sales continue to grow, it'll need more resources dedicated to online orders. So, limiting fulfillment center build-outs now is pushing it toward profitability, but it's not necessarily best for the long-term goals of Walmart.com.

Walmart may move more aggressively with new fulfillment centers as its high-margin marketplace and advertising businesses keep expanding. That will allow it to operate closer to breakeven as it continues to grow. Still, it has a long way to go, and not being as aggressive now could hold it back in the long run. 

Walmart may show continued improvements in operating losses for its e-commerce business, but long-term investors in the retail company should pay closer attention to management commentary on the progress of its marketplace and advertising businesses and plans to expand fulfillment capacity to see if it's sustainable.