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The Future of Amazon May Soon Be Put to the Test

By Jay Yao – Feb 11, 2014 at 11:45PM

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Amazon is considering raising the price for Amazon Prime for the first time ever. What are the implications?

Even though goodwill is not a big part of Amazon's (AMZN 0.91%) balance sheet, it explains a big part of Amazon's capitalization. Amazon's market capitalization is around $160 billion, while it carries goodwill of only $2.6 billion. 

For decades, Amazon has been forgoing profits to "get big fast" and build customer loyalty. Customer loyalty is theoretically worth a lot. Studies show a totally satisfied customer generates 17 times more revenue than a dissatisfied customer and 2.6 times a more revenue than a somewhat satisfied customer.  

Many Amazon bulls argue that because it has built up significant customer loyalty, Amazon can raise prices and realize higher margins in the future. This thought may soon be put to the test. 

Rising costs may lead to rising Prime prices
In a recent conference call, Amazon said it was considering raising the price of an Amazon Prime membership by $20 to $40 because of higher costs. The price hike is significant because the $79-a-year, free two-day shipping service has not had a price raise in almost nine years. If implemented, the price hike will be one of the first instances that test how loyal customers are to Amazon.

Some investors worry that Amazon could go through the Netflix (NFLX -0.69%) experience. Back in 2011, many investors thought Netflix had great customer loyalty. Netflix had a killer product that everyone loved. Then the company raised fees by 60%, and its growth slowed dramatically. The online video streamer lost more than 800,000 subscribers in a single quarter, and its stock tanked before eventually recovering.

Long-term thinking
Mr. Bezos is the ultimate long-term thinker. He has positioned Amazon to be long-term greedy rather optimizing profits for the short term, like many other companies. The long-term thinking has helped Amazon gain market share and become a seemingly unstoppable revenue-growing machine. Wall Street has played along, valuing Amazon stock based on its revenue growth rather than on profit metrics. 

With Amazon's new plan, it seems that Bezos is acknowledging that Amazon will no longer grow as fast as it did before. To satisfy investors, Bezos is beginning to better monetize Amazon, starting with raising the cost of Amazon Prime memberships. 

Whether Amazon succeeds in raising profits without ostracizing its customers will offer a crucial tell on Amazon's ability to monetize its entire base. 

Smooth operations
If Amazon succeeds, the future is still bright.  It is still the early innings. Retail accounted for around $4 trillion in revenue in 2013  with E-commerce accounting for only $260 billion. Unlike Wal-Mart (WMT 0.38%), Amazon can sell/launch new products by simply adding new links on its website. Amazon can take its low-margin, hyper-efficient model and grab market share in new, tangential marketplaces. It has the right corporate DNA to innovate and create total game changers, such as the crown jewel, Amazon Web Services. 

Whereas Wal-Mart mainly targets the price-conscious market segment, Amazon targets everyone. Because it targets everyone, Amazon has more customers with significant disposable income. The average household income of an Amazon customer is around $89,000, versus the $71,000 for the U.S. as a whole. Because it has more customers who are not as price-sensitive, Amazon has a higher margin ceiling than Wal-Mart or other discount stores. 

The Foolish bottom line
Nothing is easy. Discount retail is a cutthroat business where profit margins are often in the low single digits. So far, though, Amazon has done very well growing a large user base. How well it does monetizing that user base will soon be put to the test. 

Jay Yao has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. 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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