Amazon (NASDAQ: AMZN) is making another big change to its supply chain services. It's suspending its third-party shipping program, Amazon Shipping, starting in June. The move follows a mid-March announcement that it will only receive essential items in its warehouses from third-party merchants.

Amazon Shipping is a service the company offers businesses to deliver non-Amazon packages. It uses excess capacity in its fulfillment network to offer prices that are often lower than UPS (NYSE: UPS) or FedEx (NYSE: FDX). The program is only available in a few cities.

Amazon's decision to suspend the Amazon Shipping service indicates that it's seeing a significant increase in demand, and it's stretching the capacity of its fulfillment network.

Image source: Amazon.

Why Amazon Shipping has to go (for now)

Amazon has a serious capacity problem. It's suspending Amazon Shipping "because it needs its people and capacity to handle a surge in its own customers' orders," according to a report from The Wall Street Journal. That capacity challenge is also why it's prioritizing essential items in its warehouses and delaying Prime Day until at least August.

Amazon Shipping and Fulfillment by Amazon are services that take advantage of excess capacity in Amazon's fulfillment network. That's how they're able to produce strong profit margins for the company. But that capacity no longer exists. And there are no profits in those businesses if Amazon can't leverage existing costs of operating warehouses and delivery trucks.

Deprioritizing those services is the best move for Amazon's business. While it'll likely see compression in its operating margin as revenue shifts to more consumer staples retail sales and fewer third-party seller services, Amazon is maximizing profit dollars over margins in this decision. Moreover, it's the smart move for the long-term growth of its core retail business, which ultimately supports Amazon Shipping and FBA.

Surging demand for groceries and household items

Social-distancing efforts have led many to turn to Amazon to fulfill more of their basic household needs. And by prioritizing consumer staples, Amazon's making a bet that the surge in demand it's seeing presently will turn into greater revenue per customer long-term if it can provide timely service.

One way it could do that is by drawing in more Prime subscriptions. Amazon offers free grocery delivery through AmazonFresh and Prime Now in select areas. And that's an area that's seen a significant increase in demand since social-distancing practices took hold.

Prime members historically spend more than twice as much on Amazon's marketplace than non-members. That trend has held true even as Amazon starts to saturate the market for Prime memberships in the United States.

Moreover, people become habituated quickly. If Amazon is the place they go to for their online orders right now, it's likely going to be the place they go to in the future. Amazon's constantly increasing its capacity and demand should return to more normal levels after the threat of coronavirus abates. As such, Amazon stands to see a permanent step-up in sales going forward.

Ultimately, Amazon's retail operations drive most of its other businesses. Due to the scale of its operations, it typically has excess warehouse and fulfillment capacity to provide services like Amazon Shipping and Fulfillment by Amazon. It can offer those services at relatively low prices versus the competition, and do so profitably because it's already providing the same services to itself as a retailer.

FedEx and UPS shouldn't be celebrating

Investors in FedEx and UPS sent shares higher on the news that Amazon would suspend Amazon Shipping. Indeed, both delivery providers will see some short-term benefits from Amazon bowing out of the market temporarily.

But the long-term threat of Amazon may be made greater by the increased demand for its core retail business that it's telegraphing in its decision. As Amazon increases the scale of its own retail operations, it sees even greater benefits from building out its own fulfillment network. And the bigger that network gets, the more of UPS' and FedEx's business Amazon will be able to take long-term. Amazon will ultimately put pressure on both shipping providers' profit margins and market share as it looks to undercut their pricing and take their business.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and FedEx and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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