Amazon (AMZN 0.37%) posted record profits once again in the third quarter, topping the mark it hit just three months prior. A big contributor to those record profits is its booming advertising business, which carries considerably higher profit margins than Amazon's core retail business.
The third quarter saw the company's "other" revenue, which mostly consists of its advertising services, climb 122% year over year to $2.5 billion. Even adjusting for an accounting change this year, which moved $750 million from contra cost of goods sold to advertising revenue in the third quarter, the line item grew about 56%.
That's faster growth than every major digital advertising company, some of which are smaller than Amazon at this point. It's also about the same pace Amazon was growing its ad business throughout last year.
Considering the importance of Amazon's advertising business to its profitability, investors may be wondering how long the company can keep up this pace.
What management had to say about it
When CFO Brian Olsavsky was asked about the potential opportunities for continued advertising growth during the company's third-quarter earnings call, he was very optimistic.
"We still believe that there is a lot of room to continue to improve the presentation of bringing to our customers, new and more relevant purchase options," he told analysts. "We'll continue to invent both on the product side, the tool side with our goal being improve the usability of the tools for our advertisers, make smarter recommendations for customers, automate activities so that advertisers don't have to work as hard, and invent new products for advertisers."
So far Amazon's ad business has largely gotten by on the immense volume of valuable searches that take place on its website. About half of all online product searches start on Amazon.com. Amazon has rapidly expanded the number of ads it shows in those search results over the last couple years.
Olsavsky dodged a question about ad load -- the amount of ads it shows compared with organic results. "We don't have that quantified for you," he said. Instead, he focused on the idea that there's a lot of room to improve the product.
Those improvements will come from both the advertiser side and the consumer side. Consumers will want to see more relevant ads. Instead of shoppers seeing eight mediocre options, Amazon could generate more income from two or three highly relevant sponsored products.
On the advertiser side, Amazon is in the process of completely revamping its ad-buying tools. Amazon's current ad sales are built on a backbone of products that were meant for a much smaller business. But as the company is growing the business, creating new advertising products and expanding the places it shows ads, those tools have become cumbersome.
In August, Amazon started rolling out a streamlined ad-buying tool for marketers. As the company improves upon that base with new buying, automation, and measurement tools, it should be able to attract more ad buyers to the platform. With increased demand, price per ad ought to increase further.
Could it double in two years?
Analysts at Piper Jaffray estimate Amazon's ad business could reach $20 billion in 2020, double its current run rate.
The crux of the analysts argument is that Amazon increasingly controls the supply of product searches. Consumers are going to Amazon to find products, and if a merchant or manufacturer wants to sell their products, they more or less have to be on Amazon's marketplace. On top of that, as more products become available on Amazon.com, those merchants will have to do more to stand out from the crowd, and that means paying for advertising.
All of the above gives Amazon considerable pricing power due to its ownership of the channel. It's also capable of adding its own products to the mix thanks to its expanding portfolio of private-label products. As Amazon continues adding new products to its marketplace and attracts the lion's share of product searches (thanks in large part to its success with Prime), advertisers can still see better return on investment by advertising on Amazon than trying to advertise products through other channels.
There should still be plenty of room to increase pricing, as it seems most of Amazon's ad revenue growth stems from increasing ad impressions. Product improvements will help facilitate price increases, but regardless, market forces should ultimately push ad prices higher.