Amazon Stock Has a Secret Weapon That Could Deliver Monster Returns for Investors

Key Points

• Amazon’s commerce divisions don’t generate a substantial amount of profits.

• Amazon’s revenue growth appears slow.

• AWS and advertising services are a key part of the Amazon investment thesis.

• 10 stocks we like better than Amazon ›

Amazon (NASDAQ: AMZN) is well known for its e-commerce platform, where you can purchase nearly anything. Combined with its wide selection of products, it also offers lightning-fast delivery that consumers have come to demand from every other store.

However, within Amazon’s business are two divisions that are delivering growth much faster than Amazon’s commerce division. Furthermore, they have much higher margins, allowing Amazon’s profits to increase at a much faster rate than revenue. This is Amazon stock’s secret weapon, and it could supercharge returns for investors over the next few years.

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Image source: Getty Images.

Amazon’s commerce platform isn’t the top reason to invest in the stock

The vast majority of Amazon’s revenue comes from its commerce business. In the first quarter, online stores and third-party seller services generated $57.4 billion and $36.5 billion in revenue, respectively. Considering Amazon generated $143.3 billion in total sales during Q1, these two combined make up the majority of Amazon’s revenue.

But there are two problems with that.

First, these two business segments are Amazon’s slowest-growing, with online stores experiencing a 5% year-over-year growth rate and third-party seller services increasing by 6%. Because these two make up such a large chunk of Amazon’s total revenue, the slow growth of these two segments drags down Amazon’s overall growth rate, which was 9% for the quarter.

Second, commerce businesses have notoriously slim margins. Because it doesn’t break out the operating margins of individual segments (except for Amazon Web Services, which we’ll address in a moment), it’s impossible to know exactly how much money a segment is making (or losing). If you examine other retailers, such as Walmart or Target, their operating margins typically hover around 5%. If these two segments have similar operating margins to those retail giants, then these divisions don’t contribute significantly to Amazon’s profits. If another segment within Amazon’s business can rapidly grow profits at a much higher margin, then Amazon’s profits will grow substantially from that smaller contribution.

That’s exactly what we’re seeing from AWS and advertising, and this is Amazon’s secret weapon.

AWS and advertising play a huge role in Amazon’s profit margins

In Q1, AWS, Amazon’s cloud computing division, produced a stellar 17% growth rate and generated $29.3 billion in revenue — not far off from third-party seller services. However, it delivered a 39% operating margin. This allowed AWS to account for 63% of Amazon’s total operating profits during Q1 despite making up only 19% of revenue.

So, even though Amazon’s commerce business is the most forward-facing of the company, it doesn’t deliver the lion’s share of profits.

Advertising is likely the same way, although it’s buried within the commerce division. Advertising has been Amazon’s fastest-growing business over the past few years. The consumer data it has is unparalleled, as it includes first-party data that allows advertisers to understand customer purchasing habits. This enabled Amazon’s ad revenue to soar, consistently making it Amazon’s fastest-growing segment over the past few years. Q1 was no exception, with revenue rising 18% year over year.

Unfortunately, Amazon doesn’t break out the advertising segment’s operating margin, but if we use another advertising-focused company as an example, Meta Platforms, we can see that an operating margin of 40% or greater are feasible. This makes advertising another key profit contributor, and investors need to keep an eye on it to ensure it continues to deliver market-beating growth.

Because both divisions have outgrown their commercial counterparts in recent years, Amazon’s operating margin has improved significantly. As long as these two entities maintain their current performance, this trend is likely to continue.

AMZN Operating Margin (TTM) data by YCharts

Although Amazon’s top-line growth may appear slow, it is offset by rapidly rising profit growth. This is driven by two high-margin business segments: AWS and advertising. As long as these two continue to grow at a rapid pace, Amazon’s profits will rise in tandem. There are numerous tailwinds propelling these two divisions higher, which gives me confidence that Amazon can deliver long-term outperformance for its shareholders.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Keithen Drury has positions in Amazon and Meta Platforms. The Motley Fool has positions in and recommends Amazon, Meta Platforms, Target, and Walmart. The Motley Fool has a disclosure policy.