The warehouse club model employed by Costco (NASDAQ: COST) has proven to be extremely popular in the U.S. By late 2020, the company was operating nearly 800 stores, mostly in North America, and had 98.5 million members. It's safe to say that the vast majority of those dues-paying members are regular buyers of Costco's jumbo-sized merchandise.

What's the secret to Costco's success? Here are three factors that make Costco a great company.

It Makes a Profit Before Selling a Thing

In fiscal 2019, Costco sold $152.7 billion worth of merchandise. Its gross margin, excluding membership fees, was around 11%, as it has been since at least 2014.

This is far lower than the margin enjoyed by traditional retailers. Wal-Mart, for example, managed to top 24% in 2019.

Key Takeaways

  • Costco makes a little of its money selling goods, and a lot of its money selling memberships.
  • This business model allows it to undersell the competition and ensure customer loyalty.
  • Its advertising budget is zero. Its customers return to get the full advantage of their membership dues.

But Costco doesn't actually make most of its money selling things. It charges its members an annual fee for the privilege of shopping at its stores, and these fees represent the bulk of Costco's operating profit. In 2019, Costco made $3.35 billion from membership fees, an increase of 7% from the previous year. Its entire net income for the year was $3.66 billion.

Other retailers need to worry that a decline in same-store sales will lead to collapsing profits. Not Costco. Its profits rest on its ability to persuade people to shell out $60 per year for its Everyday Value membership or $120 to upgrade to Gold Star Executive status.

A High Retention Rate

With prices often far lower than at competing retailers, it's not difficult to make the case to consumers, especially since the average Costco member has a household income of nearly $100,000. This leads to an extremely stable base of members, with retention rates in excess of 85%.

It's no surprise, then, that Costco's profitability has been so consistent over the years.

No Advertising? No Problem

Most retailers spend huge sums of money on marketing to bring customers into their stores.

Wal-Mart, for example, is considered to be stingy on advertising, spending only about 0.5% of its revenue on marketing expenses. But that adds up to about $2.4 billion, making Wal-Mart one of the largest advertisers in the world. Target spends more than 2% of its revenue on marketing.

Costco spends essentially zero. It has no advertising budget, though it does spring for mailers targeted to prospective members and coupons sent to existing members.

The Argument Against Advertising

How can Costco manage to completely shun traditional advertising? There are two reasons.

First, Costco has a product that sells itself. The membership offers a great value to those who shop regularly at Costco, and traditional retailers simply can't match Costco on price.

Second, driving existing members to the store more often through marketing wouldn't really help the bottom line, since membership fees are the real driver of profits, and spending heavily to gain more members doesn't make much sense.

In fact, if Costco were to spend 0.5% of its revenue on marketing, it would wipe out 17% of the company's operating profit. If it were to spend 2% of revenue on advertising, as Target does, that spending would erase nearly 70% of Costco's operating profit. It's just not worth it.

High Wages and High Productivity

Costco pays its employees unusually well in comparison with other retailers. In early 2019, it raised its minimum hourly pay to $15. Its average hourly pay is about $17.60 an hour, compared to about $10.88 on average for retailers, according to Payscale. Most Costco employees are eligible for company-sponsored healthcare.

For Costco, the result is a highly motivated workforce. Here's how Costco's revenue per employee stacks up against other retailers:

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COST Revenue Per Employee (Annual) data by YCharts.

The average Costco employee generates nearly triple the revenue produced by the average Wal-Mart and Target employee. Now, part of this is due to Costco's business model. Its spartan warehouse stores require far fewer employees than the typical big-box store.

But what keeps customers coming back, and keeps members renewing their memberships, is a consistently good shopping experience. With highly paid, happy employees, Costco delivers better than its retail rivals.

Great Company, Expensive Stock

Costco is a wonderful company but that doesn't mean it's a great stock. As of mid-October 2019, Costco had a price/earnings ratio of close to 42. The historical average for the S&P 500 is about 12 to 15. The average for retailers is about 15.5.

It's certainly reasonable to pay a high price for quality, but there is a limit. Costco is a stock that should be on every investor's radar, and if it ever falls back down to more reasonable levels, it should be snapped up in a heartbeat.

Timothy Green has no position in any stocks mentioned.