A "Prime" Driver Of Amazon.com Inc. (AMZN)'s Stellar Stock Performance

Amazon Prime, with 64 million members, is a key value driver of Amazon.com stock.

  • Prime is very different from other loyalty programs, being designed as a sales conduit.
  • The success of Prime has led to consistent profitability in North America.
  • What are the other stable and emergent growth drivers?

The bulk of Amazon's (NSDQ:AMZN) newer initiatives are all designed for one thing: to drive consumers to their retail portals. That has been the company’s single-minded objective, and it has taken them to a point where retail sales are now scraping the $100 billion mark.

Of course, Amazon Web Services would be the one exception to the company’s efforts, but everything else is purpose-built that way. There are several such initiatives, the foremost of those being Amazon Prime, which I’d like to delve into today.

At the Speed of Prime: From 0-64 million in 10 years

From the time it started as a free two-day shipping offer for members, Amazon Prime has expanded to include numerous services to its list. Now, you get multiple shipping options that include the original free two-day shipping, same-day delivery and free two-hour delivery for home essentials, free one-hour restaurant delivery, streaming music and video, unlimited photo storage, exclusive deals, e-books and much more. (See also: Amazon.com's Real Growth Strategy Holds Multi-Year Upside For AMZN Stock)

Offering multiple services for $99 a year or $10.99 a month clearly shows that the company is subsidizing the cost of running those programs through the cash flow it generates from other sources.

The Need for Prime

But why would Amazon continue to pour money into something that’s obviously hitting their bottom line profitability?

The answer to that is two-fold. On the one hand, by continually adding free services to the original offer, Amazon is increasing the perceived value of the Prime membership fee. $99 a year for free two-day shipping might not seem like such a great deal, but when you throw in dozens of value-added services and benefits, customers naturally see it as a killer deal.

The second consideration is the returns that Amazon gets on its investment in Prime. By subsidizing services and piling on benefits, Amazon, in turn, sees more purchase volumes from these customers.

And this is a tangible benefit because, on average, a Prime customer on Amazon spends more than twice the amount that a non-Prime customer does. This is especially true in the >$200 purchase bracket.

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When you think about it, it makes so much sense. When someone pays $99 a year and gets a ton of free stuff including special Prime-only offers and other benefits, as a consumer, they’d want to leverage that $99 as much as they can.

How is Prime Different from Other Loyalty Program Models?

Obviously, they can’t do the same thing at Costco or Wal-Mart because there’s a cap on benefits for members at both places.

For example, Costco’s Executive Membership only has the following benefits for the $110 that customers must pay:

  • Includes a free Household Card
  • Valid at all Costco locations worldwide
  • Annual 2% Reward on qualified Costco purchases Terms and conditions apply.
  • Additional benefits and greater discounts on Costco Services
  • Extra benefits on select Costco Travel products

With Wal-Mart’s Sam’s Club, it’s a little bit better, but it’s still all about discounting and making things cheaper. There are hardly any value-added services that are continually added to the list, unlike what’s happening with Amazon Prime.

The move from merely discounting to offering value above and beyond what the customer pays is a significant differentiator between Amazon Prime’s model and those of other large retail houses.

How Big is Amazon Prime?

And that differentiation, I believe, is what has enabled Prime to grow into the juggernaut it is today. According to estimates from Evercore ISI Research, total Prime memberships in the United States was an estimated 64 million nearly a year ago.

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That’s a strong figure, and it would have grown even stronger now, but it is further validated by the fact that Costco - after several decades in the business - only has 87 million members in total.

There is another major difference as well, one that most investors overlook - Costco works on a membership-only model, while Amazon Prime is completely optional.

If an optional service can garner 64 million members in ten years, that means something is working.

While Amazon does not reveal numbers around how much it costs to subsidize the various Prime services, it’s obvious that they’re out of the pocket every quarter over maintaining Prime. And the proof of the profitability pudding is in the operating margins that Amazon has been posting for North America over the past few quarters.

Prime has irrefutably contributed to making Amazon profitable in North America, and it is reasonable to assume that their margins will get better as Prime membership grows in their home market. Right now, at 64 million members in the U.S, market penetration stands at about 20%.

It will ultimately slow down when penetration reaches much higher levels but, for now, Prime is a key driver in Amazon’s current and future success in U.S. retail volumes.

Stable and Emerging Upsides

This major upside is complemented by the fact that AWS is now delivering (downloadable PDF) an annual revenue run rate of $12.924 billion based on the last reported net sales of $3.231 billion for Q3 2016. Operating income run rate for the unit stands at $3.444 billion based on a quarterly operating income of $861 million.

And, last but not least, is Amazon Echo and Amazon Alexa, the smart virtual assistant built into Echo devices. Amazon hasn’t had any significant success on the device front other than perhaps the Kindle and Fire TV lines, but the Echo family is running riot. The last estimate puts devices sold at a massive 5.1 million since launch, and that was before the holiday season 2016, during which the device saw a 9X growth over the year before.

The number of devices sold is not necessarily significant, but what is significant is that Amazon Alexa on Echo has now opened up to voice shopping. Echo device owners can order anything from Amazon’s massive catalog by just using voice commands and their existing Amazon accounts. (Is Amazon.com, Inc. (AMZN) Becoming A Threat To Alphabet Inc?)

Again, this is yet another conduit to generate traffic and drive it towards their retail portal. It might be too early to call it a success, but what it does is put Amazon’s catalog literally within speaking distance of its customers. The capability has yet to be fully built out to include all categories of items, but guess what - the current list includes all “Prime-eligible items” as well as recommendations from Amazon, called Amazon’s Choice.

That implies that voice shopping will not only lead customers back to Amazon’s retail portal but will also encourage them to take up the Prime membership, further feeding the growth engine behind the Prime program.

With that many upsides, it’s easy to see why Amazon’s stock price chart for the past five years looks like this...

12amazonamigo1

...instead of looking like this…

12amazonamigo2

The Investment Angle

Considering the magnitude of the upside, it’s clear that everything hasn’t yet been priced into the stock. At the current P/S ratio of around 3, it does look a bit pricey. However, considering the longevity of Amazon’s upside and the continual efforts to add customer conduits and revenue channels, it’s still a great buy, especially if you can catch it on the dips.

What’s more important to remember is that Amazon’s model is not something that even a Wal-Mart or a Costco can replicate, and this is their biggest moat. New players will have an especially hard time keeping up because they would have to be willing to bleed money for several years in the hope that they can reach the scale required to be profitable. Amazon went through the same thing, but they’re far more stable as a company now, not to mention far more profitable than they’ve ever been.

Looking for great tech stocks? Check out our top stock picks, which have beaten the NASDAQ by over 110%.

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