In a world where price has become an increasingly important factor for consumers, big-box retailers remain challenged to compete against that retailer in the sky named Amazon.com (NASDAQ:AMZN). Amazon lacks fancy retail locations and all the other added costs with running a retail store, which has largely contributed to success of its business model over the traditional retail model.
Although Amazon remains an ominous threat within the traditional big-box retail world, the one bright spot within retail continues to be wholesale clubs. Considering Costco's (NASDAQ:COST) most recent earnings results, Amazon has yet to make significant inroads within the wholesale-club market. However, the rise of Amazon Prime members suggests that Amazon has begun taking a page out of Costco's unconventionally successful playbook.
Breaking down the numbers
Last quarter, Costco's net revenues increased 8% year over year to $24.3 billion, which brought home $547 million in net income, a 39% increase from the previous year. During the period, same-store sales increased by 5% year over year, and membership fees accounted for more than 71% of Costco's $738 million operating income. Membership revenues remain critical to Costco's overall profitability, because without them, Costco's business would operate with about a 10% gross profit margin, which doesn't leave much room for margin of error.
Like Costco, Amazon also operates with a similar gross profit margin, which could be a motivating force behind increasing its Amazon Prime membership base. Although Amazon itself doesn't release exact numbers as to how many Prime members exist, Morningstar analyst R.J. Hottovy believes Amazon has lured in more than 10 million Prime members, which currently contributes to about one-third of Amazon's operating income. Although this number is dwarfed by the 37 million households that have a Costco membership, Prime members are estimated to outspend non-Prime members by a factor of 2. In other words, when a consumer pays for a membership, it compels that person to use it more, and that's a very powerful preposition for Amazon.
In an all-out price war between Costco and Amazon, Costco comes out on top because the wholesaler leverages its economy of scale more effectively by selling fewer products. You aren't going to find countless brands for sale at a Costco, but the ones you do will probably be offered for a better price than anywhere else.
In exchange for an added discount, Amazon offers "Subscribe & Save" to anyone who's willing to receive automatic scheduled deliveries of consumer-staple products. To top it off, Subscribe & Save now offers an additional 15% off your total order when five or more Subscribe & Save items are delivered within the same month. Clearly, Amazon is appealing to consumers who value convenience more than getting the absolute best price. Since there are only 448 Costcos located in 42 states and Puerto Rico, chances are you'll have to take an outing to receive the absolute best price, or you may simply live too far away from a Costco to partake. Amazon's success against Costco largely boils down to whether a consumer values his or her time more than getting the absolute best deal.
Central to Costco's business model is getting members returning to their warehouses on a regular basis. Once inside the warehouse, there's a high chance members will be buying more than they've bargained for. One of the most effective ways Costco gets its members to return is with a fresh-grocery store, accompanied with free food samples. This key characteristic provides Costco with a great opportunity to instill in its members its core philosophy of relentlessly improving quality while driving down prices. Naturally, instilling this philosophy was a huge contributor to Costco's impressive 89.8% membership renewal rate last quarter.
The power of numbers
It's estimated that Amazon has 182 million active members, a number that gives it a tremendous base to market its Prime membership. The more services Amazon can bolt onto its Prime membership, the more enticing the $79 annual fee becomes. As more Amazon users convert to Prime members, the cheaper it will become for Amazon to provide membership benefits on a per-user basis. In other words, investing in added membership benefits could come at a fraction of the cost relative to the potential return of increased sales.
Over the long term, it seems that Amazon will continue on the path of becoming more like Costco in terms of adding more membership services to drive increased value to its brand. However, it's not going to be easy for Amazon to directly poach Costco members, given the company's high membership loyalty. As long as Amazon doesn't figure out how to offer free food samples while you shop online, I think Costco will continue to remain rather Amazon-resistant.