Amazon's Prime Pickle

Aug.22.12 | About:, Inc. (AMZN)

Amazon Prime is now the best bargain in the history of shopping - that is not hyperbole...What hasn't changed since we launched Prime? The price. It's still $79.

This quote from Jeff Bezos appeared in the most recent quarterly results for Amazon (NASDAQ:AMZN). It was not bragging; it was a cry for help. A careful reading of Amazon's recent financial statements shows that the prime program has backfired and trapped Amazon in a downward earnings spiral that cannot easily be easily resolved. As a result, I believe Amazon will need to announce drastic changes to the program, most likely in the next half year, which may trigger a consumer backlash.

Historically, the $79 Amazon annual fee has existed for purely psychological reasons - online product sales were profitable even after covering shipping costs. But between the launch of Amazon Prime in 2005 and today, a combination of tighter margins for direct online sales and rising shipping costs has eaten up the difference.

I shall show below, the profitability of the Amazon Prime program has in recent quarters declined to the point that marginal profits for the program have become negative. Starting this year, orders from Amazon prime members began to actually cost the company money.

As background, here is the record of UPS rate changes (compiled by searching their website) over this time period:

UPS Rate Hikes

Year 2006 2007 2008 2009 2010 2011 2012*
Percent Increase 3.9% 4.9% 5.4% 5.9% 5.7% 6.9% 5.9%
Click to enlarge

*Took effect June 29th, more on this later

All in all, shipping is 45% more expensive then it was when Amazon Prime was announced. This is already well outpacing inflation, and fuel surcharges are making it even more expensive. Common sense would tell you that Amazon's shipping program would be impacted by this.

So turning to Amazon's financials, Here's how to roughly calculate the marginal profit from Amazon prime sales:

Begin with net product sales. Service revenues are a nice thing to have, but they represent separate businesses (marketplace and AWS) and are irrelevant for our purposes here.

Next, subtract out the entire cost of sales. The cost of sales represents the wholesale cost of products, packaging, and shipping costs. Since none of these costs are incurred for service sales they are all attributable to the product sales segment.

Then, multiply the fulfillment line item by the percentage of direct (non-3P) unit sales, reported on the company conference calls, and subtract that out as well. Most 3P sales do not use fulfillment by Amazon, but I make this correction anyways as this is where Amazon places credit card processing fees.

This gives us the marginal profit from all direct product sales. The final step in the calculation is to approximate the impact of Amazon prime by subtracting shipping revenues from both the numerator and denominator.

Amazon Prime Estimated Marginal Profits

Q2 2012 Q1 2012 Q4 2011 2011 2010 2009

Net Product Sales

10,791 11,249 15,309 42,000 30,792 22,273
Cost Of Sales 9,488 10,027 13,830 37,288 26,561 18,978
Fulfillment 1,356 1,295 1,659 4,576 2,898 2,052
Percent Direct Sales 60 61 64 64 70 72
Adjusted Fulfillment 814 790 1,062 2,928 2,029 1,477
Product Sales Profit 489 432 417 1,783 2,202 1,818

Product Sales Profit Margin

5% 4% 3% 4% 7% 8%
Shipping Revenues 469 461 531 1,552 1,193 924
Amazon Prime Profit Margin 0.20% -0.27% -0.77% 0.57% 3.41% 4.19%
Click to enlarge

All numbers in millions of dollars unless otherwise noted.

It appears that Amazon received a small amount of relief in the most recent quarter as shipping costs as a percentage of sales declined slightly. Unfortunately, that 2012 5.9% freight rate hike took effective the day before the end of the Amazon's most recent quarter. So the margins should fall negative again in the second half of the year, and the loss will grow as the trend toward higher fuel prices and shipping rates continues.

The big problem for Amazon is that the nature of the Amazon prime program disconnects prices from the associated costs. The skyrocketing cost of shipping- cannot be directly addressed as it is not billed. Management has been in a mental pickle where they can't decide if they should raise product prices or raise the subscription fee. And because they are in a pickle, they haven't done either. Earnings have simply slid as consumers have made out like bandits.

But now Amazon has let it get to the point that they are projecting a loss for the next quarter. And after that they will have to address the busiest shipping season of the year, when the majority of prime subscriptions roll over. I think this will be the trigger that will finally force them to make the painful choice.

They have three options:

1. Raise product prices so the margins cover shipping

This would be the most direct and simplest solution to the problem, but it would result in raised list prices for regular, non-Prime profitable shoppers as a side effect. This also might end up hurting search rankings, market share, and/or page views, hurting profitable third party sales.

More importantly, it cuts against the whole image of the brand. I simply can't imagine Jeff Bezos wanting to do this.

2. Raise the Amazon Prime subscription fee to make up the difference

This only sounds like a solution- it may actually make the problem worse.

User defections would likely come largely from the ranks of low-volume users. People who've fallen into the habit of paying the annual fee even though they don't really buy enough to justify it. High volume users- the ones who actually make the program unprofitable- would stick around even at higher rates.

3. Just cancel the program

In whole or in part. Either way, the most loyal customers feel betrayed. This would be a PR nightmare, but I think it may actually be the most likely outcome.

Seeking Alpha readers have seen the bear case on Amazon well expressed time and time again by Paolo Santos. And the bull case on Amzaon well expressed by Rocco Pendola. I don't need to rehash the earnings or valuation argument; I think we can all agree that Amazon's stock price has been responding to sales growth, and the halo effect of positive consumer perception and will continue to do so as long as those things continue.

But if Amazon is forced to address Prime before this Christmas, those things won't continue. The three options for dealing with the Prime pickle mentioned above all have two things in common; they would immediately reduce sales, and they would shatter consumer perception.

Time to short 'em.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.