Amazon (NASDAQ:AMZN) sent shares of Roku (NASDAQ:ROKU) down last week following a report that the e-commerce giant wants to launch a free ad-supported video-streaming service. The tentatively named Free Dive is just one of several moves Amazon's made into advertising lately -- a strategy that could have some really big implications for the company and its shareholders.

In this episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Evan Niu take a closer look at Amazon's streaming service, how the company fits into the ad world, what this means for competitors, and more. How can Roku differentiate itself? What makes Amazon so much more enticing to marketers than Facebook (NASDAQ:FB) or Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) subsidiary Google? Find out more below.

A full transcript follows the video.

This video was recorded on Aug. 31, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, August 31st, and we're talking about Amazon's next big moneymaker. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: Not much.

Lewis: You're joining me on Skype, but we are testing out a new recording approach, which I'm very excited about, and I think our producer Austin Morgan is even more excited about.

Austin Morgan: Yeah, I'm super excited.

Lewis: [laughs] A little bit more work on your end, but hopefully the audio sounds better. Listeners, if you notice a difference, please let us know. We're doing some stuff in the background to try to make the audio a little bit better across the shows.

Evan, happy belated birthday! I didn't know it was your birthday yesterday until we talked this morning. What'd you wind up doing?

Niu: Thank you, thank you! I took the day off and played video games. And I'm going gambling this weekend in the mountains. But I do have the same birthday as Warren Buffett, which is always interesting. 

Lewis: Yes! He just turned 88, right?

Niu: I don't know.

Lewis: It's something crazy like that. You're a bit younger. It sounds like you had a pretty good birthday, and you're off to a pretty good birthday week. 

There's been quite a bit of news about Amazon this week. Maybe you missed some of it while you were taking your day off. The company's shares passed $2,000 yesterday for the first time. If you are tracking them over the last one, five, 10 years, that's up 100% over the past year; 500% over the last five years; and 2,000% over the last 10 years. It seems like we're inching closer to that $1 trillion figure, Evan.

Niu: They're going to be No. 2 after Apple, it seems like.

Lewis: I think as of recording, they're at $980 billion or so. Maybe one 1% move should be enough to do it. The reason I wanted to talk Amazon today was, increasingly, we're seeing the next big business for this company come out. Some news from this week really illustrates what that's going to look like. Do you want to talk about it?

Niu: Sure. The Information reported that Amazon is developing a new free ad-supported over-the-top streaming service. It's going to be called Free Dive. That could certainly change. Any of these details could change since it's just a rumor at this point. Their subsidiary IMDb is developing it. It sounds very similar to the Roku Channel. It's going to be mostly older, licensed content that is available for free with ads. Roku shares fell a bit on this news, just because anytime you hear of Amazon coming to compete with you, investors get kind of skittish. 

Lewis: Yeah, the market generally doesn't like big tech hopping into a space where there's a smaller pure-play player. Right?

Niu: Particularly Amazon, a company that is so aggressive competitively, and is so willing to sacrifice its margins and take losses to beat you. I mean, it's really hard to compete against them. This service will reportedly be exclusive to Fire TV devices. It would be separate from its subscription-based Prime Video service, which people tend to liken to Netflix -- as part of Prime membership, you get access to all this free video, a lot of original content.

If Amazon launches this service, then its video platform will basically have a little bit of everything. It'll have à la carte purchases, just like iTunes. It'll have this subscription-based membership with original content, kind of like Netflix. Then, it'll have this free ad-supported channel that's similar to the Roku Channel. They'll be doing a little bit of everything.

Lewis: This kind of thing also builds demand for its devices. In the past, I think the Fire devices haven't had a ton of competitive difference with some of the other streaming options out there. This is just one more service to layer on top, to maybe incentivize people to get these. 

Niu: Right. I think that is an interesting aspect of this rumor. Amazon is going to be tying this to their Fire TV hardware. They have the Fire TV Stick, Fire TV dongle, and then they have this newly released Fire TV Cube. I think they are very much trying to grow that installed base of Fire TV usage. That's interesting for a couple of reasons. It's the exact opposite of what Roku is doing. Roku has been very rapidly shifting away from first-party hardware, to the point where it's devices are less and less important over time -- both in terms of revenue and active account acquisition. These days, most of the active accounts that they're generating are coming from licensed sources, which are those third-party TV manufacturers that license and integrate Roku's platform. That's great for Roku because they don't have to worry as much about actually developing the hardware. The big move earlier this month is that they launched the Roku Channel on the broader web. Anyone can watch the Roku Channel from a web browser or computer. Obviously, you have to create a Roku account. 

Most of their accounts are going to be coming from these licensed sources. Now, they're opening it up to pretty much everyone else. They're calling this off-platform distribution. Again, it's totally the opposite direction than Amazons is reportedly going to go with their service, which is to really tie it to the hardware.

On a related note, I checked out the Roku Channel recently on the web. The interface is basically identical to Netflix.

Lewis: [laughs] I'm glad you did the follow-up on that. We did that episode, what, about a month ago?

Niu: I think it was earlier this month, when they did earnings.

Lewis: We had talked about that. Truth be told, I have not yet checked out the Roku Channel and what is available off-device. I'm glad that you checked it out. Anything in particular that you noticed in kicking the tires? 

Niu: Not really. I mean, I didn't create an account or anything. It's pretty much exactly what you'd expect. Just imagine a Netflix interface with a bunch of older movies. It had The Matrix, which is 20 years old. They actually have some live TV, which is interesting, some of these live streaming services that offer news and things of that sort. It's going to be pretty interesting to see it play out. It does seem to be pretty promising if you don't have to buy a Roku device. It can really help them expand their audience.

Amazon is in the opposite direction, like, "Hey, you have to buy our hardware to get access to the service." The Fire TV Cube that they launched over the summer is notable because it has hands-free Alexa integration. That's similar to why people love the Echo line so much. You just ask Alexa, wherever you are, vs. the older Fire TV devices that would have like Alexa's built into the remote, but you'd have to push a button. Taking out that step of having to push a button to activate it is a really huge convenience play, and really core to the whole smart home use cases. I think that what we're seeing is that they are trying to grow the installed base of Alexa-enabled devices, which now will start to include these Fire TV Cubes that have more of an Echo-like functionality than the traditional remotes they've been using.

Lewis: One of the reasons I love doing this show with you, Evan, is a piece of news comes out like this, and you're focusing on the smart home market implications and the Roku side of this. I see all of this, and I think, digital ads, and what this is doing as a next step in the digital ad strategy for Amazon, which is becoming increasingly important for this company and creates a lot of competitive threats in the marketplace. I like that our heads go to two different places there.

Niu: There are a lot of angles to look at. Certainly, Roku and Amazon are going to be competing now for ad dollars, once Amazon releases this. But the market's growing so quickly that I don't think a zero-sum competition. The ad budgets are shifting very quickly away from linear TV toward these over-the-top services. Roku estimates that right now, the linear TV ad market is somewhere around $70 billion. As more and more of shifts to OTT services, there should be plenty to go around. 

Lewis: Roku is not the only one that is going to be impacted by this news and by the larger strategy of Amazon getting into the ad business. We're going to talk about some of the other companies that are going to be impacted by this type of decision, and the general trajectory I think Amazon is moving. We're going to talk about that on the second half of the show. 

Alright, Evan, on its own, I don't think that this news item about Amazon getting into the free streaming space is a huge, huge deal, maybe aside from the Roku implications. But it looks to me like the very next natural step in what we've seen as an expanding ad strategy for this company. 

Niu: Yeah. It makes me think back to that old famous quote from Google's then then CEO, Eric Schmidt, saying how Google's biggest competitor is Amazon. He was talking about how, when people go to Google to search for a product they want to buy, that's one of the most valuable ads that they sell. If you just bypass Google completely and just go to Amazon and just search for what you're looking for there, then Google stands to lose quite a bit. I think that we are seeing Amazon really ramp up this ad business. Like you said, this ad-supported TV service probably isn't going to be a huge piece of their ad business quite yet. The bulk of it would be these product listing ads. But we are seeing other things that they're doing to really grow this ad business. For example, earlier this month, Twitch -- which is the live-streaming e-sports platform they bought a few years ago for a billion dollars -- had previously allowed you to basically have no ads if you were a Twitch Prime member, which is linked to your Amazon Prime account. They backtracked on that benefit this month. They're reintroducing ads in a big way. Again, that's probably not going to be a huge driver. But incrementally, add up all these little pieces, and all sudden, you have a big ad business. 

Lewis: Yeah, and they have so many different ways that they can use it. We're just starting to see the beginning of this. The company does not break out advertising specifically, but puts it into the umbrella category of Other -- although, management has said on several occasions that advertising makes up the majority of that segment. 

So, looking at some of the numbers here to paint a picture, last quarter, the Other segment came in at $2.2 billion, which was up 132% year over year. That's a tiny fraction of Amazon's overall sales. But because of the margin profile for this business, it has a very outsized effect on the company's profits. 

Niu: Exactly. Advertising is a very profitable business for the companies that can really scale it well, because you don't have a ton of costs with it. Obviously, on the e-commerce side, their margins are so tiny that any little bit was going to help. 

Lewis: I think it's funny. A lot of people, myself included, have really championed Amazon's Web Services segment for a long time, because it has been this highly profitable business that just throws off cash flow and allows Amazon to do of all this internal investment and expand out its product categories, its reach. Well, that cloud infrastructure business of AWS has roughly a 25% operating margin. That alone has been able to take this company profitable in the last year or so. Advertising has an even better margin profile than that 25% I just cited for AWS. If you're using Facebook as a comp, it's somewhere around 50%. 

Niu: Right. If you're thinking about back-end costs, a big piece of it for AWS, they have to spend a ton of money on capital expenditures for infrastructure, to actually buy these data centers, the servers. There's a lot of costs that go into actually ramping up the infrastructure business. Of course, at this point, they've scaled it so well and they're the biggest player that they're starting to really enjoy some operating leverage. But the point being that an ad business doesn't have that kind of capital expenditure. It's not as capital-intensive as the infrastructure. 

Lewis: The way that those two different operating margins work, at half of the overall top line revenue, an ad business would create just as much in operating profits, because it's twice as profitable as AWS. It goes even further on the e-commerce side. Frankly, we're not too far removed from it being about half the size of AWS. Management has talked multiple times on conference calls about the fact that this is already a multi-billion-dollar business and they're seeing very strong adoption across the board. 

Niu: Like I was referring to earlier, these product listing ads, that's like gold for an advertiser. You go to Amazon, you're searching for something, and you buy that sponsored listing at the top, then that's the first thing people see, and they already know that they want that. It's just prime real estate. Pardon the pun.

Lewis: [laughs] You just couldn't resist, huh?

Niu: That was unintended!

Lewis: I think that actually transitions nicely into the pros and cons of working with Amazon as an advertiser and as a retailer. So, product related search is super high value because you know that you have purchase intent. If you're a marketer, that's a really compelling group to meet online. If you're in Google Search, there's a good chance that someone's looking for a product if they're searching product information. But they also might be looking for reviews or something like that. There's a certain element of Amazon that makes people even more qualified because it's an e-commerce platform.

What I've seen also in a lot of discussions about the digital ad space is, we've had this duopoly, basically, for a long time with Alphabet's Google and Facebook essentially controlling the market. I've seen estimates, anywhere between 53-70% of the digital ad spend is going to those two companies. Having a third player in there could really force those other companies' hands, in terms of data transparency, and even pricing, I think.

Niu: Right. I think that they do have a potential to really become a much more meaningful player here. If you just think from a consumer behavior standpoint, for example, if I'm looking for some physical product, I go straight to Amazon. If I'm looking for something like a local service contractor to do stuff on my house or whatever, that's where I go to Google, because that's not something that Amazon -- I mean, I think they do a little bit of home service stuff, but that doesn't come to my mind first. I think there's this dichotomy of, you go to different places based on what you're looking for. 

Lewis: To go full circle and go back to the news that we started this show with, I think that Amazon has a cross-platform functionality and an interoperability advantage that maybe some of these other players don't. There have been some rumors about Amazon incorporating TV and mobile to have this cross-device strategy, where if you see something as a streaming TV ad, you are then served up something very similar in mobile, as a retargeting down the road. Being able to have a much fuller look at a consumer is exactly what advertisers want.

Niu: That's a good point. As more and more advertising shifts toward online, digital, over-the-top platforms -- like Roku, like Amazon, whatever it might be -- that's something you don't have on linear TV because it's just fundamentally not a data-intensive business. When you're watching something on cable TV and you go buy it online, it's harder to connect those two dots compared to online streaming.

Lewis: The one con, I think, in retailers and advertisers working with Amazon is that for a long time, there has already been this frenemy relationship. Retailers say, "OK, so many shoppers are on Amazon and getting stuff that we kind of need to be there. But, by being there, we're devaluing the presence of our owned and operated verticals." If you're a retailer and you sell specialty goods, you want to have access to that customer base that's on Amazon. But by doing that, you're becoming dependent on a third-party, and you're weakening your own digital reach.

Niu: And they don't really have much of a choice.

Lewis: They kind of have to do it, right?

Niu: Yeah, what are you going to do? Not go on Amazon? Not put yourself on Amazon?

Lewis: The one advantage that a Google and a Facebook have is, they are a little bit more agnostic there. They are pointing people to the right thing. Certainly the case for Facebook, and I think Google, too. It's a matter of paying to be within a certain search result. They aren't saying, "We're selling stuff, and we're going to sell stuff that you also sell instead of you." There's a little bit less of that competitive element to it.

Niu: Right. I mean, I think Facebook a little different. Facebook is more about, you're just idly browsing, passively looking at stuff or interacting with people. There's not as much of that explicit purchase intent on Facebook relative to Google or Amazon. Everyone has their own place. It's just trying to get in front of your eyeballs, with how much time people spend on all these services. 

Lewis: As an Amazon, shareholder, I look at this ad business and I say, this is really the next big thing for this company. You look at Facebook building, essentially, a $50 billion dollar run rate business on ads. Alphabet's annual revenue is double that. If they are able to capture even 5-10% of the digital ad market, it's going be huge money for this company, and it's going to be something that pretty much flows right down to the bottom line. It makes a very quickly growing company even more profitable. 

Niu: Yeah, I agree. I think there's a lot of upside.

Lewis: I think this is the ace in the hole for this company. They are so early on in the growth ramp for it. There's still a lot of opportunity to be seized.

Niu: Yeah, totally. 

Lewis: Evan, we're going to wrap there. Anything fun going on this weekend?

Niu: Nah, just going gambling.

Lewis: Just going gambling. Well, I'm going to be at the Nats game. I believe Austin Morgan is also going to be at the Nats game tonight.

Morgan: I'll be there!

Lewis: We have a Fool outing, which is going to be super fun. Are you bringing anyone, Austin?

Morgan: I am. My girlfriend and roommate are coming.

Lewis: Nice! I'm also bringing my girlfriend, Jess. There were multiple calls out, though, for more people to come to the game because we had a bunch of extra tickets. So, I'm not just bringing my girlfriend, I'm bringing four other friends, as well. 

Morgan: Nice!

Lewis: It's basically a Fool-sponsored Dylan Lewis friend hangout, which is kind of cool. I guess that's what they get for putting a stadium trip on a holiday weekend. But I'll take it. Austin, anyone in particular you're excited to see tonight? I know you're big Nats fan. 

Morgan: I don't know. I just got news while we were taping this podcast that the Nationals sent Ryan Madson to the Dodgers. The bullpen is getting thin. 

Lewis: How do you feel about that, as an avid Nats fan?

Morgan: It seems like they've given up on the season when they could make a run. They're playing a lot of teams that are ahead of them.

Lewis: And the Brewers tonight?

Morgan: The Brewers tonight. They're ahead of them. 

Lewis: I can't wait to see the Nats give up live in person with a whole bunch of Fools and some of my friends. 

Morgan: Last time we thought they gave up, they went out and scored 15 runs. Maybe they'll do that tonight.

Lewis: I'd love to see it. Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

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. Dylan Lewis owns shares of Alphabet (A shares), Amazon, AAPL, and Facebook. Evan Niu, CFA owns shares of AAPL, Facebook, and NFLX. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, AAPL, Facebook, and NFLX. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.