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Meet Amazon's Next Megabillion-Dollar Business

By Jamal Carnette, CFA – Aug 26, 2018 at 5:02PM

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This small but fast-growing business has the potential to be the next AWS and drive Amazon stock higher.

Four years ago, after enduring its second full-year earnings-per-share loss in the last three years despite 20% top-line growth, Amazon (AMZN -2.02%) bears questioned whether the e-commerce company could become a reliably profitable entity. Amazon underperformed the S&P 500 by 36 percentage points that year, falling 22% versus the 14% total return from the greater market.

Undeterred, CEO Jeff Bezos had other plans to grow the company's bottom line -- and those plans didn't involve e-commerce. In his 2014 shareholder letter, Bezos wrote that "Amazon Web Services (AWS) is growing big and fast," later adding: "Finally, I'm optimistic that AWS will have strong returns on capital." AWS has since provided the bulk of profits.

Now Amazon has another embryonic business, and it could be the next AWS for investors.

Dollar symbol with an arrow pointing right

Image source: Getty Images.

Advertising will disproportionally reward Amazon investors

In what's become the worst-kept secret in the advertising industry, Amazon is aggressively building out its digital advertising business to better compete with Alphabet (GOOGL -7.68%) (GOOG -7.44%) and Facebook (META -4.27%).

Although it's folly to expect Amazon to immediately threaten the Alphabet-Facebook duopoly on a market-share basis, even small market-share gains will disproportionally reward investors. The chart below compares Amazon's operating income by division to Alphabet's and Facebook's in 2017:

Chart of revenue, operating income, and margin percentages for Amazon, Facebook, and Alphabet

Data source: Company annual reports. Revenue and operating income in millions. Chart by author.

As the chart shows, digital advertising has a significantly higher operating margin profile than Amazon's retailing businesses, or even Amazon's high-margin AWS division; pure-play digital advertiser Facebook's operating margin is approximately 50%.

Alphabet's margin is understated because the company reported an operating loss of $3.4 billion from its non-advertising-based Other Bets division. Removing that division and other nondirect items would give Alphabet's digital-ad-based Google division an operating margin of 30%. If Amazon's advertising division simply matched Alphabet's 30%, every $1 million in ad revenue would produce more profit than $11 million in North American retailing revenue.

Amazon is growing fast in a fast-growing industry

Unlike AWS, Bezos hasn't discussed marketing significantly in a shareholder letter. However, investors noticed the company added another division in its quarterly report: "other." While this includes other revenue, the company notes it is "primarily" attributable to marketing.

Over the last two quarters Amazon has reported revenue growth attributable to this division of approximately 130%. The point is: Amazon is succeeding in this space and acquiring market share.

Metric Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018
Revenue $850 million $945 million $1.123 billion $1.735 billion $2.031 billion $2.194 billion
Year-over-year growth 58% 53% 58% 60% 132% 129%

Data source: Amazon's second-quarter 10-Q.

Like Amazon's other businesses -- cloud computing and e-commerce -- digital advertising has a long runway for growth. Advertising-focused market-research firm eMarketer reports that this year mobile digital advertising spend will eclipse TV-based advertising, and total digital advertising -- desktop, laptop, and mobile -- will take nearly half (48.5%) of all spending.

Chart showing proportion of U.S. ad spending by outlet

Data source: eMarketer. Chart by author.

Look for rapid growth to continue, as the digital advertising industry has a long runway for growth. eMarketer predicts mobile advertising alone will grow to nearly half of total media ad spending, and total digital advertising will grow from 48.5% to 62.1% of the total market. The combination of strong growth from Amazon's ad business and a growing market will make digital advertising its next megabillion-dollar business.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Jamal Carnette, CFA owns shares of Alphabet (C shares) and Amazon. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Facebook. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.

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