U.S. Markets close in 4 hrs 7 mins

Amazon's Free Shipping Is Killing These Companies' Margins

Billy Duberstein, The Motley Fool

Amazon.com (NASDAQ: AMZN) CEO Jeff Bezos once said, "Your margin is my opportunity," and Amazon has truly backed that up over the years. Despite explosive top-line growth, Amazon has consistently shown little-to-no GAAP profits in its core e-commerce business.

One of the biggest drivers of sales growth has been Prime, Amazon's $99 per year (or $12.99 per month) subscription service. Started back in 2005, Prime offers a suite of intriguing benefits, most notably free two-day shipping for an unlimited number of items.

Today, it seems increasingly clear that this was a farsighted and ingenious invention. As Prime has grown, Amazon has added benefits, spurring increased membership in a virtuous cycle. Now Prime is so large, it's causing problems even at Amazon's largest (and well-run) competitors: Walmart (NYSE: WMT) and Latin American e-commerce platform MercadoLibre (NASDAQ: MELI)

Amazon is competing hard against Walmart in the United States, but recent rumors suggest it's eyeing Latin America, specifically Brazil, potentially threatening MercadoLibre's leading position there. How are both companies trying to fend off the Amazon machine? With free two-day shipping, of course.

a roll of hundred dollar bills at the end of a mousetrap.

Image source: Getty Images.

Prime's progress

The bet on Prime may have seemed crazy at the time it was launched in 2005. Analysts often cited the fact that Amazon lost significant amounts of money on every Prime member due to shipping costs. But since then, Prime's annual price has increased from $79 to $99, and the service is now estimated to have between 65 million and 80 million members (Amazon does not disclose these figures). Those members contributed $3.2 billion in subscription revenue for Amazon, or just under 10% of sales, in the recent quarter. Consumer Research Intelligence Partners estimates that Prime members spend roughly $1,300 per year with Amazon, versus $700 for non-Prime members. That has, in turn, bolstered Amazon's third-party fulfillment business, which has higher margins.   

Amazon's stock has rocketed in recent years as Prime has grown, winning over legions of loyal customers. It is only now, more than a decade after Prime launched, that competitors are biting the bullet to invest in free shipping.

MercadoLibre claws ahead

MercadoLibre rolled out free shipping in Mexico in 2016, then added it in Brazil in August 2017. Perhaps not coincidentally, that change came not long before rumors that Amazon was looking hard at the Brazilian market.

The introduction of free shipping has been a huge positive for MercadoLibre's sales and gross market value (GMV), which grew a huge 70.5% and 66.5%, respectively, over the past year.

But the company's margins tell a different story. Gross margins shrank from 63.5% to 46.5%, and operating margins plummeted from 25.2% to 4.8% (stripping out the effect of Venezuela, which the company de-consolidated in December). The largest cost difference? Free shipping, of course. MercadoLibre still applies volume conditions on free shipping, which vary by country, so its offering is not yet unlimited. 

Larger volumes should also generate more revenue from its fulfillment and payment businesses, Mercado Envios and MercadoPago, which have made encouraging progress to the point that optimism around these businesses offset concerns about MercadoLibre's lower margins. 

Still, the free-shipping initiative combined with investments in fulfillment centers caused management to suspend its dividend going forward.

Walmart

Unlike MercadoLibre, which is trying to stay one step ahead of Amazon, Walmart is actually playing catch-up in the mature U.S. market. Walmart began pivoting in earnest to becoming more of an e-commerce company in recent years, buying Jet.com in 2016, and even changing its official company name from Wal-Mart Stores, Inc. to Walmart, Inc. in December, highlighting the company's renewed focus on e-commerce.

Walmart's transition incorporated -- you guessed it -- free two-day shipping. Initially, Walmart tried to build its own Prime-like subscription service called ShippingPass, for which it charged $49, but obviously, the endeavor wasn't working as the company scrapped the subscription service in January 2017 in favor of free two-day shipping on eligible items included in orders over $35. 

Trying to play catch-up while fending off a giant

Amazon has built quite a powerhouse in its Prime service, and the company's long-term orientation and willingness to lose money for years has put the e-commerce giant in prime position (pun very much intended), even against its largest-scale rivals.

More From The Motley Fool

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Billy Duberstein owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and MercadoLibre. The Motley Fool has a disclosure policy.