Amazon's Prime Strategy Sound
Amazon Prime has likely hit a key inflection point and will help the online giant lock in customers while neutralizing competitive efforts from traditional retailers, says Morningstar's R.J. Hottovy.
Amazon Prime has likely hit a key inflection point and will help the online giant lock in customers while neutralizing competitive efforts from traditional retailers, says Morningstar's R.J. Hottovy.
Wide-moat Amazon (AMZN) capped off its 2013 in strong fashion, with fourth-quarter active users (up 19% to 237 million), total units sold (up 25%), and third-party units (up 25% according to our estimates) outpacing low- to mid-teens global e-commerce growth trends and implying market share gains.
Competitive pricing has always been central to our investment thesis, but Amazon's fulfillment capabilities also played a key role in the market share shift by effectively extending the company's holiday selling window by several days during an already shortened holiday shopping season. This was evident in the sharp increase in Prime memberships, but also management's comfort in proposing a $20-$40 increase to the annual Prime membership fee in 2014. Although there aren't any inherent switching costs in the retail industry, we don't expect much attrition due to the fee increase and believe Prime memberships will lock many in Amazon consumers while neutralizing price matching and direct-to-consumer investments by traditional retailers.
In addition to Prime, the other components of our five-year operating margin target of 5% (6% excluding stock-based compensation and amortization of intangibles) remain intact, with third-party sales, Fulfillment by Amazon, and AWS each playing a role in the 240 basis points of gross margin expansion to 26.5%. Gross margin gains more than offset ongoing fulfillment, technology, and content investments, and helped consolidated segment operating income margins grow by 20 basis points to 3.4%. We've adjusted our model to incorporate modestly higher revenue growth estimates due to the uptick in Prime members and the proposed fee increases, but also partly tempered by fulfillment capacity investments. These factors cancel one another out, and will keep our $375 fair value estimate intact. We still view Amazon as one of the most compelling long-term growth stories in the consumer space today, but consider the stock as fairly valued at current levels.
We believe the fourth quarter of 2013 will go down as a key inflection point in the evolution of Amazon Prime. Management noted there are now "tens of millions" Prime members worldwide, and we believe that the number of Prime members more than doubled during 2013 and now exceeds 20 million members across the globe. Much of this growth took place during the fourth quarter--management noted one million customers became Prime customers during the third week in December alone--and puts the company well ahead of our earlier estimates of more than 25 million Prime members by 2017.
Management discussed that it is considering a $20-$40 hike to the annual Prime membership during 2014 (citing fuel and other transportation costs as well as increased Prime usage), and we expect minimal member attrition given the still-compelling consumer value proposition (which includes digital content and Subscribe & Save platforms) at the new membership price points. With Amazon having already established itself as a vital shopping destination for Prime members (who spend make the majority of their online purchases on Amazon and spend nearly twice to three times as much as non-Prime customers, according to our analysis), we believe the incremental free cash flow stemming from the from new members and the membership fee hikes will help to fund infrastructure investments to facilitate the expanded number of Prime members (as well as an expanded Amazon Fresh rollout) and keep our medium-term margin goals intact.
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