Amazon.com, Inc (NASDAQ:AMZN) CFO Tom Szkutak revealed on the company's earnings call last week that the company is considering raising the price of its Prime service by $20 to $40 in the U.S. That would represent the first-ever price increase for Amazon's popular membership program, and would take the annual cost to $99-$119.
Increasing the Prime subscription price to $99 per year may be a reasonable move for Amazon. Most Prime users probably get enough value out of the service that they would fork over another $20 to keep their membership. By contrast, a price increase to $119 would be a big mistake.
Not only would that break the psychologically important $100 threshold, it would represent a 51% increase. This still might not faze the majority of Prime users, but it would cause a significant number of cancellations, depressing Amazon's growth rate. This phenomenal growth rate has been the main factor driving Amazon's market cap higher. A slowdown in growth caused by a Prime price hike could lead to severe multiple compression.
Amazon's growth motor
Amazon Prime was introduced nearly a decade ago as a program to provide free two-day shipping on various Amazon items. The Prime-eligible selection has expanded to more than 19 million items today. Additionally, Amazon has added other perks in recent years, most notably the Kindle Lending Library (which offers free rentals for a large selection of e-books) and Prime Instant Video (which offers free rentals for a variety of movies and TV episodes).
Amazon Prime has been a key factor driving Amazon's rapid growth from annual revenue of less than $7 billion in 2004 (before the introduction of Prime) to more than $70 billion last year. The express shipping benefit removed two big barriers to e-commerce: long shipping times and the need to reach particular order minimums to get free shipping.
As a result, Amazon.com has become the default e-commerce site for most Prime members. Most retail analysts believe that Prime members spend significantly more on Amazon than they would if they were not members. A Morningstar report last year found that the average Prime member spent more than $1,200 a year on the site.
According to Szkutak, increases in the Prime selection and rising shipping costs are pressuring Amazon's profitability, necessitating the first price increase in Prime's nine-year history.
Indeed, Amazon's global shipping costs reached $2.34 billion last quarter, while shipping revenue was less than half that amount, at $1.14 billion. The resulting shipping loss represented 4.7% of Amazon's revenue, up from 4.5% of revenue in Q4 of 2012. Considering that Amazon's pre-tax profit margin was less than 2% last quarter, these shipping costs are a clearly an anchor weighing down Amazon's earnings power.
Accordingly, many analysts were excited about the prospect of an increase in the Amazon Prime membership price. They see it as a savior that will bring in hundreds of millions of dollars in "free" revenue that will drop straight to the bottom line. This will finally lead to the margin expansion that Amazon bulls have been expecting for more than a year.
The margin paradox
Paradoxically, a significant increase in Amazon's earnings power won't necessarily translate to a higher stock price. Analysts currently expect Amazon's EPS to more than triple this year, from $0.59 to $2.04, and then double in 2015 to $4.27. However, Amazon already trades for 80 times that 2015 earnings estimate.
Even if a higher Prime price boosts 2015 EPS to $5, the company would still need massive long-term growth beyond that to justify its valuation. However, the extra Prime membership revenue that would come from a price increase could be greatly outweighed by lost revenue from former Prime members who quit -- especially if the price jumps all the way to $119.
Costco -- which operates another one of the most successful membership programs within retail -- has found that few members protest about membership fee increases. However, Costco most recently increased its basic membership fee by $5, from $50 to $55. Considering that members spend around $2,000 a year at Costco, it's easy to see why another $5 is no big deal to them.
By comparison, even a $20 increase for Prime would be significant and could slow new member additions while causing a few members to quit. A recent Wall Street Journal poll found that 47% of Prime members might resist a price increase. The poll was unscientific, and probably overstates the number of people who would actually quit, since people who are most unhappy about a potential price increase are more likely to take the time to voice their frustration. However, it still suggests that the number of people who would consider dropping Prime is not trivial.
An increase to $99 per year might not alienate too many Prime members. However, while going to $119 per year might be good for Amazon's near-term profit margin, passing the $100 mark will make the service seem a lot more expensive. Moreover, while Amazon points out that the price has been the same for nine years, most Prime members have joined in just the last two to three years. A sudden 50% price increase will therefore seem excessive.
It's impossible to be sure of how Prime members will react to a price increase. However, a jump all the way to $119 seems incredibly risky. If Amazon needs to raise the price, $99 would be more defensible and cause less of a gut reaction against the company among Prime members.
For investors, the problem with a Prime price increase is that the potential for extra profit dollars in the short term is outweighed by the likely reduction in Amazon's growth rate. The law of large numbers is already kicking in and will probably drive Amazon's revenue growth below 20% either this year or next year.
A big Prime price increase could reverse the main driver of Amazon's long-term revenue growth -- at least temporarily. This could send revenue growth down toward a noticeably slower rate by 2015, perhaps 15% or less. A growth slowdown of that magnitude would raise the specter of massive multiple contraction, devastating Amazon's stock price.
Adam Levine-Weinberg is short shares of Amazon.com. The Motley Fool recommends and owns shares of Amazon.com and Costco Wholesale. 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.