Think about the last time you spent money at a Costco (NASDAQ:COST) or on Amazon.com (NASDAQ:AMZN). Did you do it because it was cheap? Perhaps it was just to save time. Sure, price and convenience are big, but something else may have played a role. It's sneaky, it's counter intuitive, but it works like a charm.
There is a subtle benefit for companies that make you pay to use them. When you spend money on a service, something triggers in your subconscious. You feel compelled to continue using whatever it is you bought. It prevents you from wasting money.
And as a marketing technique, it works really well. Amazon and Costco have built tremendous businesses off of this model. By paying a membership or admission fee, customers have more of a reason to spend money with these companies. It becomes a game to get the most bang for your buck.
Here's the thing
Amazon Prime customers spend an average of $538 per year. Non-prime customers spend $320 according to survey by RBC. Clearly, Amazon wants as many Prime customers as possible. And it's not just because they spend more money; it's because they're more engaged. If you can effectively engage your customer, you're one step closer to victory.
And those Prime memberships come with some pretty sweet margins. Assuming the company is fine shipping a ton of items in two days for free, these sales are pure profit. Amazon doesn't give the exact number, but it claims there are at least 20 million prime members.
At $99 per member, that's $200 million that flows right to its bottom line per year. And with all of the extra features, like video and music streaming, customers keep ponying up. Best Buy and Barnes & Noble probably wish they had such a tool.
Costco is similar. It charges $55 per year for a basic membership, and you get to be in its "club." Whether it's a $1.50 hot dog combo or a big-screen TV, Costco is able to deliver at a value few others can match. The relationship works for both the business and the customer. That's what makes it such a fierce competitor.
At $110 for its Executive Level Membership, Costco isn't messing around. When you consider that more than 50 million members pay at least $55, things get really silly. Between those two membership levels, Costco adds at least $2.75 billion to its business per year.
Getting away from retail but staying focused on the membership business model leads us to Pandora Media (NYSE:P). Its high-quality, commercial-free product costs $60 per year. But the difference between Pandora and Amazon or Costco is that Pandora has no end game. Once it gets you past the free stuff and earns your business, it has no other way to monetize you. In my opinion, this makes it a much weaker business.
That's because there's no way for it to control its churn. According to Investopedia, a company's churn rate is defined as, "The percentage of subscribers to a service that discontinue their subscription to that service in a given time period." If new customers do not come on board faster than the old ones leave, the business cannot grow. With Pandora, there's nothing (aside from its content) to keep customers from coming and going.
According to Consumer Intelligence Research Partners, 23% of Amazon Prime customers let their service lapse every 12 months. That may sound high until you consider Costco is in the same ballpark, around 80% maintain their membership per year. Pandora is a whole different ball of wax. As of February, 65 million accounts (of around 250 million registered users) went inactive over the previous 13 months.
Free is better?
Doesn't all this seem counterintuitive? You would think companies like Wal-Mart would dominate this type of model because it doesn't charge you to get in the door. Customers are free to come and go as they please without incurring that cost. But lately, the numbers haven't been supporting that theory.
Unlike Costco, which grew same-store sales at a 6% clip in May, Wal-Mart's comparable store sales were slightly negative in its first quarter and have been trending poorly for some time now. One reason might be that it allows customers to get in and out of its stores cheap. Obviously, Wal-Mart is the largest retailer in the world for a reason, but it if ever wanted to change its model and add some sort of admission fee, it probably wouldn't go over too well.
Foolish final words
Admission or membership fees serve a dual purpose. They generate high-margin sales for a company, and they compel you to keep visiting so you get your money's worth. This works out splendidly for the company, which earns consistent, predictable, future cash flows. In turn, customers feel a bias toward that company, which improves engagement. The cycle feeds itself.
Ultimately, good companies like Costco and Amazon will pass on that value to the customer, which enhances loyalty even more. Once you take this into account, you begin to realize the power of these types of businesses. The admission fee model is a brilliant marketing technique that works. With time, I think more companies will adjust the way they do business.
Wade Michels has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Costco Wholesale, and Pandora Media. The Motley Fool owns shares of Amazon.com, Costco Wholesale, and Pandora Media. 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.