Amazon, the world’s largest online retailer and provider of cloud infrastructure services, reported stellar Q2 results last week, beating consensus top line by $1 billion and EPS by 60 per cent, as revenue growth accelerated and operating leverage finally appeared in the business. This article will focus on Amazon’s retail business, which contributed to over 90 per cent of total revenue and 60 per cent of consolidated segment operating income in 2015.
Last week’s strong result included a 28 per cent YoY increase in both North American and International retail sales (in constant currency), representing not only an acceleration of growth over a year ago, but also sequentially from Q1 2016. For a business doing over $100bn in annualized net retail sales to accelerate growth at a near-30 per cent clip, something must be going on under the hood. We suspect that something is Amazon Prime.
Jeff Bezos has long described Prime as the flywheel that drives Amazon’s enviable retail sales growth, and in the Q2 results we can find, for the first time, persuasive evidence that the flywheel is operating with full effect. The concept is simple enough – free shipping and on-demand video streaming entice shoppers to sign up for Prime membership. Once they have paid their membership fee, members are incentivized to spend more with Amazon, which attracts more sellers to the marketplace and drives adoption of Fulfillment By Amazon, which then increases Prime’s already-vast selection of items, and thus further entices Prime members to spend more. The incremental earnings can then be reinvested into the business to drive further sales and original video content.
However, not being satisfied with only a qualitative, spoon-fed understanding of the Prime flywheel, we decided to take a deeper dive into the company’s “third pillar” of growth and attempt to estimate the unit economics of Prime. When the founder and CEO of a company paints a business unit as a core pillar of growth, it behooves investors to do the legwork necessary to satisfy themselves of how (quantitatively) the business unit drives growth and what impact it has on the company’s earnings. We say “attempt to estimate” here because Amazon is notorious for its tight disclosure, and very little is known about Prime (not even the membership numbers are disclosed). It therefore does not surprise us that most sell-side brokers and perhaps a lot of investors don’t dig deeper into what our analysis reveals to be a key driver of Amazon’s intrinsic value. We believe this is where Montaka adds value for our investors – by drawing variant insights from a mosaic of scant publicly available information (on Amazon, in this case) that is easily missed by those who don’t do the extra work.
For readers not familiar with the Amazon Prime service, here is a summary of what Prime membership offers:
- Free 2-day shipping (and same-day shipping for a range of selected items);
- Unlimited on-demand streaming of movies and TV shows through Prime Instant Video;
- Unlimited on-demand streaming of music from Prime Music;
- Borrow books from Kindle’s lenders library;
- Unlimited cloud photo storage; and more,
for $99 a year or $10.99 per month subscription.
Also widely known is that Prime members spend materially more than non-Prime shoppers, buy more from third party sellers under the Fulfillment By Amazon program, and love the “extras” that the membership provides on top of free shipping (e.g. movies, music etc). On Prime Day this year (Amazon’s version of Alibaba’s Singles Day), worldwide orders on Amazon.com were up 60 per cent over last year’s inaugural Prime Day. US Prime Day sales figures eclipsed Black Friday sales, traditionally the most important day on the calendar for US retailers. In a single day, Amazon sold 90,000 TVs, 215,000 pressure cookers, 200,000 pairs of headphones, and 24,000 hammocks; and analysts estimate Amazon’s incremental Prime Day 2016 sales will exceed half a billion dollars.
With the overview of Prime out of the way, the rest of this article will be devoted to your author’s attempt at quantifying (even if imprecisely) the incremental impact that Prime has on Amazon’s earnings. While it is impossible to have high conviction in the numbers presented below, our best estimate using the available information and our internal operating model suggests that a Prime member adds an incremental ~$110/year to Amazon’s gross profit. Using the latest third-party estimates of US Prime membership, we arrive at ~$6.8bn incremental gross profit driven by Prime. We have left aside the international Prime business in this analysis, as third-party membership estimates vary wildly and each country has a different membership fee.
The following assumptions were made to reach the estimated ~$110 incremental gross profit:
- The 63 million US Prime members as at July 2016, and the estimated annual spend of $500 for non-Prime shoppers and $1,200 for Prime members, are based on the latest study by Consumer Intelligence Research Partners. The same source estimates that Prime membership grew 19 million from 44 million in July 2015. These estimates are broadly in line with sell-side broker estimates. 63 million is just over half of US households, which means there is still some runway left for Amazon to grow its US Prime membership base. Globally, Amazon reported over 300 million active customer accounts (including US) in Q2 2016, so global Prime penetration even as a percentage of existing shoppers is low and this represents material upside.
- The analysis does not distinguish between first party (Amazon) and third party (marketplace sellers) retail sales, as our internal modelling suggests the first party gross margin is lower than, but broadly in line with, the assumed third party take-rate.
- Net shipping costs for non-Prime sales are inclusive of shipping revenue, as default free shipping is not available to non-Prime members. Shipping costs for Prime sales are gross shipping costs, as the headline feature of Prime membership is unlimited 2-day free shipping.
- We estimate Prime Instant Video content costs using management disclosure for 2014 ($1.3bn), management guidance for content cost growth in 2H16, and how competing streaming video services have grown their content costs in the interim. This gives us approximately $2.8bn in content costs for 2016 on a P&L basis (likely higher on cash basis), or less than half of Netflix’s estimated $6bn in content costs.
Finally, the incremental gross profit from Prime (in addition to margin expansion at Amazon Web Services) allows Amazon to leverage its fixed cost base, as evidenced by three straight quarters of operating margin expansion to 4.2 per cent in the most recent quarter (up from 2.0 per cent pcp) and the highest since 2010.
If our estimates of Prime’s unit economics are anywhere near the correct ballpark range, we can conclude from the above analysis that not only do Prime membership fees cover the incremental free shipping and video content costs, the service itself generates a 140 per cent increase in annual spend per shopper and an incremental ~$6.8bn of gross profit, or 25 per cent of Amazon’s 2015 retail gross profit. After netting out the incremental fulfillment costs and some marginal marketing and technology expenses, Amazon has the luxury of either reinvesting the remaining profit to drive future earnings (as it has done historically), or leveraging the existing fixed cost base by letting it fall through to current earnings. Either way, with numbers of this magnitude, it is easy to see how the Prime flywheel is accelerating the growth of a $100bn retailing behemoth.
The Montaka and Montgomery Global funds own shares in Amazon.