Analysis: One-day free shipping buoys Amazon sales, but comes with big cost

After a few periods of more muted growth, Amazon’s sales uplifts accelerated during the third quarter, with a 23.7% rise in total revenue. While service sales made a solid contribution, it was product sales which registered the biggest improvement with the best rate of growth for over a year. In many ways, today’s results signify that Amazon is back on the front foot in terms of driving its online business.
 
The better performance is mostly down to the transition from two- to one-day free shipping for Prime members, which really took hold this quarter. Our data show that this has been well received and that it has persuaded existing customers to use Amazon more – particularly for products that are needed or wanted urgently. Customers appreciate the immediacy of the delivery and now see Amazon as a more viable alternative for quick purchases. Amazon also picked up some new Prime members as a result of the change. 
 
The transition to free one day shipping was a classic Amazon move. It put the company one step ahead of the competition and helped to create a strong point of differentiation for the customer. However, the change comes with a significant cost attached: compared to last year shipping costs are up by 46%, or by $3 billion in monetary terms. This huge hike has taken its toll on the bottom line where operating income fell by 14% and net income by 26%.
 
Amazon will not necessarily be spooked by the increase in costs. Indeed, it sees the higher shipping expense as an investment in the Prime platform and as a way to retain the loyalty of its shoppers. As the top line results testify, there is some merit in this argument. However, one of the issues is that delivery is the new battleground for all online players. As such, it has not taken long for others such as Walmart and Best Buy to roll out their own versions of one-day delivery. Other retailers, like Target, are equally ramping up efforts around same-day in-store collection and free shipping for the holidays. Where Amazon leads, others quickly follow.
 
The question is whether this undermines Amazon’s differentiation and the mechanism that has powered better results. To some extent, the answer is yes. As free next day delivery becomes normalized, there is less of a reason to favor Amazon over other merchants. This could well take the edge of future growth. That said, Prime acts as a partial defense against this as customers who have paid for the service are often keen to stay within the Amazon ecosystem to ensure they get value from their subscription. Equally, Amazon’s vast assortment will continue to make it a magnet for shoppers looking for convenience and value.
 
Looked at in a broader context, the push towards faster and cheaper or no-cost delivery is a race to the bottom. It is value destructive as it is essentially subsidizing a service that customers should, in economic terms, pay for. Interestingly, the strategic point here is that Amazon can absorb this margin erosion far better than most of its rivals. This is because of the profitability of its other service divisions and because of the tolerance of investors. So, in a sense, Amazon is still winning the long-term war of attrition.
 
Away from online and the dynamics of shipping, this was another lackluster quarter for the physical retail business where sales declined by 1%. In our view this underlines the fact that there is still a great deal more work to be done with the Whole Foods business, especially in terms of improving value for money perceptions.