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Amazon's free shipping offers are getting more costly

Amazon's Prime service may be starting to become too much a good thing for the tech giant.

The offering has attracted some 100 million subscribers. That sizable customer base has in turn encouraged a growing number of third-party merchants to sign up as customers of Amazon's fulfillment services. That's because products offered by vendors who are part of that program are eligible for Prime's free shipping offers.

So far, so good right? Prime brings more customers to Amazon, which lures into more merchants, which helps Amazon expand its product offerings, which probably attracts more shoppers and encourages existing ones to buy more items from Amazon.

The problem for the company is that shipping costs are rising, cutting into its profits and making its free shipping more costly. Amazon's fulfillment costs have already been rising faster than its revenue, noted Dan Morgan, a senior portfolio manager at Synovus Trust, which owns Amazon shares.

One of the key questions for the company, he said in an email, is "How can Amazon balance its fulfillment / shipping costs with increased order volumes from Prime members?"

Free shipping is expensive for Amazon to offer

Morgan is a longtime bull on Amazon, but much of his optimism about the company is due to its Amazon Web Services cloud computing business and its burgeoning advertising business. He's more skeptical about the prospects for its traditional retail business.

Read more:Gold mine is buried 'under the weeds' at Amazon – here's why it could take the company beyond the $ 1 trillion mark

Amazon charges $ 119 a year for its Prime subscription. But about half of that amount is now being consumed by the cost of offering free shipping to customers, Morgan estimates.

Dan Morgan, a senior portfolio manager at Synovus Trust, is worried about rising shipping costs at Amazon.
Bloomberg / YouTube

These costs could continue to rise.

Amazon spent $ 25.2 billion on fulfillment costs in 2017, which was up 43% from the year before and amounted to 14% of the company's total revenue. That sum likely rose to $ 35 billion, or 15.1% of the company's sales, for all 2018, and will likely jump to $ 43.3 billion, or 15.4% of sales this year, estimates Benchmark analyst Daniel Kurnos in a recent report.

Indeed, Kurnos worried that shipping-related factors may have weighed down Amazon's results over the holidays. While Wall Street analysts as a whole are betting that the company posted $ 3.7 billion in operating revenue in the fourth quarter, Kurnos is forecasting $ 3.2 billion.

Amazon is slated to report its holiday period results on Thursday.

"We are somewhat cautious … given external pressure on delivery costs and significant increases in same-day to two-day shipping," he said.

Amazon is facing price hikes

Part of the problem for Amazon going into this year is that all three of the major domestic shippers – the US Postal Service, FedEx and United Parcel Service – just hiked their prices. Amazon has recently adjusted its own charges for merchant customers who take advantage of its fulfillment services. But it's unclear if its higher charges will fully cover its increased costs. And regardless, those fees only apply to third-party merchants, not to Amazon products sells itself.

Add it all up, and Prime's free shipping offering is becoming a better deal for customers – and a worse one for Amazon.

The "rising fulfillment costs not only hurt operating margin, but also erodes revenue from Prime members, as the $ 119.00 annual fee revenue evaporates as shipping costs rise," Morgan said.

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