Amazon's Prime and punishment

February 21, 2012: 3:02 PM ET

Is the retail giant's rewards program profitable? Probably not. Is it a vital part of the company's future? Almost certainly.

amazon_primeFORTUNE – Launched in 2005, Amazon Prime aimed to get customers to spend more. For $79 a year, members got free two-day delivery on an unlimited number of items. Amazon sweetened the pot from there. Last year, it introduced Prime Instant Videos, an unlimited movie and TV streaming service similar to Netflix. It also created the Kindle Owners Lending Library, a digital public library that makes select ebooks available for free. Only Prime members got access. Then, the company announced that each of its Kindle Fire tablets would come with a free month of membership in the box. Prime's real purpose is now clear: it has become the retail giant's Trojan horse into a broad range of businesses, from tablets to streaming media. As CEO Jeff Bezos doubles down on an ambitious growth strategy, Prime may very well be Amazon's riskiest gamble in the company's 17 year history. Not to mention its most promising.

Because Amazon does not break out Prime data, the number of subscribers remains a mystery. Estimates skew wildly between three million and ten million. (A Bloomberg report last week claimed growth was more sluggish than Amazon has let on.) What's clear is that Prime members spend, upwards of three times what they would without the service, according to Well's Fargo (WFC) analyst Matt Nemer. "Amazon (AMZN) wants to steal wallet share away and use other parts of its business to subsidize profitability," adds Forrester (FORR) analyst Sucharita Mulpuru. (Amazon declined to comment for this story.)

Also nearly certain, that Prime is costing Amazon. Piper Jaffray (PJC) analyst Gene Munster believes Amazon is spending more money than it earns on the program -- by as much as $11 per user. What's more, the company lost some $2.4 billion last year in net shipping costs, a large part of that attributable to Prime shipping says Nemer. Amazon has shown it doesn't mind lower margins to accommodate expansion, spooking some investors. In the most recent quarter, profits plunged 58% to $177 million, despite a 35% jump in sales, due to heavy investments in new sales fulfillment centers. "We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers," the company wrote in its 2011 annual report.

The market opportunity for a loyalty shipping program appears quite large. By one estimate, between 20 and 30 million U.S. households may be willing to pay for something like Prime. Shoprunner, a counteroffensive launched two years ago by GSI Commerce in partnership with over 40 brick and mortar chains like Toys 'R Us and Radio Shack (RSH), remains the only other major competitor. Though Shoprunner drove more than $100 million in sales last year and now works with 60 retailers, analysts believe Prime remains dominant. To wit, Google (GOOG) reportedly wants to get into the game with a Prime-like service of its own.

Now, Prime is poised to grow. Already, the company has expanded its video service, inking a deal with Viacom (VIA). Prime Instant Videos has some 15,000 videos now, within striking distance of Netflix's (NFLX) 20,000 titles. Kindle owners also have a more vast library of books to borrow from -- about ten times larger -- than they even did a few months ago. Both catalogs will only grow with time.

More interesting yet are the ways Prime could evolve. One of the few content areas Amazon hasn't taken full advantage of yet is its MP3 music store. Offering a Spotify-like, all-you-can-listen service seems inevitable. Meanwhile, shipping times could be trimmed to one-day or same-day service. Amazon already offers same-day shipping in ten U.S. cities for Prime members, a convenience that could be extended across the country as the company builds more fulfillment centers near metropolitan areas. "If you're a competing retailer, it should be in your plans that Prime will someday be a next-day or same-day delivery service with 100,000 free movies -- it's going in that direction," chimes analyst Nemer.

If that day comes, Prime won't just be a nominal loyalty program or balance sheet customer acquisition cost. It'll be a monolith few can compete with.

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About This Author
JP Mangalindan
JP Mangalindan
Writer, Fortune

JP Mangalindan is a San Francisco-based writer at Fortune, covering Silicon Valley. Since joining in 2010, he has written on a wide array of topics, from the turnaround of eBay to the evolution of net neutrality. A graduate of Fordham University, Mangalindan has also written for GQ, Popular Science, and Entertainment Weekly.

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