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How Amazon Is Becoming More Like Costco

By Adam Levy - May 19, 2016 at 4:26PM

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The e-tailer is reportedly launching its own brands of food and consumer packaged goods.

Image source: Flickr/Karlas Dambrans.

Members of Amazon (AMZN 3.15%) Prime are in store for another perk: The Wall Street Journal reports that Amazon will begin releasing several private-label food and home goods products in the coming weeks exclusively available to Prime members.

Amazon's latest lineup is targeted at certain niches with generally higher profit margins like food and consumer packaged goods. This will allow it to undercut pricing while producing a better profit margin for its first-party sales, which have historically remained minimal. The new lineup will join Amazon's recent efforts with its own clothing lines, and its established AmazonBasics line of electronics accessories.

Expanding gross margin

Private labeling generally carries higher profit margins than name brands because retailers don't have to spend money on marketing. Those savings are often passed on to consumers with lower prices than comparable products. But retailers generally keep some of those savings in the form of higher gross profit margins.

Costco (COST 1.35%) has successfully grown the popularity of its Kirkland Signature brand. In its annual report, management noted, Kirkland Signature products "generally carry higher margins than national brand products carried in our warehouses and represent a growing portion of our overall sales." That statement rings true in its gross margin results. Over the last five years, Costco's gross margin expanded 40 basis points, from 10.69% to 11.09%.

Amazon's retail gross margin is as slim as they come. Last year, Amazon's retail operating margin was just 2.3% (it doesn't provide gross margin). But analysts see a lot of room for improvement. An outsized increase in sales coming from high-margin markets like apparel and consumables will naturally increase margins going forward. Combine that with Amazon selling its own private label products in those categories, and the impact on gross margin will be even greater.

Becoming Costco

With the expansion of its private label business, Amazon is becoming even more like Costco. As mentioned, access to Amazon's new products will require an Amazon Prime membership, just as access to Costco stores requires a membership. These memberships are essential to Costco's business, producing about 70% of its operating profit.

Likewise, Prime memberships are becoming increasingly important to Amazon. With an estimated 50 million Prime subscribers in 2015, membership fees accounted for 167% of its retail operating income. While Prime requires Amazon to spend more on fulfillment, technology, and content, it's a good bet Amazon would still be operating at a loss if it weren't for Prime's annual $99 membership fee.

The move into more private-label products, reportedly aimed toward more premium higher-gross-margin products, gives Prime yet another perk enticing shoppers to sign up for the membership. Not only does the less expensive brand produce more shopper loyalty, the two-day shipping included with Prime reinforces it. As a result, Amazon will benefit as shoppers spend more money on -- something that's been exhibited by Prime members in the past.

Costco notes the same thing about its private label producing member loyalty. "Maintaining consistent product quality, competitive pricing, and availability of our Kirkland Signature products for our members is essential to developing and maintaining member loyalty," the company wrote in its annual report.

Growing private labels will not only improve Amazon's gross margin, it will help add Prime members and keep them signed up year after year. That means more revenue in high-margin membership fees, as well as the potential for more product sales, and higher overall margins for its retail operations.

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