Prime Is Killing Amazon's Profit

Amazon.com (NASDAQ: AMZN  ) reported earnings last night and those glossing over the numbers may see a few positive signs. Gross margin was up to 26.6%, a nice 2.6% jump from a year ago, and earnings per share of $0.18 were double what analysts expected.

But a closer look at the numbers shows that margins aren't improving at all and Amazon is only digging a bigger hole on its income statement. It's become reliant on Amazon Prime to drive growth and it's giving away goodies that destroy any chance it has at making a significant profit.

The draw of Prime
Amazon's Prime service is supposed to be a mutually beneficial partnership between Amazon and customers. For consumers, it costs $79 a year to get two-day shipping and access to Amazon's growing catalog of instant streaming videos. From Amazon's perspective, this is meant to provide an incentive to use Amazon for more purchases and generate more income.

In reality, what we've seen over the past two years is that fulfillment costs and technology/content costs of providing Prime have grown faster than revenue, offsetting any benefits of Prime to Amazon.

Prime costs Amazon
It's true that gross margin increased 2.6% in the first quarter to 26.6% but this neglects to include very important costs. The commonly quoted number doesn't include costs associated with Prime like shipping and content, which are very real costs that are ongoing in nature.

If we include these two costs, which are both directly related to generating sales, we find that what I'll call the "real" gross margin actually fell 0.2% over the past year to 6.8%. Over the past two years this real margin has been relatively flat while advertised gross margin has risen steadily.

I don't see the trends changing anytime soon either. Sales grew 21.9% in the first quarter but fulfillment costs rose 38.7%, a trend we've seen over and over again. Technology and content costs were up 46% in the quarter and as we've seen at competitor Netflix (NASDAQ: NFLX  ) , the margin pressure won't subside. Netflix just reported an anemic first-quarter profit because content costs are rising as it tries to grow its customer base. More customers mean higher content costs and these customers demand more content, which costs more. It's a never-ending profit killing cycle in streaming. 

Amazon is arguably in a worse position than Netflix in streaming video because it has one revenue stream (Prime subscriptions) for two major costs (two-day shipping and streaming content).

Foolish bottom line
I'm one of only a few Fools who don't see the value in Amazon and it stems from the fact that the company doesn't seem to be interested in making money. The economics of the Prime service only highlight this problem, adding significant costs to the income statement and keeping real margins extremely low. Unless Amazon can grow margins after shipping and content costs, I think the stock is worth selling, or even shorting if you're crazy enough. 

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Read/Post Comments (12) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 26, 2013, at 12:15 PM, yahoouser4529 wrote:

    I have amazon prime and I love 2 day delivery for free. I do not believe it's hurting amazon. Look at the explosive amazon stock growth for the past 5 year. It is their sellers that Are Killing Amazon By Overpricing Products. For example lg nexus 4 phone costs 450 on amazon hot on Google play its 350. You find cheaper prices on same products elsewhere. Google play shipped me lg nexus in 2 days too

  • Report this Comment On April 26, 2013, at 12:28 PM, veritas75 wrote:

    I'm not sure that Prime is the problem. Not only do you pay for the service, but you pay a premium for the products, which should compensate for the shipping costs. Price an item you want while signed in under your Prime membership. Sign out and see what the item costs as a non-Prime member. It's usually 5-7% cheaper although that is not true 100% of the time.

  • Report this Comment On April 26, 2013, at 12:28 PM, hmsthehood wrote:

    Amazon selling Kindles for $3.00 less then what they cost to make. I know they consider this a loss leader but I think business practices like this one is what is hurting Amazon.

  • Report this Comment On April 26, 2013, at 12:34 PM, buzzltyr wrote:

    At some point wall street will figure out Amazon will never make a profit. There whole business is about selling for no profit

  • Report this Comment On April 26, 2013, at 1:01 PM, tjalsma wrote:

    So, the worst thing that can be said about Amazon is that they are actually providing something to their consumers? Okay.

    Also, Amazon may sell a Kindle for "$3 less than they cost to make" but they also have the ability to understand that each user will, in almost every case, purchase more than $3 worth of goods through the Marketplace on their Kindle.

  • Report this Comment On April 26, 2013, at 1:40 PM, Deepwater805 wrote:

    I am an Amazon ultra extreme shopper. Prime is my prime motivatin for shopping there. If Amazon pulls the plug on Prime, I pull the plug on Amazon. Simple as that.

  • Report this Comment On April 26, 2013, at 2:21 PM, teebee99 wrote:

    I now how to make Amazon Prime less costly to Amazon - I'll stop buying from them and then they won't have to worry about the shipping costs. The more they save, the less I spend!

    Geez - companies make money from selling stuff - looking at "making it easy for people to buy and obtain (free shipping) products" as a bad thing is absurd.

  • Report this Comment On April 26, 2013, at 2:27 PM, gwtx2 wrote:

    The author obviously has no idea about the company. Amazon's board of directors is more concerned with growth than profit. And growth they have and are accomplishing. If amazon were to take this author's advice, they would be just another online retailer.

  • Report this Comment On April 26, 2013, at 3:20 PM, vagrant291 wrote:

    I don't buy this for a second. Amazon should only grow further in Q3/Q4. The AWS cloud service is only growing and their investments are starting to pay off. Prime is a membership service they people pay for, and the markup on the items to offset this premium service is there as well.

  • Report this Comment On April 26, 2013, at 3:59 PM, juxta99 wrote:

    Amazon is still trying to figure the shipping out. They temporarily offered $1 off for not using free 2-day shipping with Prime. They are still installing picking robots in the warehouses and building new warehouses close to cities, right?

    I agree with others about Amazon being a great shopping experience. So far this year I've spent about $2500 on 59 orders which is one box coming to my home every other day on average. So they need to figure out how to give the convenience of free shipping at a lower cost. They make it hard to combine orders placed within say 7 hours of each other and I do get a little annoyed with all the cardboard boxes coming to my home!

    I spent over $10000 last year with no big ticket items. Three years ago I bought an LCD TV, Bluray player and surround speakers from Amazon with no problems. Over the last 18 months I've bought lots of baby / toddler toys and clothes and also strollers and car seats. Recently I started buying all the bulk items I can so I can lighten shopping trips to the grocery store - paper towels, toilet paper, cookies, cereal, rice milk, etc.

    So Amazon has potential to increase sales (maybe not profits anytime soon) because they are eating away at sales for me personally from Lowes, Safeway, Whole Foods, Walmart and CVS. I'm busy like everyone else so the less time I spend in retail stores the better.

  • Report this Comment On April 26, 2013, at 5:47 PM, VegasSmitty wrote:

    The more I read these articles, the more I realize the people writing them know jack.

  • Report this Comment On April 27, 2013, at 3:40 AM, margiecfl wrote:

    thks for the column :)

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