Costco Wholesale Corporation (NASDAQ: COST) goes against the grain. In today’s world of shopping via smartphone and next-day delivery, Costco remains the largest warehouse retailer in the United States. Its secret is simple: Instead of trying to compete on margins alone, the company sells membership cards. And it sells a lot of them.

Costco counted roughly 98.5 million membership households in eight countries in 2019. That brought in roughly $3.35 billion a year in membership fees alone. The company boasts a membership renewal rate of over 91%, so even when sales are depressed it has a decent and predictable cushion of revenue.

That's good for investors who have already bought in, but it means that Costco's shares are never really priced low.

Getting in at the Right Price

Investors are willing to pay more per share relative to the company's earnings because they believe the company will be able to continue to grow going forward.

Key Takeaways

  • Costco has a unique and highly profitable business model but it was late to adapt to the e-commerce world.
  • Its stock has been on a tear, outpacing the retail industry as a whole.
  • Ahead, look for greater expansion of e-commerce, here and abroad.
  • And keep an eye on the California economy!

As of late January 2020, Costco stock was doing very nicely. Its share price ended the week on Jan. 24 at $310.03, up 5.8% in a month compared to a 2.75% gain for the retail wholesale sector as a whole.

A Premium Price

Costco had a forward price-to-earnings (P/E) ratio of 36.82, and that is fairly high for its industry. In comparison, the SPDR S&P Retail ETF has a P/E ratio of 5.29 and Walmart's is 22.85.

Costco has a dividend yield of 0.84%, which could help make up for some pricing, but other companies are priced lower and pay a higher dividend. For instance, Wal-Mart’s dividend is 1.85%.

Costco is expanding its in-store pickup option, an advantage over pure online retail competitors.

Costco stock has been very consistent. It just keeps climbing. But if you do not buy in at the right price, it could take a long time for you to see a return on your investment.

The E-Commerce Issue

While getting in at the right price is good advice for any investment, the risk is particularly pronounced in Costco stock. There's still a question of whether the company will be able to keep up with its customers' changing habits.

Costco members are loyal right now, but shoppers are steadily shifting to online stores via smartphones or laptops.

That Was Then

Back in late 2014, Costco, in a 10-K filing, acknowledged that a multichannel experience is critical to remaining competitive in the modern economy. The company identified the need to keep pace with its members' expectations as well as new developments in the retail space. Costco said that it was making technology investments in its website and mobile apps, but it cautioned, "If we are unable to make, improve or develop relevant member-facing technology in a timely manner, our ability to compete and our results of operations could be adversely affected."

Initially, it didn't look like Costco's business model adapted well to that hyper-connected reality. "We're not going to be the company that delivers two different cereals to your doorstep at 7 a.m. as long as you order by 10 p.m. the night before," said chief financial officer (CFO) Richard Galanti in a conference call back in 2015.

A Strategic Recalculation

Galanti may have revised his thoughts since then, as the e-commerce juggernaut rolls on.

By 2019, Costco had same-day grocery delivery available within a short drive of 99% of its U.S. locations, and two-day delivery everywhere else in the U.S. E-commerce sales were up 20% year-over-year in its second quarter of 2019. The increased sales were not just in groceries but in consumer electronics, hardware, health and beauty, and apparel.

It also was expanding its pickup-in-store option, one of the rare instances for which brick-and-mortar retail has an edge on Amazon (for now).

When Galanti made that comment about delivering groceries overnight, e-commerce was just 3% of Costco's business. By early 2019, it was 5% to 6%. That's good growth, though maybe nothing to keep Amazon's Jeff Bezos awake at night.

The Business Model

Costco's brick-and-mortar business model is still the heart of the operation. Everything is in a warehouse setting, and the selection is limited.

Pricing is unique to each store or area, and it is based as much on local members' shopping habits as it is on whatever deal Costco can negotiate.

The value of being a member comes from purchasing staples in bulk and maybe filling up your fuel tank on pantry-stocking trips.

The margins on those items are low, but Costco makes it work through high-volume selling and the membership system.

Customer Loyalty Is Key

Investors should understand Costco's business model before investing in the company's stock because it is a very real risk given current trends.

If Costco's members end up deciding that membership is not worth it – for example, if they find that they can find similar deals at Amazon or Wal-Mart without ever having to leave the house, or if they decide they can buy better-quality goods for a similar price – the company loses out.

There is the issue of membership fees, which are essential to the company's business model.

Another factor to watch is Kirkland Signature, Costco's private label. Because Costco owns the brand, it earns a higher margin on its products. If there is a quality issue, and the company is no longer able to command loyalty to the Kirkland Signature brand, Costco's profits will suffer.

All Roads Lead to California

Then there is the issue of geography. While Costco had roughly 782 warehouses around the world by early 2020, the bulk of its income still comes from the U.S. As such, its sales are vulnerable to the domestic economy, which is not an unusual risk.

However, roughly one-third of Costco's domestic sales come from a single state, California. The state's economy is strong right now, but if that changes, Costco's sales could take a hit.