It turns out that even mighty Amazon (AMZN 0.09%) is not immune to the adverse effects of inflation and rising interest rates. For example, its quarterly revenue growth rates for its North American and International e-commerce segments peaked in the first quarter of 2021. Even worse, both e-commerce businesses turned in an unprofitable fourth quarter of 2022.
As for Amazon Web Services (AWS), revenue has consistently decelerated over the last several years amid intensifying competition and the law of large numbers, which states that the larger a company grows, the more difficult it is to achieve prior growth rates.
For instance, in the fourth quarter of 2018, AWS grew revenue at 45% year over year, and in the fourth quarter of 2022, the cloud unit only produced 20% year-over-year revenue growth. Additionally, operating income for AWS dropped 2% year over year during the latest fourth quarter.
Since Amazon's primary growth engines offered investors little to be excited about since the first quarter of 2021, investors became fascinated with the growth potential of Amazon's nascent digital advertising business. However, since Alphabet's (NASDAQ: GOOGL) (NASDAQ: GOOG) Google ad business and Meta Platforms' (NASDAQ: META) family of app businesses, including Facebook, dominated the online advertising industry for about a decade, the question is whether Amazon's advertising business is worth investors' attention as a possible long-term growth engine.
Let's take a look.
Its advertising unit is taking share
According to an article by Axios, which cited statistics from Insider Intelligence, Google and Meta combined in 2022 for a less than 50% market share for the first time in eight years. These statistics show that both companies are losing market share, and the prime cause is Amazon, which ended 2022 with a 7.3% digital ad market share. Still, analysts project its share to explode to nearly 13% by 2024, closing the gap with Meta's projected 17.9% share -- a drop from the 19.6% market share Meta achieved in 2022.
Many advertisers are gravitating to Amazon ads since it's the most effective and cheapest way to advertise online.
According to a Feedvisor report that cites a 2020 survey of over 1,000 brands, 36% of all brands say Amazon generates the highest return on media spend, followed by paid social at 29% and then Google at 27%. Even better, 59% of the brands on Amazon's e-commerce marketplace say that it drives the highest return on media spending, followed by Google at 22% and then paid social at 17%.
As far as cost, according to a report from e-commerce analytics firm Sellics, Amazon ads are 68% cheaper than Google, 44% cheaper than Facebook, 79% cheaper than Instagram, and 13% cheaper than e-commerce competitor Walmart (NYSE: WMT).
Why investors are interested in its ad unit
While Alphabet's advertising unit and Meta's advertising lost approximately 4% year over year in revenue in the fourth quarter, Amazon's ad unit generated 19% year over year, despite an ad market that global media company Magna Global forecasts to slow further during 2023. And only the 20% revenue growth of the AWS segment was better for it in the fourth quarter. However, the prime rationale behind the investors' strong interest in the ad segment is that it is likely the most profitable piece of its business.
While the company does not reveal the profitability of its ad business, analysts have roughly figured the profitability that Amazon gains in advertising by comparing it to Google and Meta's advertising units' profitability and using a few assumptions. Most analysts conclude that Amazon's advertising unit is more profitable than AWS.
In addition, AWS also requires substantial capital investment, long-term investments in property, equipment, land, computers, and software needed to operate the cloud business. In its fourth-quarter 2021 earnings call, Chief Financial Officer Brian Olsavsky revealed for the first time that just under 40% of its capital expenses go toward supporting AWS.
Suppose that is true; in 2022, $25 billion of capital expenditures went into supporting AWS, while AWS only produced $22.84 billion in operating income in the same year. Amazon likely uses all of the AWS segment's operating income to pay the cloud unit's capital expenses. Thus AWS currently has a feeble free cash flow. And if you assume advertising is a less capital-intensive business, it produces better free cash flow than AWS.
So however you want to parse it, advertising is a rapidly growing, profitable growth engine for Amazon that might already be its most valuable business.
A foggy short-term future
Amazon shareholders should understand that a recession would not benefit any of its businesses, including advertising, which relies substantially on the health of its e-commerce markets.
Suppose you want to invest in Amazon stock for its long-term potential in advertising. Be aware that things could get much worse before getting better, and the ad business won't ride in to save the day.
Still, as the economy normalizes over the next year or two, the ad business will likely become its most significant growth engine and a strong thesis for becoming a shareholder.
