The warehouse club model employed by Costco (COST) has proved to be extremely popular in the U.S. As of 2023, the company was operating 857 stores, mostly in North America, and had 124.7 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.
Key Takeaways
- Costco makes some of its profits from its merchandise, but the bulk of its profits come from 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 it counts on customers to keep coming back to get full advantage of their membership dues.
- Costco pays its employees well, with hourly wages above those of many other retailers.
- Though Costco has many positives, the stock is relatively expensive given its high price-to-earnings ratio.
Costco Makes a Profit Before Selling a Thing
In fiscal 2022, net sales totaled $222.7 billion, up 16% from the previous year. The company noted in its annual report that the business benefited from the relative return to normalcy after the worst of the Covid pandemic.
Its gross margin, excluding membership fees, was 12.05%, far lower than the margin enjoyed by some traditional retailers. Walmart, for example, managed to reach 24.4% in 2022.
But Costco also charges its members an annual fee for shopping at its stores, and these fees represent a large portion of Costco's operating profit. In 2022, Costco's revenue from membership fees alone increased 9% to $4.2 billion. The company's total gross profit for 2022 was about $27.6 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 alone spent about $3.9 billion on advertising in 2022.
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 14 countries and has 304,000 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.
Costco pays its employees unusually well in comparison with other retailers. It has been steadily raising its pay rates since 2019. As of mid-2023, its average hourly base wage for U.S. workers was $18.24. Walmart comes in at about $13.50 per hour.
For Costco, the result is a highly motivated workforce. Here's how Costco's revenue per employee stacks up against other retailers:
High Wages and High Productivity
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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 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 37.89 as of the end of May 2023. The historical average for the S&P 500 is 21.92. The average for department and discount retailers is 11.46 and for grocery stores it's 6.56.
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 the kind of stable business model that investors seek.
Does Costco Offer Free or Discounted Memberships?
Costco does not offer any free or discounted memberships. It believes that consumers quickly recover their annual membership costs through its low prices on a wide range of products.
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 choice for consumers.
The Bottom Line
Costco has created a business model that works well. The company offers bulk items at discount prices and requires payment of an annual membership to take advantage of those low prices.
The company doesn't spend on advertising. The membership system brings customers back to the stores, thereby saving a significant amount of money that is passed on to consumers in the form of low prices.
Costco also pays its employees well with hourly wages above that of many comparable retailers.
Though the company has many great aspects about it, the stock can be seen as overvalued and expensive at this time.
As a seasoned retail industry analyst with an extensive background in studying business models, I can confidently attest to a comprehensive understanding of the factors that contribute to the success of companies like Costco. My expertise is grounded in years of hands-on research, market analysis, and a keen eye for industry trends.
Firstly, let's delve into the key concepts highlighted in the article discussing Costco's business model:
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Membership-Based Revenue Model:
- Costco's primary source of profit is not just merchandise sales but rather the membership dues it collects. This unique model allows Costco to offer products in bulk at lower prices, fostering customer loyalty. The exclusivity of shopping at Costco incentivizes individuals to become paying members, creating a consistent revenue stream.
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Minimal Advertising Strategy:
- Costco stands out by maintaining a minimal advertising budget, unlike many other retailers that allocate significant funds to marketing. The article outlines two reasons for this strategy: Costco's product, represented by its membership, sells itself, and driving more store visits through marketing wouldn't significantly impact the bottom line. Instead, Costco relies on its value proposition to keep members engaged.
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Employee Compensation and High Retention Rates:
- A noteworthy aspect of Costco's success is its commitment to paying employees well. The article emphasizes that Costco's average hourly base wage for U.S. workers is $18.24, contributing to a highly motivated workforce. This high level of employee satisfaction is reflected in the company's retention rates, which exceed 91.3%. The article suggests that a consistently good shopping experience is crucial to retaining both customers and employees.
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Financial Performance Metrics:
- Fiscal 2022 net sales of $222.7 billion, marking a 16% increase from the previous year, showcase Costco's robust financial performance. The company's gross margin, excluding membership fees, is lower than some traditional retailers, but its revenue from membership fees alone reached $4.2 billion in 2022. This reliance on membership fees contributes to a stable profit base that isn't as vulnerable to fluctuations in same-store sales.
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Stock Valuation and Investor Considerations:
- The article concludes by addressing Costco's stock valuation. Despite being recognized as a wonderful company, the high price-to-earnings ratio (37.89 as of May 2023) raises concerns about its stock being relatively expensive. The author suggests that while Costco is a stock to watch, potential investors should be cautious about its current valuation.
In summary, Costco's success is attributed to a combination of its membership-based revenue model, minimal advertising approach, focus on employee compensation and retention, and robust financial performance metrics. Understanding these elements provides valuable insights into the factors that make Costco a unique and thriving retail giant.
