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Morningstar chart showing the estimated growth and future potential of Amazon Prime.
Morningstar chart showing the estimated growth of Amazon Prime since the Kindle Fire launch.

The $79/year Amazon Prime subscription service has experienced rapid growth since late 2011, reaching an estimated 10 million members as of the end of 2012, with the potential to reach 25 million members by 2017.

amazonsignage2These members as a group are Amazon’s best customers, spending twice as much with the company as non-members do — boosting Amazon’s operating income by nearly $600 million last year even after accounting for the cost of free shipping and other Amazon Prime membership perks.

Those are some of the estimates from extensive research by Morningstar analyst R.J. Hottovy, in conjunction with Amazon customer survey data from Consumer Intelligence Research Partners.

The new Morningstar report crunches the numbers and predicts that Amazon Prime memberships will be one of the primary drivers of growth for the company in the years ahead — supporting Morningstar’s belief that Amazon, notorious for slim profits, will be able to expand its margins meaningfully.

Morningstar’s report was noted by Business Insider yesterday, and we’ve also been reviewing a copy. It’s notable in part because Amazon keeps a tight lid on official Prime membership numbers and results.

Wait a second: Didn’t Bloomberg News report that Amazon Prime members numbered a mere 3 million to 5 million as of October 2011 — fewer than many analysts believed?

Yes, and Morningstar’s research actually supports Bloomberg’s report, based on an analysis of Amazon’s financial statements. However, since that time, Morningstar believes that Amazon Prime’s numbers have risen significantly thanks in part to the strategy of offering Amazon Prime trials with new Kindle Fire tablets.

Here’s an excerpt from Morningstar’s report …

Since the third quarter of 2011, we believe Amazon has witnessed explosive Prime membership growth, fueled in large part by trial membership attachments tied to the Kindle Fire launches as well as increased consumer awareness of Prime’s value proposition. Amazon offers one free month of Amazon Prime with every purchase of a Kindle Fire — which remains the best-selling product on since its launch (we estimate that more than 10 million units have shipped since the 7-inch color tablet was launched in November 2011) — and we believe this attachment has been instrumental in driving Prime memberships (we believe trial memberships have been converted into full Prime memberships at approximately a 30%-40% clip).

Amazon Prime started out with free shipping as its primary perk but has since added features including video streaming and book lending. Memberships are important to Amazon in part because members, after paying the annual fee, are less likely to use other online retailers. That loyalty is also important as Amazon competes with the likes of Netflix and Barnes & Noble in the market for digital videos and books.

Morningstar estimates that Amazon saw an average of $719 in product sales from each member in 2012. Coupled with the $79/year membership fee, that translates into slightly less $798 in revenue per member for the year. The cost of goods, shipping, fulfillment, marketing and content add up to an estimated $721 in annual expenses per member — resulting in incremental operating income of $78 per member. At an averge of 7.6 million Amazon Prime members over the period, that adds up to $593 million for the year.

That’s a big number in the scheme of things — 36 percent of Amazon’s reported consolidated segment operating income of $1.67 billion.

That, at least, is Morningstar’s estimate. (We’ve contacted Amazon to see if it wants to comment on the report.) Morningstar puts the “fair value” of Amazon shares at $300, compared with the current share price of $275 as of earlier today.

Morningstar contends that “Amazon warrants a premium valuation based on its wide economic moat, meaningful avenues for growth, and margin expansion potential.”

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