With the rise of mobile, social and the cloud, you are also seeing the rise of subscription model businesses. A model of business built on building long-term customer relationships, and not on one-off transactions. Companies like The Tie Society, who don’t sell you ties, but a subscription to wear a tie for a while, ship it back, and then where another tie for a while. Or the Dollar Shave Club, where you get razor blades sent to your house each month so you never have to go to a store for razors again. These subscription-based companies have to continually provide value to keep people signed up, or else they’re out of business. One of the more popular subscription-based offerings is the Amazon Prime Membership – Amazon.com’s $79/year service that allows you free 2-day shipping on pretty much everything they offer.
In this interview, my featured guest, R.J. Hottovy of Morningstar, discusses the findings of his recent report on how Amazon Prime members are worth eight times as much to the company than non Prime customers. And how building a subscription-based membership program can drive revenue and create an army of loyal customers that keep competitors away.
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Small Business Trends: Can you tell us a bit about your personal background?
R.J. Hottovy: I am a senior eCommerce analyst at Morning Star. I also am the Global Director of Consumer Equity Research and I am responsible for a team that covers three hundred equities with 100 of those either in Europe or Asia or closer to our teams in Sydney, Australia and Shenzhen, China as part of Morningstar’s global equity research coverage.
I’ve been covering the eCommerce space for over a decade at this point and it’s been one of the most disruptive forces in retail since the advent of warehouse clubs in the early 90’s.
Small Business Trends: One of things that I want to talk to you about is the effect the Amazon Prime Membership has had?
R.J. Hottovy: Amazon, in particular, is one of the more debated stocks in the consumer universe. I think most people would recognize the tremendous growth; with cumulative average revenue growth averaging above 25% the last three years. So no one can deny that this is a tremendously fast growing company.
But the question – with operating margins contracting from 5%, three years ago to essentially just 1% this past year on a reported GAAP basis – is, ‘Can Amazon monetize this growth?’ Because without that, the growth becomes a moot point.
I started building some frameworks on how Amazon can monetize its growth. Some things that caught my eye are its digital content through its Kindle ecosystem, Amazon Web Services and the idea of Fulfillment by Amazon. One of the things that was under appreciated in the market was the fact that Amazon Prime, in its own right, was a pretty meaningful building block of profitability for this company. Something that, as it gets more and more members, not only increases top line revenues, but can also be profitable.
Small Business Trends: You estimated at the end of 2012 that there were roughly 10 million Amazon prime members. That number dramatically jumps in the last couple of years to around 25 million?
R.J. Hottovy: That’s approximately where we see things going as of 2017. Granted, there’s a lot of different variables at play. We feel there is a reasonable assumption of where this program can grow. I think that the idea of having Amazon Prime trial memberships that go long with a Kindle Fire purchase is going to help. I think the idea of adding substantial content – both video as well as some book and magazine content to the membership – is going to go a long way.
But I think at the end of the day, what’s been the selling point of this program is just the idea of having access to a wide set of products that you can get to your doorstep within a couple of days at low prices.
I think that is a combination of things which is going to help you draw more people to Amazon and entice them to become Prime members.
Small Business Trends: The other thing from an Amazon perspective is the impact that this program seems to have on buying patterns and behaviors. Your research pointed out that the average Prime member spends a little over twice the amount of the average Amazon shopper?
R.J. Hottovy: This study was done in partnership with a company called Consumer Intelligence Research Partners. What we found is that, generally speaking, last year Prime members spent about twice as much as non Prime members. They spent about $1,200 dollars compared to $600 for non Prime members. What’s also interesting is that the average person shopping online last year spent approximately $1,000. What that says to us it that Prime members generate more incremental revenue per than non Prime shoppers. They are doing most of their online shopping on Amazon as opposed to going to other sites. Prime members generate more income.
To us that’s interesting because that shows that Amazon has a powerful network effect it and has become a destination for consumers – that they have to be on that site. I think that’s powerful and shows that Amazon is protecting it’s customer base with it’s Prime membership program.
Small Business Trends: You actually say that a Prime member is eight times as valuable to Amazon as a non primer?
R.J. Hottovy: That is correct. They are driving a significant portion of the overall revenue. I think the interesting thing to is tying in this whole idea around, ‘Can Amazon be profitable?’ What we found doing the analysis is we broke down every line item that Amazon has. We pointed out that an average Prime customer brings in $700 in incremental revenue. When you include the $79 membership fee, what we found is that Amazon is actually generating about $80 in incremental profit on that revenue that they take in from a Prime member which is an operating margin of about 8%.
Now that compares to Amazon’s overall operating margin of 1%. The difference there is because Amazon is investing a lot in technology and a lot of investments in fulfillment centers, etc. What we’ve found, if you isolate them and take a look at the incoming revenue and the incremental cost of a Prime member, they are quite profitable.
As Prime membership grows over time, that gives a very good indication that Amazon can, in fact, monetize their growth.
Small Business Trends: One of the things that stood out to me is an article where you were interviewed for Wired titled, “Why Amazon Prime Can Soon Cost You Next to Nothing .” Can Amazon actually drop down the cost of a membership to next to nothing and still make it profitable?
R.J. Hottovy: I think it has the flexibility to make adjustments to the Amazon Prime pricing structure. Looking at potential different uses such as having a lower price membership for somebody who is just accessing Prime for video. I think that’s an alternative. I think that this is potentially an opportunity to upscale.
We’ve been able to be more confident that Amazon Prime is actually profitable. I think that really speaks to the overall value of the proposition it is bringing.
Small Business Trends: How does this impact the rest of the online retail industry or retail in general?
R.J. Hottovy: It’s going to be very difficult to compete with Amazon. Particularly those stores in commoditized categories like, clothes, electronics, toys, etc. because, by those companies having a physical storefront, Amazon can maintain a pretty significant price leadership. Even with online sales tax collection, Amazon can still undercut these companies and consumers will flock to the lowest price.
This is the whole idea of show rooming. Where consumers will potentially go out to BestBuy, play with the items so they can understand a little bit better and then go make a purchase elsewhere. The only way that retailers get to compete with Amazon is to essentially match prices — to keep people from making an ultimate purchase on Amazon. At the same time, they’d be doing so at the expense of the margins they maintain and it will make it a lot less possible for these retailers to stay in business.
Small Business Trends: Where can people people learn more about the research you’ve done on the subject?
R.J. Hottovy: For people interested in learning more about the research we’ve done, you can go MorningStar.com .
This interview on subscription based membership programs is part of the One on One interview series  with thought-provoking entrepreneurs, authors and experts in business today. This transcript has been edited for publication.