- Amazon had recently announced that it is testing a new online ad placement product and also acquired Twitch, a gaming focussed video streaming portal.
- Twitch will enable Amazon to accelerate its online advertising initiatives.
- The high profit margins of the online advertising industry will be a huge relief for Amazon investors, in stark contrast to Amazon’s constantly increasing presence in low margin businesses.
- However, Amazon’s current valuations are hard to justify even considering an exponential rise in earnings and our Amazon stock analysis re-iterates our negative long term outlook on the stock.
Amazon (NASDAQ:AMZN) has recently been in the financial news for more wrong reasons than right. Among these have been questions raised about the efficiency of their operating model and their never ending focus on topline growth. A greater focus on earnings was hugely required and two developments in the recent weeks could help bring in earnings for Amazon, something which has remained elusive at the firm for far too long.
Amazon announces expansion of its ad placement network
Amazon recently announced an expansion of its ad network which will help it scale its ad placement program to third party partner sites and take on Google AdWords in a bigger way. Why do we call it an expansion? The program was launched over a year ago as reported by mercurynews.com in 2013. Also a post on WSJ states,
“The Seattle-based retailer already has a limited business placing ads on other sites. In a sign that it has larger goals, Amazon is testing ways to expand that program with new types of ads.”
The conclusion of the above is that the recent announcements is more about an expansion of Amazon’s ad network initiatives rather than a new launch as reported across the web by many.
The second news event which caught our attention was obviously the Twitch acquisition. Amazon announced on Monday (August 25) that it was acquiring Twitch in an all cash deal for $970 million. This is an acquisition which will help Amazon take advantage of the more lucrative video ads and provide advertisers with an inventory of video ads.
Nevertheless an interesting question to ask is if the inventory size of Twitch will ever match that of YouTube. After all, the number of the gaming community will always be a subset of the community in general. While YouTube is a general purpose video sharing/viewing platform, Twitch’s niche focus on gaming will hinder the number of users and broadcasters on the platform.
It is still unclear as to how Amazon will integrate the twitch acquisition to drive sales through its retail segment. However, what is clear is that the company has decided to step on the gas in industry that is rapidly growing.
According to eMarketer, digital ad spending is estimated to grow from $119 billion in 2013 to $204 billion in 2018 implying a 5 year CAGR of close to 12%. The chart below displays eMarketer’s forecasted growth in online as spends over the next 5 years.
A larger presence in the advertising industry will help drive Amazon’s ad revenues, which are estimated to reach over a $1 billion in 2014. Apart from that, Amazon’s affiliate marketing program will also help the company drive incremental sales through its retail platform. However, revenue growth resulting from ad revenue isn’t as important as the higher margins which these revenues will generate for Amazon. Topline growth has never been a problem at Amazon; it’s only the wafer thin margins which are a constant worry. More revenues from advertising could help solve this problem. How?
Online advertising has traditionally been a high margin business with Net margins ranging from 20% to 30% of revenues. In online advertising video ads are highly lucrative and this is where the Twitch acquisition will help Amazon as it offers a platform for offering greater number of video ads. The high margins of the online ad industry are in stark contrast to Amazon’s current operations, which generate little to no profits (less than 5%). Hence the earnings quality of Amazon advertising revenue will be greater than its current operations from the viewpoint of earnings growth. However, a critical question to answer is what are the implications of these events on Amazon’s valuation?
Amazon trades at a huge PE ratio of 900 on a price-to-sales ratio of 1.9. The huge PE ratio inspite of a low price-to-sales indicates the meager earnings which the firm currently generates. Hence to justify its current market valuation based on earnings growth, Amazon needs to find a way to deliver exponential growth in earnings, which is only possible by a consistent expansion of profit margins. Hence, the move to expand its advertising program and the Twitch acquisition are steps in the right direction. However, Amazon’s current valuations are extremely risky and seem hard to justify even with an exponential rise in earnings. Moreover, any tangible impact of rising advertising revenue on earnings growth is yet to be seen. Hence, we view the stock as a high risk bet which is reflected in our current Amazon stock analysis.