The warehouse club model employed by Costco (COST) has proven to be extremely popular in the U.S. As of March 17, 2022, the company was operating nearly 820 stores, mostly in North America, and had 114.8 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.
- Costco makes a small percentage of its profits from its merchandise, whereas the bulk of its profits come from its membership dues. Only members can shop at Costco.
- The membership business model allows Costco to undersell the competition by offering products in bulk at lower prices to ensure customer loyalty.
- Costco's advertising budget is zero as customers return to get the full advantage of their membership dues.
- Costco pays its employees well, with hourly wages above the federal minimum wage and above many other retailers.
- Though Costco has many fine attributes as a company, the stock may be expensive for some investors given its high price-to-earnings ratio.
It Makes a Profit Before Selling a Thing
In fiscal 2021 Costco sold $192 billion worth of merchandise and brought in $3.9 billion from membership fees. 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. Walmart, for example, managed to reach 24.3% in 2021.
But Costco doesn't actually make such a large portion of its profit selling goods. It charges its members an annual fee for the privilege of shopping at its stores, and these fees represent a large portion of Costco's operating profit. In 2021, Costco's merchandising costs were $170 billion on $192 billion of revenue. Selling, general, and administrative costs were $18.5 billion. The total profit for the year was $5.2 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 Gold Star membership or $120 to upgrade to its 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 $93,000. This leads to an extremely stable base of members, with retention rates in excess of 91.3%.
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.
Walmart spent $3.2 billion on advertising in 2021. Target spent more than 2% of its revenue on marketing. In 2020, Target spent $1.5 billion, which is approximately the same amount it has spent since 2010.
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.
Costco operates in 12 countries and has 288,000 employees worldwide.
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, in 2021 it raised it to $16 and the same year raised it to $17. Its average hourly pay is about $18.04 an hour, compared to about $13.99 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:
COST Revenue Per Employee (Annual) data by YCharts.
The average Costco employee generates nearly triple the revenue produced by the average Walmart 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 March 28, 2022, Costco had a price/earnings ratio of 44.64. The historical average for the S&P 500 is about 21.92. The average for department and discount retailers is 32.29 and for grocery stores is 10.57.
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.
What Is Costco's Competitive Advantage?
When compared to other similar retailers, Costco's competitive advantage lies in its own private label, its discount prices, and its membership dues. This has provided customers with a product that they can rely on at low prices. It is also a stable business model that investors seek as a good investment.
Does Costco Offer Free or Discounted Memberships?
Costco does not offer any free or discounted memberships. It believes that its annual membership costs are recovered quickly through its low prices and many products that result in overall savings if customers were to shop at similar companies.
Who Owns Kirkland?
Kirkland Signature is a private label brand owned by Costco. Kirkland products sell for about 20% less than national brand name competitors, making both Costco and Kirkland an attractive shopping destination.
The Bottom Line
Costco has created a business model for itself that works well. The company offers bulk items at discount prices, requiring a membership to take advantage of those low prices. The company doesn't spend on advertising as the membership brings customers into the stores, thereby saving a significant amount of money and passing that onto consumers in the form of low prices.
Costco also pays its employees well with hourly wages above that of the federal minimum wage and many other comparable retailers. Though the company has many great aspects about it, the stock can be seen as overvalued and expensive for some investors.