Video has become an essential part of Amazon Prime. Source: Amazon
When Amazon.com (AMZN +0.20%) reported its fourth quarter earnings last month, the announcement came with an interesting note from CEO Jeff Bezos. He wrote in the earnings release that Amazon "paid billions of dollars for Prime shipping and invested $1.3 billion in Prime Instant Video."
That amount includes funding for its original productions like Transparent and licensing for other popular content. It might fall short of the $3.2 billion Netflix (NFLX 0.68%) spent on content in 2014, but Amazon is expected to further increase its Prime video investments this year.
But why is the company willing to spend so much on programming for a service that started out as a flat-fee shipping program?
Because content is key to retaining Prime members
The determining factor as to whether or not Prime subscribers renew their membership is not how much they shop on Amazon but whether or not they watch video.
On the third quarter conference call, CFO Tom Szkutak told investors, "Those customers who are streaming are renewing at considerably higher rates ... When customers come in for ... free trials and they engage from a video content standpoint, we see the conversion being higher."
Therefore, it is important for Amazon to maintain a compelling library of content -- and that does not come cheap.
As mentioned, Netflix spent approximately $3.2 billion on programming last year. Hulu spent approximately $750 million on licensing and millions more on originals. With both companies competing with Amazon for exclusive rights to the hottest titles, the prices will only continue to climb.
At some point it becomes unprofitable
There must be a breaking point for the three players, where the price is simply too high. But I would venture to guess that Amazon is ultimately willing to pay more than both stand-alone streaming services, as the retail king continues to make money from Prime members shopping on the site.
While Amazon has to foot the bill for two-day shipping as well as video content, we know that it would rather sell something to Prime members than nothing at all. In fact, Prime members spend more than non-members. Mr. Szkutak noted "Prime members are buying more." While he did not give details on how much more, a survey by RBC Capital last summer puts the number as high as 68%. With a gross margin of 29.5% in 2014, Amazon has plenty of room to maneuver.
With the initial subscription price approximately matching the yearly rate of both Netflix and Hulu, it is safe to say Prime subscriptions ultimately produce more cash flow than Netflix and Hulu subscriptions. That puts Amazon in a strong position to outbid its competitors for new content, while still making money from Prime.
Do not underestimate the power of cash
Amazon ended 2014 with $17.4 billion in cash and investments. Comparatively, Netflix had just $1.6 billion.
In a fourth quarter letter to shareholders, Netflix CEO Reed Hastings told investors that the company will look to raise at least $1 billion in debt this year to help fund its content purchases as the rest of cash flow goes toward building out its service around the world. While interest rates remain low, the fact that Netflix must borrow to fund content acquisition will significantly impact the amount it is willing to bid, and the company has noted that it will have to factor interest expenses into its content budget.
That leaves Amazon in a position to buy more content at an effectively lower price than Netflix, while producing more revenue per subscriber through Prime.
Video is the key to making Amazon Prime work. Even if Amazon does not offer the best prices on the Internet, most Prime subscribers will choose Amazon anyway because of convenience and the psychological impact of already having paid the subscription fee. For Amazon, this "moat" around Prime explains Amazon is willing to spend billions on new Prime Instant Video content.
