The warehouse club model employed by Costco (NASDAQ: COST) has proven to be extremely popular in the United States. The company operates nearly 700 stores, mostly in North America, and both revenue and profits have been growing relentlessly over the past decade. Costco is one of the most consistent retailers around, with its gross and operating margins barely fluctuating at all during the past 10 years.
What's the secret to Costco's success? Here are three reasons Costco is a great company.
Profiting before selling a thingIn fiscal 2014, Costco sold $110 billion worth of merchandise at a gross margin of around 10.7%, excluding membership fees. This is far lower than traditional retailers; Wal-Mart, for example, typically manages a gross margin of around 25%.
But Costco doesn't actually make 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 2014, Costco generated an operating profit of $3.22 billion. Of this amount, $2.43 billion came from membership fees.
Unlike other retailers, where a decline in same-store sales can lead to collapsing profits, Costco's profits rest on its ability to persuade people shell out $55 per year for a membership. With its 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.While many retailers spend huge sums of money on marketing, attempting to drive customers to their stores, Costco spends essentially nothing. It has no advertising budget, only sending targeted mailers to prospective members, and coupons to existing members.
Wal-Mart is also stingy on advertising, spending just 0.5% of its revenue on marketing expenses. This adds up to about $2.4 billion, making Wal-Mart one of the largest advertisers in the world, but as a percentage of revenue, Wal-Mart spends less than most of its peers. Target spends more than 2% of its revenue on marketing, and department stores like Kohl's spend in excess of 5% of revenue on marketing.
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 trying to gain more members likely doesn't make much sense.
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, like Target does, this spending would erase nearly 70% of Costco's operating profit. This advertising spending would need to create tens of millions of new Costco members in order to pay for itself, and that seems awfully unlikely.
Costco's ability to grow and attract new members without expensive advertising is one major attribute that makes it one of the best retailers around.
High wages and high productivityCostco pays its employees unusually well for a retailer. While the company's starting pay is $11.50 per hour, not much better than many other retailers, the average employee wage is around $20 per hour. The national average wage for a retail sales worker is just $11.39. In addition to high wages, the vast majority of Costco employees also get company-sponsored healthcare.
Costco can afford to pay such high wages because its employees are extremely productive. Here's how Costco's revenue per employee stacks up against other retailers:
The average Costco employee generates nearly triple the revenue compared to the average Wal-Mart and Target employee. Now, part of this is because of Costco's business model. Its spartan warehouses require far fewer employees to run compared to a big-box store. But what keeps customers coming back, and what keeps members renewing their memberships, are consistently good experiences. With highly paid, happy employees, Costco is able to better deliver on this than traditional retailers like Wal-Mart.
A great company, but an expensive stockDespite Costco's status as a wonderful company, the stock probably isn't a great buy. Shares of Costco trade at nearly 33 times 2014 earnings, and with analysts expecting just 10% annual earnings growth going forward, it's difficult to justify such a high price.
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.
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Timothy Green has no position in any stocks mentioned.