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Amazon's Price Increase Is a Win For Netflix

By Ishfaque Faruk – Feb 13, 2014 at 2:00PM

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Amazon's price increase actually benefits Netflix and gives it cause to raise its own prices for streaming television and movie services. (AMZN -0.77%) has been investing heavily in its Prime business to gain more subscribers. The company has succeeded in generating more than 20 million customers for the Prime shipping service, but the company is pondering a price increase for this service after nine years. The company's leading Internet video competitor, Netflix (NFLX -2.04%) stands to benefit from this decision as well. 

Investing heavily in Prime
Amazon has been heavily investing in Prime, making the company's shopping delivery better during the holiday quarter. Amazon has also been ramping up its video selection for Prime Instant Video, which now has more than 41,000 titles.

Amazon has been investing in developing original shows from its own studios, and recently rolled out 10 new pilots for its Prime and LOVEFiLM customers in the U.S. and Europe. Based on customer feedback, the company intends to develop the pilots into full seasons. Amazon previously aired a number of original shows, but the response from customers was underwhelming. In addition, Prime subscribers have an even larger selection via the Kindle Owners' Lending Library, as customers can now borrow more than 475,000 books, an added benefit now provided to Prime subscribers only.

Amazon is reportedly considering a Prime price increase of $20-$40 per subscription. The company hasn't raised the price of its Prime service since its inception over nine year ago, and has now cited increased fuel and transportation costs, as well as increased streaming data usage, as reasons for the potential price hike.

When Amazon launched Prime, the eligible product selection was 1 million items. That has now grown to more than 19 million items. Thus, a price hike is rather justified and will aid Prime's very scalable business model because the company can potentially generate in excess of $800 million in incremental revenue. This will aid the company in controlling rising shipping costs, which have also been constant at 4.7% of total revenue for the past two years. On an absolute dollar basis, revenue rose to $3.5 billion in 2013, up from $2.85 billion in 2012. 

The price increase might expedite the churn rate and prompt trial consumers to quit the service, but Amazon continues to grow its Prime user base both in the U.S. and abroad. The company has been able to continuously add to its Prime selection, thanks to its Fulfillment by Amazon (FBA) service, under which it ships goods directly from its warehouses on behalf of third-party sellers. The company will also be able to invest in adding more original and exclusive content with the incremental revenue generated from the price increase.

Netflix stands to gain
Netflix has been doing very well in adding new subscribers at a rapid pace. The company is expecting to end Q1 2014 with 48 million subscribers, and the stock has generated excellent returns for shareholders. Netflix has also already given the green light for a third season of the Emmy-winning House of Cards, even before the second season airs. A Netflix executive stated that the average Netflix viewer watches two-and-a-half episodes per sitting, so the company is aiding the binge viewing habits of its subscribers by adding more originals. 

The company finished 2013 with 33.4 million subscribers in the domestic market, but CEO Reed Hastings firmly believes that the addressable market for Netflix in the U.S. ranges between 60 million-90 million subscribers. Netflix raised $400 million of debt at 5.75% (due in 2024), but the company's financials are in good standing. Moody's issued an upbeat outlook on Netflix's credit profile, which will enable the company to get better rates in debt capital markets in the future (even though it still has a junk credit rating from Moody's). 

Amazon's price increase will benefit Netflix, as a number of Prime subscribers are likely to abandon the service in favor of less expensive streaming competition. In addition, it will pave the way for Netflix to increase its monthly pricing. If Netflix increases prices from $7.99 per month to $8.99, that could translate into $528 million in incremental annual revenue. The company's business model yields a lot of leverage and immense pricing power, and it will gain from Amazon's decision to increase rates. 

The bottom line
Both companies are in a good position and stand to gain from their immense pricing power. But, Amazon can possibly extract a lot more value from its video business by offering Prime Instant as a solo service. Both Netflix and Amazon provide tremendous value to consumers in their own distinct ways, and will generate a lot of value for shareholders in the long-run.

Ishfaque Faruk owns shares of Netflix. The Motley Fool recommends and Netflix. The Motley Fool owns shares of 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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