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Amazon stock will benefit from the strong growth in Amazon Prime subscription.
Last week, in his letter to shareholders, Amazon (NASDAQ:AMZN) CEO Jeff Bezos revealed a key piece of data which is at the center of Amazon's sales strategy, the number of Prime subscribers. According to the Bezos, the total number of Prime subscribers has crossed the 100 million milestone. Prime is important for Amazon because it drives up per capita purchase on its eCommerce platform. A Prime subscriber spends twice the amount on purchases from the eCommerce platform compared to non-prime subscribers.
Amazon Prime subscribers tend to spend a lot more than non-Prime members.
Prime subscription helps Amazon to lock in a customer as he has an added incentive (of free shipping or early access) to shop from Amazon. This helps Amazon to increase the lifetime value of a customer. Let's look at some numbers. Firstly, there is the subscription revenue. In the U.S, annual prime subscription fees is around $99, though many choose to pay the monthly subscription which is higher. However, this is compensated by lower prime subscription fees in some developing countries. So on average, the total subscription fees is $9.9 billion a year ($99 *100 million).
The main benefit for Amazon though is from higher spending by Prime subscribers. According to a report by Morgan Stanley, Prime subscribers spend $2,486 per year on Amazon, 4.6x higher than non-Prime subscriber spending of $544 per annum. On the other hand, Consumer Intelligence Research Partners (CIRP) estimates a Prime member in the U.S spends on an average $1300 per year compared to a more modest $700 per year by a non-prime member. If we take total U.S Prime subscriber number to 80 million, total additional spending from U.S prime subscribers is to the tune of $48 billion per annum (taking the conservative figure of $700). If you include the non-U.S Prime members, additional spending is even higher.
Prime will continue to deliver high growth.
Going forward, there are three factors which will drive Prime's contribution to Amazon's top line: a) growth in prime subscribers (both US and international), b) increase in Prime subscription rate and c) growth in spending by Prime subscribers. First, let's look at the growth in Prime subscribers. In thirteen years, Amazon has added 100 million subscribers. According to Amazon, the number of paid subscribers grew by 54% in 2014 and by 51% in 2015.
In 2016 the company said that it added tens of millions of paid Prime subscribers and in his recent letter to shareholders, Mr. Bezos said that in 2017 "more new members joined Prime than in any previous year – both worldwide and in the U.S". This clearly indicates that Prime subscription is continuing to post strong growth rates. However, given the increasing size, we can expect the addition to the Prime subscription to slow down going forward. If we make a conservative assumption of 15%, 10% and 5% growth in 2018, 2019 and 2020 we come up with total Prime subscriber number of 132 million. We expect the U.S Prime subscriber growth to grow at a slower pace to 95 million by 2020.
Next, we look at the subscription rate. Amazon recently announced that it will be raising its monthly Prime subscription rate by 18% from $10.99 to $12.99 which comes to $156 a year, compared to the current annual rate of $99 per year. Of course, it is highly likely that Amazon will raise its annual subscription charge relatively soon. The revision in the monthly subscription rate has increased the gap between current annual subscription and the monthly subscription for a year to $56 compared to $32 earlier. This provides enough room for Amazon to raise the subscription rate. We are assuming that in the next three years, Amazon will reduce the gap between the annual and monthly plan to previous $32 by bringing up the annual rate to $124. We are also assuming no increase in monthly subscription rate in the next three years.
We are also assuming that, in the US, the spending gap between the Prime user and non-Prime user will further widen by $100 (about 16.7% growth) in the next three years which is a conservative estimate. So, as per our estimates, by 2020, the Prime will bring in $16.38 billion in subscription revenues and $66.5 billion in extra spending in the U.S alone.
There are costs involved.
Of course, there are few things we should keep in mind. Firstly, we can't attribute the full spending difference between Prime and non-Prime members to Prime subscription. It can be reasonably argued that only those users who are already spenders subscribe to Prime. In others words, most of the current Prime members would anyway spend higher than non-Prime members. But despite that argument, we can clearly make a case that Prime is influencing the user behavior.
Secondly, there are costs involved with Prime. Since Amazon offers free two day delivery on millions of goods, many subscribers tend to order even small value goods from Amazon. This increases both packing and shipping costs for Amazon. Then there is content spending for its videos, songs, and books. Amazon is reportedly spending around $5 billion on producing video content this year.
Prime is adding value to Amazon.
Amazon is taking several steps to reduce its packing and shipping costs and leverage its existing infrastructure. The company is planning to build physical stores and entering into partnerships with other physical retail stores from where customers can pick up their orders. This will reduce the last mile delivery cost for Amazon which tends to be significant. Also, Acquisition of Whole Foods will give Amazon a wider distribution network. Moreover, the spending on content is a capital investment which will continue to reap benefits for Amazon in the future. The costs involved in Prime is high. But value added by Prime to Amazon is even higher. All in all, it appears that Amazon's bet on Prime is giving desired results in terms of driving top line growth. We continue to remain bullish on Amazon stock. Amazon is scheduled to report its Q1 2018 today. Investors must watch out for any commentary on its Prime service.