Buy Amazon Stock Because of Its Ad Business

Amazon stock - Buy Amazon Stock Because of Its Ad Business

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The one huge knock against Amazon (NASDAQ:AMZN) stock is valuation. AMZN has all the growth in the world. But its profits are lagging, so the price-earnings multiple of Amazon stock is huge.

There’s no arguing against that. It’s a fact. On a forward price-earnings basis, AMZN stock trades at over 60 times its forward earnings. Of the FAANNG stocks, only one – Netflix (NASDAQ:NFLX) – trades at a higher forward P/E multiple than AMZN. The rest of them have forward earnings multiples below 25.

But this valuation argument against Amazon stock only holds up on an earnings basis. On a sales basis, it’s a completely different story. AMZN stock trades for less than three times analysts’ consensus 2019 sales estimate. Only one other FAANG stock – Apple (NASDAQ:AAPL) – trades at a lower forward price-sales multiple. The rest have forward sales multiples above four.

Thus, the biggest knock against Amazon stock is its high valuation, and that is entirely a function of small profit margins, not lack of revenues. So if its profit margins head higher, the valuation argument won’t hold weight. Bears will throw in the towel, bulls will be in control, and AMZN stock will roar to new highs.

AMZN Will Generate Higher Margins

Fortunately, Amazon’s margins are about to break out to new highs over the next several years, thanks to digital advertising. AMZN has a rapidly growing digital-advertising business that will one day be huge. This business carries very high gross margins. Thus, as Amazon’s digital-ad business grows over the next several years, the company’s overall margin profile will dramatically improve, and Amazon’s profits will soar.

As that happens, Amazon stock will soar, too.

Amazon’s Digital-Ad Business Has Huge Potential

Amazon is the fourth –most-visited website in the United States. Ahead of it are Google (NASDAQ:GOOG), Facebook (NASDAQ:FB), and YouTube. Although YouTube’s numbers aren’t public, the consensus thesis is that its top line is $20 billion-plus and rapidly growing. Thus, each of these three platforms is expected to generate well over $20 billion of ad revenue per year.

Amazon’s still relatively new ad business is barely passing the $10 billion annualized revenue mark today. As a result, Amazon’s display ads alone can enable Amazon’s digital-ad business to grow and potentially more than double to $20 billion-plus of annual revenues.

But that’s just the tip of the iceberg. Amazon also owns IMDb, which is among the top-50 most-visited websites globally. That’s an entire, separate digital property that’s waiting to be populated with digital ads.

Plus, AMZN just launched a free, ad-supported video-streaming service through IMDb called Freedive. That’s big because it plunges Amazon into the intersection of video ads, which is where all the growth is in the ad industry, and streaming, which is arguably one of the biggest growth businesses in the world right now.

Amazon also owns Twitch, which is commonly referred to as the YouTube of video games. That, too, is big because all the ads on Twitch are video ads. Plus, the website is highly targeted, so the ads on it are presumably very effective and fairly expensive. Also, the rapid growth of eSports globally will continue, so Twitch’s value as a global digital advertising platform will only increase.

Beyond digital properties, Amazon is also behind the world’s leading voice assistant, Alexa. Over time, it is highly likely that brands will start to pay for “voice ads” on Alexa. Thus, Amazon’s leading position in the voice-assistant market provides it with yet another potential advertising opportunity.

Overall, because of its largely unparalleled access to the consumer through a plethora of internet-related services, Amazon has a tremendous opportunity over the next several years to create a colossal digital- advertising business. At its peak size, this business will be the key to unlocking the value of Amazon stock.

Digital Ads Will Unlock Tremendous Shareholder Value

The important point is that e-commerce margins are notoriously low, and digital-advertising margins are enviably high.

Last quarter, the operating margins of Amazon’s domestic retail business were just under 6%, while its international retail business still generates a loss.

Meanwhile, Facebook – even as it’s making huge investments in data security – reported operating margins of over 40% last quarter. At one time, those operating margins were around 50%. Meanwhile, Google’s operating margins are often in the 25%-30% range, and even the once-unprofitable Twitter (NYSE:TWTR) reported adjusted operating margins of nearly 25% last quarter.

Broadly speaking, the digital-ad industry carries significantly higher margins than the e-commerce industry. Thus, as Amazon’s digital-ad business grows over time, it will also generate high margins. Also, let’s not forget the still-rapidly-expanding Amazon Web Services business, which operates at 20%-plus margins.

As a result, over the next several years, AMZN’s growth will be driven by two 20%-plus margin businesses. AMZN’s operating margins currently hover between 6% and 7%. That means its margins will dramatically improve over the next few years. At the same time, its huge revenue base will be growing rapidly. The net result will be huge profits for AMZN, which will in turn lead to huge gains by Amazon stock.

The Bottom Line on AMZN Stock

The most exciting thing about Amazon stock is that the company’s growth is still in its early innings. Over the next few innings, AMZN will turn its profit engines on by growing two high-margin businesses. As that happens, Amazon’s profits will soar, the bearish argument about the valuation of Amazon stock will fall apart, and AMZN will hit highs it’s never seen before.

Consequently, the recent weakness of Amazon stock is nothing more than a near-term overreaction and a buying opportunity for long-term investors.

As of this writing, Luke Lango was long AMZN, NFLX, AAPL, GOOG, FB, and TWTR. 

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