Can Amazon Challenge Google In This $121 Billion Market?

Amazon.com (NASDAQ: AMZN  ) is gearing up for a big expansion into online advertising, according to The Wall Street Journal.

Its upcoming ad network, "Amazon Sponsored Links," could be a welcome alternative platform for advertisers, who often rely on Google (NASDAQ: GOOG  ) (NASDAQ: GOOGL  ) and Facebook (NASDAQ: FB  ) for targeted advertising.

Amazon CEO Jeff Bezos. Source: Wikimedia Commons.

With the accumulated data on the buying habits of nearly 250 million active users, Amazon certainly has a lot to offer advertisers. By comparison, Google targets ads based on search data and mobile habits, while Facebook uses social connections and "liked" pages.

Amazon already has a small affiliate business which pays small commissions to participating websites when users click through an ad to buy a product. However, Amazon now plans to expand that program with a much wider variety of ads through Sponsored Links.

The $121 billion business of online ads
Amazon Sponsored Links will reportedly resemble Google's AdWords, which crafts keyword-targeted ads based on search results and page context. Amazon will kick off the program by replacing Google's ads on its own site.

By launching Sponsored Links, Amazon expects to sell $1 billion in ads this year, up from $700 million last year. That won't make a huge impact on Amazon's revenue, which came in at $74.45 billion in 2013. That's also a tiny amount compared to Google, which reported $50 billion in ad revenues last year.

However, the market is still big enough for new competitors to rise. ZenithOptimedia, a division of ad company Publicis, recently projected that the market for Internet advertising (display, classifieds, and paid search) will grow 16% year over year to $121 billion this year. Next year, that market will grow to $140.5 billion, then hit $160.6 billion by 2016.

Google has a few core advantages -- it has a 67% market share in the U.S., according to comScore's July figures, and serves over a million advertisers on its 14-year-old AdWords platform. Therefore, satisfied advertisers aren't going to simply abandon Google to team up with Amazon. Meanwhile, Facebook reported nearly $7 billion in advertising revenue in fiscal 2013 -- representing 63% growth from the previous year.

Between Google and Facebook, Amazon will have to really make an impression with Sponsored Links to convince advertisers that it is a worthwhile platform.

Amazon doesn't want to rely on Google anymore
Yet I believe that Amazon isn't really trying to threaten Google or Facebook -- it just wants to be less dependent on others for advertising.

Amazon is one of Google's biggest AdWords customers. In 2011, Amazon spent $55.2 million on Google AdWords, taking the top spot among major retailers. It's unclear how much it has spent since then, but Amazon's total Marketing costs climbed 92% between 2011 and 2013.

Since it is now sitting on a huge database of information about customer tastes, it makes sense for Amazon to launch an advertising platform of its own as marketing costs rise.

Amazon is notably going head-to-head with Google in a wide variety of areas -- same-day deliveries, mobile devices, digital content, cloud computing, and even drones. Google is a formidable opponent, but it has one key weakness -- product searches, which Amazon rules with an iron fist.

Amazon Fresh. Source: Wikimedia Commons.

Amazon could eventually capitalize on this advantage in the same way it offered limited time specials through its hashtag-based shopping deal with Twitter. Therefore, instead of the static product ads that Google and Facebook offer, Amazon could promote flash sales to the customer to prompt higher click through rates.

It's also about margins
Amazon is great at generating huge revenues, but terrible at posting a profit. Amazon posted a net loss during four of its last eight quarters. Google, by comparison, reported a higher operating profit in the first half of this year than Amazon has since it was founded two decades ago, according to S&P Capital IQ.

The reason is simple -- Amazon's e-commerce model operates with a tiny profit margin of 0.2%, compared to 20.3% for Google. Selling goods online is a low-margin business, while selling ads is a high-margin one. If Amazon can make progress in the high margin ads business, it could offset those losses with more consistent profits.

A Foolish final word
Sponsored Links is a smart move which will free the company from Google AdWords and possibly evolve into a larger, higher margin business.

The service might not seem like a game-changer yet, but Google and Facebook shouldn't underestimate how much the accumulated shopping habits of 250 million customers could change online advertising.

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