There have been some concerns among the owners of Amazon (NASDAQ: AMZN) stock and others  about the slowdown of Amazon’s revenue growth. These concerns are exaggerated because Amazon can quickly ramp up its retail sales by making one or more acquisitions in the retail space.

Since AMZN bought Whole Foods, the internet giant’s last major acquisition in the retail space, Amazon stock has increased by 61.5%, while the S&P 500 has risen by 18%.

One of the ideal acquisition targets for Amazon is Costco (NASDAQ: COST), due to the similarity  between the companies’ business models. Costco’s warehouse model works because of the membership revenues that the company receives. During Costco’s last fiscal year, its membership revenue was $3.1 billion, while its operating income was $4.4 billion. Amazon’s trailing twelve-month subscription revenue came in at $14.2 billion.

There are a number of reasons why AMZN is likely to buy Costco over the next 24-36 months. In this column, I will examine the implications of this deal for Amazon stock and look at some of the other options that AMZN could use to improve its revenue growth and boost AMZN stock in the process.

A Win-Win Option for Amazon Stock

Costco’s entire business model is dependent on increasing its membership base and providing value to its members. The retailer’s membership revenue has increased from $2.4 billion in FY14 to $3.1 billion in FY18, as the chart below shows.

Fig: Costco’s sales, membership fees and operating income in the past four fiscal years.

However, its business model is being threatened by Amazon’s rapidly growing Prime membership base and the increases of Prime’s membership fee. Prime’s membership fee has increased from $79 in 2014 to $129 currently.

After the majority of U.S. consumers joined Prime, Amazon could again flex its muscles and increase the membership fee to $149. Amazon stock has reacted favorably to the continuous increases of the Prime fees. Meanwhile, the fee hikes have made it more difficult for Costco to maintain the high retention rate of its own membership program.

AMZN could easily absorb a decline in Prime membership, since it has other segments which deliver robust revenues and profits. However, Costco does not have this luxury. Even if Costco’s membership declines by a couple of percentage points, its operating income and business model will be seriously threatened, negatively impacting Costco stock.

Source: Bloomberg

Last year, Bloomberg reported that Prime’s retention rate was higher than that of Costco’s membership program. Costco’s membership revenue has also been growing at a much slower rate than Amazon’s. In the past four years, Costco’s membership revenue has increased by 29%, from $2.4 billion to $3.1 billion. This equates to an annual growth rate of only 6.6%.

However, Amazon’s subscription revenue has been growing close to 50% for several quarters, as the data below shows.

The Impact on Amazon Stock

It has been 18 months since AMZN purchased Whole Foods. Since then, AMZN stock has shot up 61% while Costco’s has increased by only 19%. Costco’s advance is roughly in-line with that of the S&P 500.  

Amazon has also been ramping up its investments in content, increasing the value proposition of Prime membership. After Walmart (NYSE: WMT) recently stopped  investing in content due to its high cost,  Amazon is the only retailer which offers a combination of retail and streaming, increasing its advantage over its competitors.

Last year, it was reported that Costco might be considering launching its own streaming platform. However, given the current size of Costco and the number of players in the streaming sector, it would be very difficult for Costco to justify spending billions on a new streaming platform.

Ideal Purchase Point

Costco stock is currently quite expensive. It has performed well in 2018 rising from the lows it hit in the second half of 2017, after AMZN acquired Whole Foods.

A lot will depend on the performance of Costco stock in the next few quarters. If the retention rates of its membership program falls, we should quickly see a correction of Costco’s stock. If its forward price-earnings ratio falls to 22 from its current 26, its market cap would be close to $65 billion.A takeover price of $85 billion-$90 billion, representing 10% of the current market cap of Amazon, would provide the owners of Costco stock with a healthy premium.

 A major acquisition by AMZN would improve its top and bottom lines, helping to boost sentiment towards Amazon stock. Costco seems like a good target for Amazon because it will help expand AMZN’s subscription program and also provide Amazon with a big warehouse base to improve the fulfillment abilities of the company.

 

 

The Bottom Line on AMZN Stock

The recent concerns over Amazon’s slower revenue growth are overdone. The company is likely going to make another acquisition in the brick-and-mortar-retail space in the next few quarters. One of the possible targets for Amazon is Costco due to the inherent synergies of the companies’ business models. The continuous growth of Amazon’s subscription revenue is a threat to Costco as it puts pressure on households to choose between the membership programs of Costco and Amazon.

Even a small reduction in Costco’s retention rate should cause COST stock to drop significantly, making Costco’s asking price more palatable for Amazon. The owners of Amazon stock  should consider the positive impact that a major acquisition can have on the price of AMZN stock.