Amazon.Com And The Netflix Pricing Conundrum

No, this is not what you think. This won’t be another article speculating on when and how Amazon.com (AMZN) might compete with Netflix (NFLX) other than through its already-competing Prime membership program.

It’s something altogether different. It’s an explanation of how something that happened to Netflix will now constitute an insurmountable barrier towards Amazon.com doing something that should, or must, be done to improve its margins.

Many certainly remember Netflix’s 2011 price-raising blunder. The timing can be seen in the chart below. It was the tippy top of Netflix’s trajectory, and initiated a slope of despair that took Netflix down 80% in around 6 months. The event was thus etched into every analyst and trader’s minds.

click to enlarge

And therein lays the problem. Amazon needs to raise the price of a program that’s very similar to Netflix. It needs to raise the price on its Prime membership program.

Why is this so?

Amazon’s prime membership was created back in 2005. It consisted back then of a membership that cost $79 per year and gave its members the right to free 2-day shipping. Naturally, the heaviest Amazon.com users, through a process of adverse selection, flocked to it. This gave rise to the statistic that prime members buy three times as much stuff as other Amazon.com buyers. (This can also be stated differently – a group that buys three times as much as average sees gains in joining Amazon.com Prime.)

Over time, Amazon.com saw an advantage in trying to grow its prime memberships. It locked buyers into Amazon, and could also be seen as leading to increased buying activity from these members. So Amazon went and sweetened the pot, while keeping the cost at $79 per year. Amazon.com added free movie streaming, as well as free book lending (one book per month).

Given that the Prime program was subject to adverse selection, leading to the heaviest Amazon users joining it while the profitable (light) users shunned it, it was speculated that it was never profitable. Indeed, Piper Jaffray analyst Gene Munster estimated that Amazon loses as much as $11 per Prime member per year.

It’s no surprise then that Amazon loses money on Prime and indeed, there’s something that leads me to think those losses have been increasing. Simply put, $79 back in 2005 bought a whole lot more postage than it does in 2012. Although we don’t have the historical evolution of rates charged by United Parcel Service (UPS) or FedEx (FDX), we can use the USPS history as a proxy, and what we see isn’t pretty:

Package delivery prices went up 362% while mail delivery prices went up 21.6%. The truth lies in the middle (packages were “too cheap” at the start of the observation period, mail is subsidized), so clearly costs for the same deliveries might have gone up as much as 100-200%. And yet, Amazon.com is still charging the same price for the Prime membership along with going and adding free video streaming and book lending to the mix.

This meant two things

1) Costs exploded. Not only were the free deliveries more expensive to carry out, even the video itself will be approaching Netflix-like content costs, and $79 / 12 = $6.58, is less than Netflix’s $8 charge (never mind that they have to deliver stuff for free, as well).

2) Margins on Amazon.com as a whole imploded. A theory was built to explain this which went somewhat like “Amazon.com is building out and the investment is temporarily eating margins.” But why does no one confront the very evident facts exposed here? It’s very obvious that these events lead to significant margin erosion – reflected in exploding net delivery costs as well as technological costs (including content), something I described in detail in my article 3 Elephants In The Amazon Room.

Which leads me to what I said in the beginning…

Amazon, facing this reality, has to somehow raise prices on the Prime memberships, or see its margins continue to languish.

But, there’s that obvious problem. The market has been trained, by Netflix, to have horror with any obvious price raising by a high multiple, content providing, tech company. So if Amazon.com tries to raise prices, the most probable reaction would be a plunge in its share price.

Conclusion

Amazon faces a conundrum. It needs to raise prices for Prime and can’t do it because of the Netflix experience. Two possible outcomes can result from this:

  • Amazon.com continues suffering margin compression
  • Amazon.com tries to disconnect the video offering from the Prime membership by launching a whole independent service to take on Netflix, and at the same time withdraws some of the freebies that are presently being given to the Prime members at great cost to Amazon.

Given the idealistic way Amazon.com is managed, what is most likely to happen is that Amazon.com will continue seeing its margins pressured while taking no action to staunch the bleeding. This will happen even though the market is about to have a “come to Jesus” moment where Amazon will finally be valued like a mortal company. This won’t be pretty.

Disclosure: I am short AMZN.

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