Third-Party Growth Has Made Amazon.com, Inc. Stock A Less Risky Investment

Amazon.com (NSDQ:AMZN) stock has been on a tear, gaining close to 18% over the past two weeks since the company delivered impressive Q1 2016 results where the company beat analyst estimates on both the top and bottom line. Amazon reported revenue of $29.13B, good for a robust 28.2% Y/Y growth while EPS of $1.07 was a massive improvement compared to EPS of -$0.12 the company posted in the previous year’s comparable quarter. This marked the fourth consecutive quarter that Amazon has been in the black after years of losses and occasional thin profits.

Flickr

Amazon has its cloud services AWS, to thank for its recent run of profits. AWS posted revenue of $2.57B, up 64% Y/Y while the segment posted an operating profit of $604M, up a robust 210% Y/Y. It’s important to note that AWS contributed just 8.8% to Amazon’s top line but an impressive 56.4% of the company’s operating income. With AWS growing so fast and supplying the bulk of its profits, it’s perhaps safe to say that Amazon’s days as a loss-making business are now behind it.

Third-Party Growth Feeds Into The Long-Term Investment Thesis

While much of Amazon’s profitability can be traced to its AWS cloud, there is another equally healthy trend in Amazon’s business that investors tend to overlook: third-party (3P) business outgrowing first-party business. Five years ago, Amazon was a predominantly a first-party e-commerce business with the company directly handling 64% of all customer orders. Right now that has fallen to just 52% with 48% of Amazon’s retail business coming from third-party sellers on its website. Fulfillment by Amazon grew to cover 38.2% of third-party orders in Q1, up from 32.1% a year-ago.

An e-commerce company that is heavily reliant on first-party business faces a much higher inventory risk due to its goods becoming stale or even obsolete in the case of technology products and electronics. Third-party margins also tend to be much better than first-party margins. One reason why this is the case is because it allows large businesses such as Amazon to utilize their warehouses, fulfillment centers and other logistics much more efficiently thus leading to a higher return on investment.

More efficient 3P operations allow such businesses to enjoy much better margins than 1P businesses. Alibaba (NYSE:BABA) is almost predominantly a third-party business; Amazon has its e-commerce business split almost evenly between first-party and third-party while JD.com (NSDQ:JD) is predominantly a first-party business with 3P contributing only 20% to its top line. This readily reflects on the profit margins of the three businesses. Amazon sports an operating margin of 3.68%. But when you back out the contribution by AWS, Amazon’s e-commerce business sports an operating margin of just 1.76%. Meanwhile, Alibaba sports an operating margin of 36% while JD.com sports an operating margin of -1.6%. Amazon’s margins could arguably be better were it not for the company’s penchant to cut prices to the bone in a bid to steal market share from brick-and-mortar stores. But judging from the company’s accelerating top line growth, this controversial strategy has been a resounding success. Many big-box retailers have lately been having a slog trying to grow as evidenced by their latest earnings reports, and one cannot help suspect that Amazon has been growing at their expense.

Conclusion

So even as AWS continues to drive big profits for Amazon.com, more third-party sellers using the platform to do their business is also going a long way to improving the company’s bottom line. Amazon’s third-party segment is growing much faster than first-party business and this trend is continuously improving Amazon’s profit margins. There is a good likelihood that Amazon’s operating margins will grow from the current 3.7% to cross 10% in less than five years. With a fast growing top and bottom line as well as expanding margins, suddenly all those worries about the apparent overvaluation of Amazon stock will evaporate. This makes Amazon.com stock a less risky long-term investment than was the case a few years back when the stock was beset by concerns about a possible big correction.