Amazon's Promising Advertising Growth Story

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About: Amazon.com, Inc. (AMZN)
by: Callum Turcan
Summary

Amazon.com Inc. is making serious inroads in the global digital advertising business.

Covering the expected growth of this lucrative market on a macro level.

How a recent accounting standards change impacted Amazon's way of accounting for advertising revenue.

Good to see Amazon leveraging its position as the world's premier online retailer to generate new growth opportunities.

Amazon.com Inc. (NASDAQ:AMZN) is aggressively moving into the advertising space, particularly digital advertising, which has long (at least by modern standards) been dominated by Alphabet Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook Inc (NASDAQ:FB). As a higher margin business with great economies of scale, this is how Amazon plans to leverage its position as the world's premier online retailer to create lucrative new growth opportunities. Alexa, an Amazon company, notes Amazon's main website has the fourth highest levels of web traffic in the United States and is the tenth most visited website in the world as of this writing. Let’s dig in.

Overview

The market research firm eMarketer notes that digital advertising spending clocked in at $232.3 billion in 2017 in a report that was issued in March 2018. That market was expected to grow to $273.3 billion in 2018, climbing all the way up to $427.3 billion by 2022. Over that time frame, eMarketer expects digital advertising will grow from just under 40% of total advertising spending to almost 54% on a global basis.

While Alphabet and Facebook dominate this market, there remains a ton of room for upside, especially for a firm like Amazon with deep pockets and a top-tier labor force. Statista’s estimates align with eMarketer’s, as that firm sees global digital advertising spending rising from $226.6 billion in 2017 to $464.7 billion in 2022 and $517.6 billion in 2023, which is more bullish than eMarketer’s forecast.

New accounting rule, growth still strong

Due to an Accounting Standards Update from the Financial Accounting Standards Board, ASU 606 to be specific, Amazon changed the way it accounts for revenue generated by its advertising services. ASU 606 seeks to standardize the way revenue is recognized from contracts to improve financial accounting transparency and ensure more comparable financial statements across individual entities. In Amazon’s 2018 10-K filing with the SEC, the company states that:

“Certain advertising services are now classified as revenue rather than a reduction in cost of sales, and sales of apps, in-app content, and certain digital media content are presented on a net basis. Prior year amounts have not been adjusted and continue to be reported in accordance with our historic accounting policy.”

Furthermore, during Amazon’s Q4 2018 conference call, its Director of Investor Relations Dave Fildes noted:

“And just on the other revenue piece, Brian, just to get back to the accounting side. We did adopt that revenue recognition standard in 2018 as I mentioned. As part of the adoption, certain advertising services were classified as revenue rather than a reduction of cost of sales. So specific to Q4, the impact of that change was an increase of approximately $1 billion to other revenue, so you will see that in the other revenue in total.”

Digging deeper into that, note Amazon posted $1.7 billion in “other revenue” in Q4 2017 which the firm highlighted as “primarily [including the] sales of advertising services, as well as sales related to our other service offerings.” By the fourth quarter of 2018, that had grown to $3.4 billion. Factoring out the accounting change, Amazon still grew its “other revenue” by $0.7 billion or 41% year over year on an adjusted basis last quarter.

Ideally, Amazon will update its financial reporting practices in the future as its advertising division becomes more relevant. Amazon isn’t alone in providing only a modest amount of information relating to its nascent divisions, Alphabet is a perfect example of that with its “Other Bets.”

From 2016 to 2017, Amazon’s “other revenue” grew from $3.0 billion to $4.7 billion. That jumped further last year, touching $10.1 billion in sales. In Amazon’s 2018 10-K, the company notes “service sales also increased by approximately $3.0 billion for the year ended December 31, 2018 due to the reclassification of certain advertising services.” Taking that into account, it appears Amazon’s advertising revenue grew by $2.4 billion or 51% in 2018 on an adjusted year-over-year basis. Marginal amounts of non-advertising revenue are included in these figures, but in light of advertising apparently not deserving its own line item as things stand today, that represents a good proxy for its ad growth trajectory.

Amazon evolving

As a relative newcomer to the space, Amazon has a lot of catching up to do. The company’s Director of Investor Relations noted that the firm was fully aware that it needs to think on its feet and be capable of change at a moment's notice. That includes changing the product offering to better suit the needs of its clients. From Amazon’s Q4 2018 conference call:

“One of the things we're trying to do is continually evolve our tools and the products to help that customer set agencies, advertisers, make sure they've got a variety of ways to meet their goals. Some of the things we've done more recently over the last few months or so is expanded sponsor brands, placements, some rolled out new campaign reports, so improved campaign manager features.”

It is still early days for Amazon’s advertising division, but so far it appears this division’s growth story really does have legs. The market for digital advertising just keeps getting bigger and bigger. While large tech firms like Alphabet and Facebook can use their largess to gain a near insurmountable advantage over their smaller peers, Amazon is one of the largest companies in the world and has shown a willingness to invest heavily in the long term even if that means losing money today.

Final thoughts

Just like how Amazon first used Amazon Web Services to support its internal operations before launching that division’s offerings to third parties, the company is doing something similar with its advertising unit. Initially, Amazon's ad unit was largely to support advertising operations on its own website. Bigger picture, the goal is to utilize the vast amount of information gathered from Amazon’s users/shoppers to enable hyper-targeted ad campaigns across numerous websites, like how Alphabet and Facebook utilize their own internal meta-data to enhance their advertising campaign offerings to third parties. Due to the higher margin nature of this business, it will be very interesting to see how this growth story plays out. As an Amazon.com Inc. shareholder, I’m happy to see the firm continuously leverage its internal operations to create new avenues for growth. Thanks for reading.

Disclosure: I am/we are long AMZN, GOOGL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.