A Deeper Look at the Amazon Prime Price Increase

During its discussion of its most recent quarterly results, Amazon.com (NASDAQ: AMZN  ) notified the world that it was considering a price hike of $20 to $40 for its Prime service. Less than two months later, the company began notifying customers that a $20 increase will go into effect when each customer renews their membership with emails similar to this:

What will the decision to raise the price of Amazon Prime mean for customers and investors?

Consumer value proposition
At $99 per year, Amazon Prime still represents a tremendous value for customers that use it regularly. Free unlimited two-day shipping (and next day shipping for just $3.99) on over 20 million items is not only a tremendous convenience, but a big money saver for customers that shop from Amazon.com regularly.

Most e-commerce sites (including Amazon.com for non-Prime customers) require a minimum purchase for any form of free shipping; while "free," these minimums often result in additional purchases to meet the minimum order requirement. For example, Wal-Mart Stores (NYSE: WMT  ) requires a minimum purchase of $50. So, a $10 dog toy costs an Amazon Prime customer $10, while the same toy costs a Wal-Mart customer either $15 (including $5 for Wal-Mart's lowest price shipping option) unless the customer purchases another $40 worth of goods.

Minimums aside, the speed of Amazon.com's free shipping is also noteworthy. Forget to shop for a birthday gift for a relative?  Amazon.com can save an emergency trip to the mall with either free two-day or $4 one-day shipping on a wide array of gift ideas. By comparison, the purchase of a pair of jeans from Nordstrom costs $15 for two-day shipping and $25 for one-day shipping. Likewise, the purchase of an iPad from Best Buy will cost $12 or $22 for these expedited shipping times.

It doesn't take long for the math to work out to justify a $99 membership based on the ability to purchase individual items below minimum purchase levels or the occasional need for fast shipping. While slightly more expensive than the $79 that ShopRunner charges for free shipping, Amazon.com offers a significantly wider ranger of products as part of its Prime membership.

Plus, it is important to realize that shipping is just part of the value proposition. Significant streaming video and digital book libraries provide a fantastic resource for customers both as an alternative or compliment to streaming services like Netflix (NASDAQ: NFLX  ) . While Netflix has a superior video library than Prime's Instant Video, Prime has quite a bit of content that Netflix does not. For example, a Netflix subscriber would be forced to pay $60 to watch the first three seasons of the hit series Downton Abbey since the series isn't available on Netflix. That content is free for Prime subscribers, and is just one illustration of how an Amazon.com customer can benefit from a library of over 40,000 titles.

With new content being added to Prime regularly, such as the rumored addition of streaming music, $99 still represents an appealing value for customers. 

Impact for investors
There are two primary reasons that investors should take notice of the Amazon Prime price hike. First, a recent study indicated that Prime members spend roughly double ($1,340 per year) what non-Prime customers spend ($650 per year). As a result, any move that dramatically changes the growth trajectory of Prime subscriptions will also impact Amazon.com's growth.

A 25% price increase for Prime will impact membership growth, but the critical question is "by how much?" This information isn't known at this time, although there is certainly plenty of speculation. Data from analysts and research firms vary wildly, but a well constructed case by analyst Mark Mahaney of RBC Capital Markets suggests that churn of 1-5% is likely, and that the price increase could generate up to $400 million of additional income for Amazon.com.

Mahaney analogizes this price increase to the minimal impact that membership fee increases for retailers such as Costco Wholesale (NASDAQ: COST  ) have historically had on membership levels. Costco is a particularly relevant example, since the company's move to increase membership fees by 10% in late 2011 had minimal impact on renewals largely because customers appreciate the value of the service provided. 

While some suggest that a higher churn rate of 10-15% is more realistic, this still wouldn't be a bad thing for investors. Assuming Amazon.com has 20 million Prime subscribers, here is an illustration of the impact of a 10-15% loss of subscribers:

Subscriber loss 2 million 3 million
Reduced subscriber count 18 million 17 million
     
Incremental membership revenue (100% income) $360 million $340 million
     
Lost revenue from former Prime subscribers* ($1.38 billion) ($2.07 billion)
Operating on lost Prime subscriber revenue** ($47 million) ($70 million)
     
Net change in operating income $313 million $270 million

* Lost revenue assumes that each former Prime subscriber reverts from average annual spending of $1,340 to non-Prime average annual spending of $650.
** Lost income associated with revenue reduction is estimated based on Amazon.com's 3.4% operating margin as a percentage of sales as reported in the company's Q4 2013 earnings release. 

While it seems unlikely that Amazon.com would lose 10-15% of its Prime subscribers based on the value proposition described above, this simplified model illustrates that this is still a net positive for investors. A $270 million to $313 million increase in operating income is significant in comparison to Amazon.com's $745 million of total operating income in 2013.

Whether it is $270 million, $313 million, or more, the move to raise the price of Amazon.com Prime is a first step in focusing on delivering income growth for shareholders. This is just one more positive for a company that has a tremendous opportunity for growth for years to come. As a result, Amazon.com remains a long-term buy.

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Read/Post Comments (8) | Recommend This Article (5)

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 March 17, 2014, at 5:39 PM, carnegiel8ker wrote:

    I found it humorous that you used a $10 dog toy as an example of the beauty of Prime. The whole reason that Prime is a profitability sump is that there is no way that AMZN can make ANY profit selling a $10 item and then paying for free shipping. Of course Prime is GREAT for the customer who buys the $10 item, but for the customer who doesn't shop AMZN that frequently, the Prime price hike will cause him to cancel. In many respects, Prime is like a health club: Health clubs lose money on the guy who comes twice a day but make 100% margin on the person who doesn't come at all...so if the health club raises the price of membership, the twice a dayer will be more than happy to pay the increase, while it will cause the guy who doesn't come at all to cancel. Now of course AMZN will continue to amaze us with stories of how many bobble-head Santas they sell at Christmas, but as long as they allow people to buy $10 items and receive free shipping, the company will never make any real profit.

  • Report this Comment On March 17, 2014, at 6:03 PM, Popnfresh100 wrote:

    Carnegie has the right idea- Prime is in a classic death spiral.

    The health club analogy is spot-on except for one critical difference: a health club doesn't actually lose money on the active user. Rent is paid either way and wear-and-tear on equipment is a minimal expense.

    With Prime, Amazon does -DIRECTLY- lose money on active users. And they didn't mean for it to be that way.

    Prior to 2010, the average direct sale product margin actually covered shipping expenses. Prime was a clever marketing tactic. But shipping costs grew faster than inflation, and ecommerce is too competitive to just raise prices. Particularly when you no longer have tax advantages.

    Shipping margins now exceed product margins.

    Now they have a business model that, due to self-selectivity, will lose money no matter what they charge upfront.

    There is actually an easy fix- admit Prime is broken and just eliminate unlimited shipping. But they are proud...

  • Report this Comment On March 17, 2014, at 7:51 PM, TMFBrewCrew wrote:

    The dog toy example was intended to be nothing more than an easy to understand illustration of the value to a Prime member.

    I see the point in your analogy to a health club, but to be honest I don't think it completely fits. The whole point of Prime is to drive people to Amazon.com to buy more stuff, and that is exactly what it does. As I noted, average revenue per Prime customer is double that of a non-Prime customer. So, the better question is whether you believe that $99 plus an incremental $700 in revenue is worth the cost of shipping. The answer depends on consumers' purchasing patterns as well as Amazon.com's pricing strategy.

    Given management's strategy to gain market share over the long term at the expense of margins in the short term, I could understand why Prime may not seem logical to some investors. We can agree to disagree on that. However, it is important to consider all of the factors (i.e., the extra $700 per customer) prior to rushing to judgment.

  • Report this Comment On March 17, 2014, at 9:00 PM, rndm6733 wrote:

    BTW, you can currently get Amazon Prime *free* for one year when you sign up for one of the two Blue Cash cards from American Express. It's a special offer they have right now.

    The two cards are the Blue Cash Everyday Card (BCE) and the Blue Cash Preferred Card (BCP). BCP has $75 annual fee; BCE does not. However, BCP has a $100 initial spending bonus (after spending $1K in first 3 months), 6% cash back at grocery stores, and 3% cash back at gas stations, while BCE has just a $50 initial spending bonus, 3% cash back at grocery stores, and 2% cash back at gas stations. There are some other differences as well.

    The math is a bit complicated, so you can use the rewards calculator at CreditCardTuneUp. com to compare the two Blue Cash cards for your particular expenses.

  • Report this Comment On March 18, 2014, at 3:29 PM, carnegiel8ker wrote:

    A typical day in the life of a heavy Prime user: Wakes up, sees that he is low on toothpaste, uses Kindle to order more; Makes coffee and discovers he is low on filters, uses Kindle to order more. Ice on windshield; orders ice-scrapper from AMZN; sees co-worker with fancy ballpoint pen; orders from AMZN....by the end of the day, he has ordered 12 items from AMZN, and because AMZN has no way to know whether additional orders are coming in a given day, ships all 12 items separately. Prime user has spent $150 on the 12 items, AMZN has gross margin of 10% on the items ($15) but just spent $36 to send the 12 packages...this theory of encouraging people to order EVERYTHING from AMZN will help them keep sales growing, but will never enable them to see any operating leverage from those incremental sales.

  • Report this Comment On March 19, 2014, at 5:56 PM, tenaciousdeucer wrote:

    popnfresh - death spiral is correct. Every Prime price increase will cause a percent of casual shoppers to cancel. Thus every price increase begets the next price increase until, eventually, the only Prime members left will be the "abusers" of the system who are getting 100 lb furniture and several $10 orders per day on 2-day shipping.

  • Report this Comment On March 24, 2014, at 9:47 AM, linlinlex wrote:

    As a PRIME member I can assure you Amazon.com is not losing money with each purchase. The price of shipping is incorporated into the price of the item. You can buy an item at a lower price from a non-PRIME supported vendor and pay shipping for about as much as you would pay for the item with free shipping. In some cases you pay a little more to use PRIME. It's all relative. Sometimes I get free shipping, sometimes I buy from a non-PRIME vendor. It all depends on the math.

  • Report this Comment On March 24, 2014, at 10:23 AM, strattitarius wrote:

    Those twelve purchases made throughout the day could ship together, you know???

    There is a break point in almost EVERY business, especially those going after daily purchases, where orders does not equal shipments. Manufacturers have been doing this for years... it's built into every single piece of order fulfillment software. But, yeah, I bet nobody at Amazon has every run an order based company before and had no idea that they could consolidate shipments. Good thing for The Fool, or Amazon could have been losing money for years on the basics of how to operate a business!!!!

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