Image source: Amazon.

At $99/year, Amazon.com’s (Nasdaq: AMZN) Prime membership program may be one of the best deals in retail. For that low annual fee, customers get free two-day shipping, and benefits including Amazon Prime Video and access to the Kindle Lending Library. 

But all those perks come at a cost, and investors seemed to take notice in the company’s latest earnings report. Amazon missed earnings estimates by a wide margin, and the stock has since fallen more than 10%.

Perks like Prime Day are popular with customers, but shipping costs are adding up. Image source: Amazon. 

Management blamed increased investments in warehouse and video content for the slowdown in profit growth, but another item stuck out in the earnings report. Net shipping costs, or the difference between what the company spends to ship packages and the income it brings in to pay for it in the form of shipping fees and Prime memberships, jumped 43% to $1.74 billion, eating up nearly all of its profits. For the third quarter in a row, the figure increased more than 40% from the year before, and that’s in spite of the company’s decision early this year to lift its free shipping minimum for non-Prime customers from $35 to $50, dissuading low-value orders.  

In the holiday quarter, net shipping costs should hit $2.5 billion or more, making the total for the year $7 billion. If it keeps growing at the same rate, net shipping costs will reach $10 billion next year, and $20 billion by 2019. 

What it means for Prime fees

It’s easy to see why shipping costs are growing so fast: Amazon is building out networks of warehouses closer and closer to consumers to support new programs like Prime Now, which offers delivery in as little as an hour. It’s also expanded Amazon Fresh, its grocery delivery service, to a number of new cities this year.

But free shipping isn’t the only expense Amazon must take on for its Prime customers. The company also spent an estimated $3-$4 billion on content for Amazon Prime Video, which is included with a Prime membership. CFO Brian Olsavsky said on the recent earnings call that video content spending will nearly double in the second half of the year — he did not include a benchmark figure as Amazon doesn’t provide data on Prime membership or video content spending. The company is expected to continue ramping up spending on video to compete with Netflix (NASDAQ: NFLX), which has nearly 100 million subscribers across the world.

Without knowing Prime membership data, the math is unclear, but Amazon is almost certainly losing money on upfront Prime membership sales. Between spending on net shipping costs and video content, the company will shell out an estimated $11 billion. Research firm Consumer Intelligence Research Partners estimated this summer that Prime had 63 million members, which would generate $6.3 billion in membership fees, part of which is already factored into net shipping costs.

Amazon is willing to take a loss on Prime membership because it knows Prime members spend more on its website, but its e-commerce business operates on already thin margins. The international division is on track for a loss this year, but the company should make more than $2 billion in operating income from its North America e-commerce operations this year. However, with Prime-related costs, between net shipping and video content, on track to increase by $4 billion next year, the company will struggle to absorb that on the bottom line.

Amazon last increased its annual Prime membership fee nearly three years ago from $79 to $99. That helped narrow the gap between shipping costs and revenue, but today shipping revenues only account for 55% of shipping costs. 

The $99 price point is an appealing one for customers, and Amazon is likely reluctant to give it up. But a monthly fee may make more sense for both parties. Amazon already made such a move with Fresh, nixing the $200 annual add-on fee in favor of a $15 monthly fee, an annual savings of $20. Earlier this year, the company also began offering monthly Prime membership for $11/month.

At some point in the future, perhaps as soon as next year, Amazon could scrap the annual fee, and just offer Prime membership monthly at, say, $10/month, matching Netflix and underscoring the value of Prime. Doing so would lift Prime membership revenues by 20%, assuming there were no additional cancellations, and help the company invest in more benefits for its Prime members.

Otherwise, at the rate they’re growing, net shipping costs and video content spending will eventually outstrip operating profits. The $99 annual fee is simply not sustainable.

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