1 Huge Risk to Amazon's Holiday Results

Amazon.com (AMZN 0.81%) is becoming a victim of its own success. As more customers take advantage of free shipping offers, the company's shipping costs are turning into a huge drain on operating profits.

And this year's holiday quarter should set a new high for those costs, weighing down Q4 earnings for the web retailing giant.

Fantastic online growth
Too many orders sounds like a great problem for a retailer to have. After all, Amazon is expected to book $22 billion in revenue in Q4, up almost 30% from the year-ago quarter. That's fantastic growth for a company that was already notching close to $50 billion in annual sales. But with the Amazon Prime membership an increasingly popular option, many of those extra orders will come from Prime members who get unlimited two-day deliveries at no extra cost on most items.

The good news for Amazon is that all those order-happy shoppers are boosting their online spending this year, to cover much more than just big-ticket items.

While total web-based spending surged through the first few weeks of this holiday season, the average spending on each order fell. Visa (V 0.33%), for one, counted a 20% boost in online charges over the Thanksgiving weekend this year. But it also saw a decrease in average order amounts. The National Retail Federation noticed the same effect on Black Friday sales results. So Amazon is bound to have a solid overall boost to sales, thanks to consumers stuffing their carts with a wider range of cheaper, more everyday items this year.

But the downside to that trend is that shipping costs will eat up a larger percentage of each order.

Feeling generous
Amazon sees its shipping offers as a vital part of the business. In its financial filings, the company tells investors:

We expect our net cost of shipping to continue to increase to the extent our customers accept and use our shipping offers at an increasing rate. ... We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers.

So, by design, Amazon's pool of high volume subscribers is getting more expensive to the company with time.

Call it the anti-Costco (COST 1.57%) model. Like Costco, Amazon sells products at razor-thin margins, but has a membership base chipping in yearly fees that help make those low margins possible. In Costco's case, its $416 million of net income in Q3 wouldn't have existed at all without the $511 million contribution from membership fees.

But Amazon is working in just the opposite way lately. And that's a big reason why margins at the two retailers have taken such different paths over the last few years:

AMZN Operating Margin TTM data by YCharts.

Amazon's net shipping costs, which include revenue from Prime membership payments, have been a large and growing drag on earnings. And those costs have been ramping up at a much faster pace than revenue growth:

Source: Company financial filings.

For comparison, Amazon's capital expenditures were $373 million,  $979 million, and $1.8 billion from 2009-2011. The company has been investing heavily in its fulfillment centers, but that's small potatoes compared to the outflow from shipping deals.

And the trend continued into this year. For the first three quarters of 2012, shipping costs came out to $668 million, $585 million, and $636 million, for a total $1.9 billion hit to sales costs so far.

How big of a hit this year?
In last year's holiday quarter, Amazon booked a $935 million loss on shipping. That was 66% higher than the year before, far outstripping the 40% growth in sales. If that trend continues, we could see a $1.5 billion charge to this quarter's costs.

But let's assume that the company slows down that crazy pace of growth in Q4 and somehow manages to cap shipping cost growth at revenue growth. That would still mean a $1.2 billion net cost for the quarter, or more than $3 billion on the year. While Amazon's expensive battles in the streaming video market and splashy entries into tablet hardware have their roles to play, its really shipping costs that carry the most risk to the company's bottom line right now.