Why Amazon Prime may not be such a good thing for the company anymore

• Amazon's Prime service may be a good deal for customers, but it's becoming a worse one for the company.
• The key component of the subscription offering is its free-shipping deals.
• But the cost of those deals also now eats up half of the $119 annual subscription price the company charges customers, estimates Dan Morgan, a portfolio manager who closely follows the company and whose fund owns Amazon shares.
• Amazon's fulfilment costs are slated to keep rising, thanks to price hikes by the major shippers.

Amazon's Prime service may be starting to become too much of a good thing for the tech giant.

The offering has attracted some 100 million subscribers. That sizable customer base has in turn encouraged a growing number of third-party merchants to sign up as customers of Amazon's fulfilment services. That's because products offered by vendors who are part of that program are eligible for Prime's free shipping offers.

So far, so good right? Prime brings more customers to Amazon, which lures in more merchants, which helps Amazon expand its product offerings, which likely attracts more shoppers and encourages existing ones to buy more items from Amazon.

The problem for the company is that shipping costs are rising, cutting into its profits and making its free shipping offers more costly. Amazon's fulfillment costs have already been rising faster than its revenue, noted Dan Morgan, a senior portfolio manager at Synovus Trust, which owns Amazon shares.

One of the key questions for the company, he said in an email, is "How can Amazon balance its fulfillment/shipping costs with increased order volumes from Prime members?"

Free shipping is costly for Amazon to offer

Morgan is a longtime bull on Amazon, but much of his optimism about the company is due to its Amazon Web Services cloud-computing business and its burgeoning advertising business. He's more skeptical of the prospects for its traditional retail business.

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Amazon charges customers $119 a year for its Prime subscription. But about half of that amount is now being consumed by the cost of offering free shipping to customers, Morgan estimated.

Those costs could continue to rise.

Amazon spent $25.2 billion on fulfillment costs in 2017, which was up 43% from the year before and amounted to 14% of the company's total revenue. That amount likely rose to $35 billion, or 15.1% of the company's sales, for all of 2018, and will probably jump to $43.3 billion, or 15.4% of sales, this year, estimates Benchmark analyst Daniel Kurnos in a recent report.

Indeed, Kurnos worried that shipping-related factors may have weighed down Amazon's results over the holidays. While Wall Street analysts as a whole are betting that the company posted $3.7 billion in operating income in the fourth quarter, Kurnos is forecasting $3.2 billion.

Amazon is slated to report its holiday period results on Thursday.

"We are somewhat cautious ... given external pressure on delivery costs and significant increases in same-day to two-day shipping," he said.

Amazon is facing price hikes

Part of the problem for Amazon going into this year is that all three of the major domestic shippers - the US Postal Service, FedEx, and United Parcel Service - just hiked their prices. Amazon recently adjusted its own charges for merchant customers who take advantage of its fulfillment services. But it's unclear if its higher charges will fully cover its increased costs. And regardless, those fees only apply to third-party merchants, not to products Amazon sells itself.

Add it all up, and Prime's free shipping offering is becoming a better deal for customers - and a worse one for Amazon.

The "rising fulfillment costs not only hurt operating margin, but it also erodes revenues from Prime members, as the $119.00 annual fee revenue evaporates as shipping costs rise," Morgan said.

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