The 1 Solution for Amazon’s Biggest Problem

It has long been said that Amazon must eventually deliver consistent profits. It looks like judgment day has arrived, and Amazon finds itself facing a dilemma. Is there a solution?

Feb 4, 2014 at 2:00PM (NASDAQ:AMZN) will have a difficult time delivering consistent profits without increasing prices for Amazon Prime memberships. Currently, Amazon Prime costs $79 per year. Amazon Prime members receive multiple benefits, including free two-day shipping with no minimum order size (non-Prime members must have an order of $35 or more to receive free shipping), unlimited instant streaming of thousands of movies and television shows with Prime Instant Videos (many members don't know they're able to take advantage of this feature), and monthly free books with Kindle First and Kindle Owners Lending Library.

The reason for the potential price hike of $20 to $40 (representing a 25% to 50% increase) is increased shipping costs. Up to now, Amazon has been all about the customer, throwing consistent profits out the window in order to please the masses. Now that Wall Street is unpleased with the company's quarterly results, which will lead to more questions being asked about Amazon's sustainability in regards to stock appreciation, Amazon must make a move.

Let's take a look at both angles, see which angle makes more sense, and figure out if Amazon's recent announcement might have a positive impact on Netflix (NASDAQ:NFLX) or Wal-Mart Stores (NYSE:WMT).

Amazon's dilemma
Imagine you owned a hot dog stand in New York. Let's keep this simple and say that each hot dog cost you $1. You then sold each hot dog for $1.01. You would be the most popular hot-dog-cart owner in the city. The masses would flock to your hot dog cart for lunch thanks to the savings. Sales would also be through the roof.

The guy around the block also owns a hot dog cart. His cost for each hot dog is also $1. However, he sells his hot dogs for $1.15. Of course, many people would buy from you because your hot dogs are cheaper, but many others would pay the premium for the $1.15 hot dog due to convenience. Your competitor doesn't do nearly as much in sales, and he's far from a hero, but he goes home with a tidy profit. So, who is really winning?

Right now, Amazon is all about taking care of the customer, and it's beating Netflix and Wal-Mart in pricing (in very different areas). If Amazon increases its prices for Amazon Prime, it will certainly lead to some discontent. Just look at what happened to Netflix in 2011, when it announced that it would raise prices 60%. This led to infuriated customers, the loss of 800,000 subscribers, and the stock price plummeting. Netflix quickly changed its mind.

Therefore, what is Amazon to do?  

The good news
Amazon Prime is in high demand. Actually, it's in such high demand that Amazon warehouses couldn't keep up with shipping orders, having to limit sign-ups during peak season. There were 20 million subscribers as of December. Also note that Amazon Prime has been around for nine years and has never once raised its membership fee.

With Amazon Prime being in such high demand, Amazon should be able to raise its membership fee. Of course, doing this at a methodical pace, such as the $20 increase as opposed to the massive $40 increase, would likely be a better approach. Surely, some customers would still be angry, but $20 over a year should be more than made up for by savings in shipping fees. After all, most people who sign up for Amazon Prime do so for free shipping on all orders. Amazon could also point out that there have been no price increases over a nine-year period, and that it opted for the $20 increase as opposed to the $40 raise. 

Even with the $20 increase, this means that Amazon Prime will cost more than Netflix: $8.25 per month versus $7.99 per month. This could act as a temporary positive catalyst for Netflix. As far as Wal-Mart is concerned, the impact should be very minimal since Wal-Mart primarily relies on brick-and-mortar sales. 

Wal-Mart shipping is $4.79 if your order is under $50, but it will take six to nine days. If you want your delivery to arrive in three to five days, then it will cost $6.97. All orders of $50 or more come with free shipping. But the real threat from Wal-Mart is in-store pickup, which Amazon can't offer as of right now. 

The bottom line
Amazon should be able to increase its Amazon Prime membership fee by $20 without experiencing massive backlash. This would represent approximately a 25% increase, which is nothing compared to Netflix's attempt at a 60% increase back in 2011. Over the long haul, it's a risk Amazon might need to take.

The only catch here is that if deflation is the real threat to the economy when you take away monetary stimulus, then gas prices and shipping costs would eventually decline. However, if Amazon raised its Amazon Prime membership fee by $20 and gas prices declined, then Amazon would be well situated. Consumers wouldn't be as strong in that environment, but $20 per year shouldn't be a monumental event for consumers interested in Amazon Prime.

If you read this column, then you already know that I like Amazon long term but have consistently warned about valuation. I felt it was best to stay on the sidelines. While Amazon is now "only" trading at 582 times earnings versus 1,400 times earnings, and while I'm not a fan of making a big deal about valuation, this is still too expensive. I'd still wait on the sidelines. However, this is just my opinion. Please do your own research prior to making any investment decisions.

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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