Reviewing the performance from 2023 to date, in terms of stock price, $Amazon(AMZN.US) has risen over 180% from its low in 2022, while the S&P index has increased by about 76%, clearly indicating that Amazon has outperformed the market.

Interestingly, as the stock price has soared, Amazon's forward price-to-earnings ratio has been on a downward trend, dropping from over 80x PE at its peak to currently less than 40x, presenting an atypical situation of "getting cheaper as it rises."

Readers who have been following Dolphin Investment Research must know that one of the biggest contributors to this surge and valuation digestion is actually the rapid turnaround and continuous improvement of the profit margin in the retail business, which had suffered significant losses in 2022, and has now reached a historical high.

But what are the reasons behind this phenomenon? What main factors contributed to the rapid reversal of the retail business's profit margin? In this article, Dolphin Investment Research will explore the underlying reasons together with everyone.

The following is the detailed content:

1. Reviewing the "Surge History," Where is Amazon Strong?

1. Continuous upward revision of net profit in retail business, AWS

Readers who have been following Dolphin Investment Research's quarterly reviews must know that Amazon has seen strong growth and declining valuations over the past two years, with the main reasons including:

① Most importantly, the significant release of retail business profits and continuous upward revision of profit margins. As seen in the chart below, after the low point in 2022, Amazon's retail business operating profit margin has been continuously raised, quickly increasing from a low of nearly -3% to a high of 5%. Historically, such high profit levels were only briefly reached during the post-pandemic recovery in Q1 2021.

Looking at a longer observation period, before 2017, Amazon's retail business profit margin was still "struggling" around the breakeven line, fluctuating in the low single digits between 1.6% and 2.7% from 2018 to 2021. In fiscal year 2024, it is expected to stabilize (not just briefly touch) around 5% operating profit margin for the first time in history, nearly doubling from the past average.

② Another reason is that AWS benefits from the arrival of the AI wave and the end of the cloud computing usage optimization cycle. After a rapid decline in growth rate, it has shown a gradual recovery trend in the past two quarters. At the same time, with the depreciation period of servers extended from 5 years to 6 years, along with other cost/product structure optimizations, AWS's operating profit margin has also jumped from around 30% and stabilized above 35% in the past two quarters.

③ As seen above, the joint profit margin increase in the retail and AWS segments has led to the market continuously revising up its expectations for Amazon's rolling net profit over the next year since Q1 2023, rising nearly 3 times from the low point. This is significantly higher than the stock price increase of about 2 times during the same period, resulting in a phenomenon of "getting cheaper as it rises."

2. Summary of Review

In summary, the essential driving reasons behind Amazon's recent stock price increase are mainly two points: ① The continuous breaking of past high points in retail business profit margins leading to profit release, and ② In the AI wave, AWS has finally shown a marginal recovery in growth (albeit modest) while profit margins continue to rise.

Therefore, looking ahead, whether Amazon's stock price can perform further mainly depends on whether the retail segment's profit margins and AWS's growth can continue to deliver better-than-expected results.

This article focuses on the first point—the space and probability for continued improvement in retail business profit margins. Further breaking it down, the two main factors currently driving the increase in retail business profit margins are: one is the revenue side, how much more room there is for Amazon's incremental monetization rate (mainly from advertising), and the other is the cost side, how much more optimization and improvement in logistics and delivery efficiency can enhance the user experience (UE). This article mainly approaches from the perspective of the revenue side.

2. A Brief Memoir of Amazon Advertising's Past and Present

1. History of Advertising Development

A brief review of the development history of Amazon's advertising business:

① As early as 2012, Amazon officially established its advertising business department, Amazon Media Group (AMG), which includes two business lines: performance advertising (CPC) and brand advertising (CPM).

However, from a retrospective perspective during the early years from 2012 to 2017, Amazon did not vigorously promote the penetration and monetization levels of its advertising business. By 2017, advertising revenue was only $4.3 billion, accounting for just 2.4% of total revenue that year In 2018, Amazon restructured its entire advertising business department (the specific structure can be seen in the image below) and launched a new advertising entry point (Dashboard), simplifying and optimizing the process for merchants to place ads. That same year, it also introduced two new advertising models: video ads and sponsored display ads.

After the aforementioned optimizations, Amazon's advertising business entered a phase of explosive growth, with advertising revenue jumping 117% to $9.4 billion in 2018. By 2024, it is expected to achieve approximately $56 billion in advertising revenue, close to 10% of total revenue.

2. What types of advertising does Amazon have?

As of now, Amazon's advertising products mainly include five types, which are: product ads, brand ads, display ads, streaming TV ads, and voice ads. (See the table above)

Specifically, the aforementioned five products can be roughly divided into two major categories, belonging to the Amazon Ad console and Amazon DSP departments:

① The first major category includes: product ads, brand ads, and display ads, which belong to the Ad console department. Among them, product and brand ads are performance-oriented ads, primarily displayed by 1P suppliers and 3P sellers on Amazon's web pages or within the app's search results and product pages.

Display ads (sponsored display) have characteristics of both performance and brand advertising, and are placed by 1P suppliers and 3P sellers on Amazon's site, Twitch, and third-party media platforms.

② Streaming and voice ads are more brand-oriented ads, belonging to the Amazon DSP department. Anyone can place these ads (regardless of whether they sell products on Amazon). The main media for placement are Amazon's streaming service Amazon Prime Video, as well as Twitch, Amazon Music, and other supported third-party media.

Among them, Prime Video ads were officially launched at the end of 2023 and are currently one of the main sources of revenue growth that the market is focusing on, which will be discussed in detail later.

3. Is advertising the key to influencing Amazon's profitability and valuation?

Looking ahead, how can we qualitatively and quantitatively understand the growth potential of Amazon's current annual advertising revenue of approximately $56 billion? As one of the largest e-commerce platforms in the world, the main component of Amazon's advertising revenue is strong conversion performance ads (also known as e-commerce ads). However, with the promotion of brand-oriented advertising services based on streaming and audio media platforms starting in early 2024, there is also potential for additional advertising revenue for Amazon **

First, let's look at the growth potential of e-commerce advertising. Dolphin Investment Research approaches this issue from two perspectives: ① From a macro perspective, how much room is there for Amazon's share in the advertising market in Europe and the United States to increase? ② From a micro perspective, how much room is there for merchants to bear the increase in advertising monetization rates?

1. How much advertising share should Amazon capture?

From a top-down perspective, advertising is a mature cyclical industry that is highly correlated with macroeconomic fluctuations. Except for a few major crises, the overall growth of the advertising industry is generally equivalent to or slightly higher than the global GDP growth rate, which is in the range of about 4% to 8%.

Therefore, any (especially leading) company that wants to achieve high advertising revenue growth essentially equates to seizing market share from other channels.

As seen in the chart below, over 40% of advertising spending in the United States is divided between Meta and Google, while the advertising share of e-commerce platforms is currently just above 10%. In terms of trends, the share of e-commerce platforms was nearly negligible 17 years ago, but since 2017, the share of e-commerce has begun to expand rapidly, making it the largest "share gainer" in the past decade, with the largest "share loser" being Meta and Google.

In contrast to the domestic advertising market, unlike the United States, domestic e-commerce platforms have always held the largest advertising share (currently over 40%), and this share has been gradually increasing over the years. However, similar to the United States, domestic platforms have also primarily lost share to search advertising.

So, can e-commerce channels led by Amazon continue to significantly increase their share? Based on the comparison of the e-commerce channels in China and the U.S. accounting for approximately 40% and 10% of the advertising market respectively, it logically suggests that there is considerable room for the advertising share of U.S. e-commerce platforms to increase.

However, Dolphin Investment Research does not agree with the "simple and crude" cross-market benchmarking, as this overly simplifies and overlooks the differences between the markets in China and the U.S. Going a step further, from the perspective of matching advertising demand and supply:

① In the domestic advertising market, taking Douyin and Kuaishou as examples, the leading online channels account for about 42% of advertisers from retail-related industries (of which about 14% is the advertising demand from the e-commerce platforms themselves). Represented by Focus Media, more than half of the advertisers in offline advertising channels in recent years also come from the consumer goods industry. It can be seen that whether online or offline, the consumption/retail industry is the main source of domestic advertising demand, accounting for a significant proportion (40%~50%). This proportion matches the situation where over 40% of advertising expenditure on the supply side is through e-commerce platforms, indicating a general supply-demand balance.**

② In contrast to the highly concentrated domestic advertising supply and demand in consumption and retail, according to Statista's survey, the sources of advertising demand in the United States are significantly more dispersed. Although the retail and fast-moving consumer goods industries rank No.1 and No.5 in advertising expenditure respectively, together they account for about 26% of the total advertising expenditure, still being the largest advertisers. However, there are also five other industries with shares around 8%~12%. It can be seen that retail and consumer goods do not hold an absolute leading position in the U.S. advertising market as they do domestically.

From the perspective of the supply side, another important difference in the internet ecosystem between China and the U.S. is that nearly 100% of online shopping in China is captured by platform e-commerce. In contrast, a significant proportion of online shopping in the U.S. is conducted through independent e-commerce sites, and the advertising demand from these merchants does not reflect in the advertising demand of e-commerce platforms. In other words, in the U.S., platforms like Meta and Google, which differ from domestic advertising platforms, also possess some e-commerce platform functions—namely social e-commerce, which can directly drive conversions and sales.

So, how much of the advertising share of non-e-commerce platforms like Google and Meta comes from e-commerce-like strong conversion effect ads? According to UBS statistics, about 31% of Meta's advertising revenue comes from the retail and consumer goods industry. This proportion is somewhat higher than the 26% proportion reported by Statista across all industries.

Assuming that Meta's proportion applies to all other social, search, and streaming platforms, and assuming that the ratio of e-commerce to non-e-commerce ads placed by retail and consumer goods companies on these non-e-commerce online platforms is 6:4. Roughly estimating, the share of e-commerce-like ads borne by social, search, and streaming platforms in the U.S. accounts for about 13% of the total advertising market.

③ From this perspective, how much room for growth is there for the advertising share of e-commerce platforms led by Amazon in the overall advertising market? Comparing the approximately 23% share of the retail and consumer goods industry (the main e-commerce advertising demand side) in advertising demand vs. the approximately 10% advertising share of e-commerce platforms themselves vs. the approximately 13% share of e-commerce-like ads occupied by non-e-commerce media platforms, it can be seen from this comparison of three sets of data that in the most optimistic scenario, the advertising market share of e-commerce platforms has the potential to double (essentially reclaiming all e-commerce-like advertising share occupied by non-e-commerce platforms). Under the neutral assumption, if the proportion of e-commerce advertising in the overall U.S. advertising market is about X, and Amazon accounts for about 40% of the U.S. e-commerce GMV, then under neutral expectations, Amazon's share of the U.S. advertising market should be 23% * 40% = 9.2%. This is not significantly different from the approximately 10% advertising share of Amazon in the U.S., of which about 80% to 85% is conversion-focused e-commerce advertising. In other words, after several years of rapid growth, Amazon's advertising share (at least in the U.S.) may have approached a neutral level.

However, the judgment that Amazon's advertising share (in the U.S.) may be close to a neutral level is more from a simplified and static perspective, and does not mean that Amazon's advertising share will not continue to grow in the future. First, the above calculations involve many uncertain predictions and assumptions. Secondly, logically, there are still many factors that could continue to drive the growth of Amazon's advertising share, such as: an increase in the proportion of advertising budgets from the retail or consumer goods industry that tend to invest in e-commerce advertising within the overall advertising market; retail or consumer goods advertisers are more inclined to invest in performance advertising, for example, the ratio of performance advertising vs. brand advertising continues to increase; advertisers' preference for Amazon compared to other e-commerce advertising channels is rising, meaning that they are capturing e-commerce advertising share from Meta, Google, or other channels. From a qualitative perspective, it is judged that Amazon's growth in e-commerce advertising may not be as "easy" in the future.

2. How high are the platform fees borne by Amazon merchants?

Above, we looked at the macro perspective, i.e., how much room there is for Amazon's market share to increase within the overall e-commerce market. Now, from a micro perspective, how much burden do the various commissions + advertising currently impose on merchants on Amazon?

Since the company does not disclose GMV figures and the breakdown of 3P merchant service revenue, the following is a display calculation based on predictions from foreign investment banks, which may not accurately match the actual situation, but the trends reflected are worth referencing.

As shown in the chart below, for 3P merchants, the proportion of commissions + fulfillment fees, which are relatively rigid monetization, has reached over 30% of their sales in recent years. In addition, the proportion of e-commerce advertising monetization in GMV has also grown to over 7% in recent years. (It is worth noting that according to our calculations, the e-commerce advertising monetization rate in 2024 has only increased by 0.2 percentage points compared to last year, far lower than the growth rate in previous years, which may also be another verification that Amazon's e-commerce advertising market share or monetization level has approached a neutral level?)

In a horizontal comparison, Amazon's current monetization rate of over 7% for advertising is already higher than the domestic e-commerce leaders' monetization level of 4% to 4.5%. From an overall monetization perspective (commission + fulfillment + advertising), Amazon's monetization rate of over 30% is also significantly higher than Southeast Asia's leader Sea, which is slightly above 12%, and South America's leader Mercado, which is slightly above 20%.

However, Dolphin Investment Research does not believe that Amazon's overall monetization rate is too high and that there is no significant room for growth. We currently do not see enough evidence to support this "alarmist" judgment. After all, as long as the platform can indeed help merchants create considerable sales, whether by raising prices or merchants continuing to cede profit margins to the platform, there is considerable operational space.

3. Video Advertising

In addition to having an e-commerce platform that can provide e-commerce-related advertising, Amazon also owns Prime Video (streaming media), Prime Music (music), Audible (audiobooks), Twitch (live streaming), Prime Gaming (gaming), and other quite rich entertainment and media platforms and services.

A considerable portion of these may have originally been "supplementary benefits" outside of Amazon Prime member shopping privileges, but after years of development, Amazon announced at the beginning of 2024 that the number of Prime Video members has exceeded at least 200 million users, and the aforementioned entertainment media platforms can also bring Amazon non-e-commerce advertising incremental space.

So, how large is the potential revenue that Prime Video advertising can bring in a stable state? First, a simple calculation method that could also be seen as a "bottom line" is:

① Prime Video users can choose to pay an additional $2.99/month to enjoy ads-free, thus avoiding most advertisements. According to Amazon's own disclosure at the beginning of 2024, Prime Video advertising can reach approximately 200 million users globally (in fact, it is predicted that the total number of Prime members worldwide should be around 300 million, but not all Prime members have activated streaming media services).

Now, under the extreme assumption that all regular Prime Video users choose to pay the additional subscription fee to go ads-free, 200 million members * approximately $36 per year in additional membership fees, could generate an additional revenue of about $7.2 billion per year. Although this is an extreme situation that is unlikely to occur, this $36 annual fee for ad-free service implies Amazon's own neutral and conservative forecast of the average revenue per user (ARPU) contribution from Prime Video advertising. ② A more conventional forecasting method is to estimate the potential advertising revenue by analogy to Netflix, with the calculation formula and key assumptions being: Ads revenue: ad load per hour * viewing hours per user * user numbers * sell-thru rate * CPM.

Under a relatively conservative expectation for a steady state, assume Amazon has an ad load of 3 minutes per hour (the industry averages about 4 to 6 minutes per hour), which corresponds to 6 ad slots per hour at 30 seconds per ad;

The average viewing time per user is approximately 2 hours per day for industry leader Netflix, and under mid-term steady state, the average viewing time for Prime Video is 40% of Netflix's;

The user count is based on the company's own disclosure of 200 million people;

The sell-thru rate, or ad sell-through rate, is assumed to be 75% under a neutral assumption;

Combining news reports and market expectations, the initial CPM (advertising pricing) for Prime Video is estimated to be around $30 (currently about $25), and it is expected that the CPM can reach $30 in the mid-term. However, as shown in the table below, the CPM will fluctuate significantly with changes in economic conditions;

Based on the above assumptions, under a neutral and slightly conservative expectation, the advertising revenue for Prime Video is estimated to be around $7.8 billion, with each user contributing approximately $3.2 per month, which is slightly higher than Amazon's own pricing of an additional $2.99 per month, essentially matching.

Under an optimistic expectation, if all the key forecasts are aligned with industry leaders, the ceiling for Prime Video's advertising revenue is estimated to be around $55 billion, which is equivalent to doubling Amazon's total advertising revenue in 2024. It is evident that the incremental advertising revenue that Prime Video alone can contribute is also quite considerable.

However, even if this optimistic scenario can be realized, it would take at least 3 to 5 years to potentially reach that optimistic figure. Moreover, this optimistic assumption does not take into account the limitations of the total advertising market and the competition among major advertising players, so it should only be viewed as a reference for an upper limit.

III. How much impact does the advertising business have on Amazon's profits?

In the above, we have spent considerable effort discussing the growth potential of Amazon's advertising business. So why does advertising have a significant impact on Amazon's performance, and what is its major connection to the continuous upward adjustment of Amazon's profit expectations over the past year? The logic is quite simple: compared to the capital-intensive, low-margin, and labor-intensive retail and distribution businesses, advertising is a highly profitable business model that can bring significant profit elasticity. **

As can be seen from the chart below, the profit margins of e-commerce advertising businesses, along with other entertainment and social advertising businesses, generally range from about 40% to 60%. Compared to Amazon's overall retail business profit margin of around single digits, the contribution to profits can leverage nearly 10x.

Quantitatively, how much does the advertising business actually contribute to Amazon's retail business profits? Due to the lack of official data, market assessments of advertising's profit contribution are mainly divided into two understanding perspectives. One perspective is from the marginal incremental angle, believing that the marginal operating profit margin of e-commerce advertising revenue can reach 70% or even higher. The other perspective is more from a holistic angle, estimating Amazon's advertising profit margin to be roughly in line with peers, between 40% and 50%.

Both perspectives have their merits. The logic of the former can be simply stated: even without the advertising business, the operational, customer acquisition, and fulfillment costs that need to be incurred are necessary expenses. In contrast, the incremental costs and expenses required for new advertising, which is a light asset business, are theoretically quite low.

The logic of the latter can be understood as Amazon's advertising business cannot exist independently of its heavy asset retail business. Without the high-cost self-operated business, marketing, and fulfillment services that establish barriers, Amazon would lack the prerequisites to attract merchants to place advertisements.

However, from both perspectives, it is clear that as the scale of the advertising business continues to grow, in recent years, the contribution of advertising to operating profits within the overall retail sector has been steadily increasing, and by 2024, nearly all profits will come from the advertising business. The difference between the marginal and overall perspectives mainly lies in that the marginal perspective shows that the general retail business excluding advertising has been consistently losing money, while from the overall perspective, aside from the significant losses caused by high logistics investments from 2021 to 2023, most years (including 2024) still maintain an operating profit margin of around 1% for the general retail business excluding advertising.

From the above analysis, it can be seen that the improvement in profit margins for Amazon's general retail sector mainly depends on the increasing monetization rate of high-profit channels such as advertising (including 3P commissions). Based on the previous analysis by Dolphin Investment Research that Amazon's market share in e-commerce-like advertising is already close to a neutral level, we expect that the speed of improvement in Amazon's e-commerce advertising monetization rate will slow down in the coming years, with advertising revenue growth aligning with GMV growth. However, Prime Video advertising will take over to bring incremental revenue, reaching a neutral expectation of around $10 billion in revenue in about 2 to 3 years.

In terms of profit forecasting, due to the gradual slowdown in the growth of e-commerce advertising, the main increment will come from video advertising. However, unlike e-commerce advertising, which theoretically can incur minimal incremental costs, video advertising is actually a relatively high-cost business, as the continuous production of high-quality video content or the cost of acquiring rights for sports events is quite substantial. For example, Netflix's content costs reached $16.5 billion in one year, and Amazon's content costs in 2024 also exceeded $7 billion.

Therefore, Dolphin Investment Research believes that logically, since the subsequent growth in advertising revenue mainly comes from video advertising and the corresponding incremental content costs, video advertising may not significantly boost the overall profit margin of Amazon's advertising business. Thus, we have a relatively conservative expectation for the improvement of advertising business operating profit margins in the coming years.

As for the improvement in profit margins of its general retail business after excluding advertising, part of it depends on whether the company will raise commission or fulfillment fee standards (an easier path), while another part comes from improvements in Amazon's operational efficiency (a more difficult path). For the former, after several increases in FBA-related fees in recent years, Amazon recently announced that it will not raise commission or fulfillment fees in the U.S. region in 2025, nor will it introduce any new fee items, and will instead consider lowering fees or providing some subsidies. This should also reflect the company's awareness of the negative impact of excessively high or frequent increases in platform monetization on the seller ecosystem.

In other words, it is likely that in the next 1-2 years, the improvement in profit margins of the retail business after excluding advertising will rely solely on efficiency improvements (i.e., the difficult path), and therefore we do not have an optimistic expectation that its operating profit margin will significantly exceed the previous high point of 1.1% in the next 1-2 years.

Finally, from a valuation perspective, since this article only discusses the profit prospects of the retail business, and given the rapid iteration of AI technology, it is indeed challenging to predict the prospects of AWS business 2-3 years down the line. Dolphin Investment Research will only reverse-engineer the current market capitalization to see how much valuation is currently accounted for.

According to our calculations of the after-tax operating profit of the retail business in 2026, due to strong competitive barriers, we assign a full valuation of 35x PE and discount it back to the end of 2024. Thus, the implied market valuation for AWS is $1.44 trillion, corresponding to an after-tax operating profit of 42x PE for 2024. However, this does not take into account the growth potential of AWS in the coming years. From this perspective, the market's valuation multiple for AWS is roughly close to that of the retail business and may even be lower

Risk disclosure and statement of this article: Dolphin Investment Research Disclaimer and General Disclosure

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