Costco's Living On the Edge

Some industries are easy to root for.

Wholesale clubs are in business because they help customers stretch a dollar in good times and in bad.

The angel on our shoulder would have us believe that these are the types of companies that should succeed. Alas, this is easier said than done.

The problem with wholesale
The wholesale club space is one of tight competition. Companies such as Wal-Mart's (NYSE: WMT  ) Sam's Club, BJ's Wholesale Club (NYSE: BJ  ) , Costco (Nasdaq: COST  ) , and even foreign-operator PriceSmart (Nasdaq: PSMT  ) are constantly duking it out with each other. Traditionally, the equation for winning customers is simple: Offer bulk goods for the cheapest price, and your company will have the most business.

While such a model is great for customers, it can wreak havoc on wholesalers, as price wars compress margins to the point where expansion becomes difficult.

While retailers such as Target (NYSE: TGT  ) and Sears Holding (Nasdaq: SHLD  ) sport gross margins north of 25%, the margins at wholesale clubs are typically compressed into the teens.  

Creating a new model
Let's use Costco as a case study. Take a look at its membership fees, those $50 annual payments you make for admittance. Instead of increasing the prices of goods sold, Costco makes most of its profit from membership fees. Goods are sold with only a razor-thin markup, meaning that it is able to offer truly great deals.

A quick glance at the chart below shows that income from membership fees typically account for about 80% of Costco's operating income; sales bring in the last 20%.

 

Membership Fees

Operating Income

Fees as a Percentage of Income

2010  $1,691  $2,077 81%
2009  $1,533  $1,777 86%
2008  $1,506  $1,985 76%

Source: Costco 2010 annual report. Figures in millions.

Though the numbers vary a bit more, the same general principle applies for other wholesale clubs. BJ's, for example, averages membership fees that are 81% of operating income over the past three years.

Essentially, this tells us that four out of every five dollars of operating income comes from membership fees.

Metrics worth watching
Knowing how important membership fees are, you now have two metrics to really keep your eye on.

  1. Membership count: This includes both individual and corporate customers. The membership count is published every quarter during the earnings release.
  2. Average cost of membership: Currently, individual and business memberships run for $50 per year in the United States, while executive memberships usually cost $100 per year.

By giving an appropriate amount of weight to these metrics, as opposed to sales alone, you'll have a better idea of how Costco and others are faring.

Want to keep an eye on Costco, BJ's, and their membership figures? Add them to your watchlist today.

Fool contributor Brian Stoffel owns shares of Costco and PriceSmart. Though he doesn't have a Costco located near him, he's pretty sure all of his mom's Christmas presents are from there.

Costco and Wal-Mart are Motley Fool Inside Value recommendations. Costco is a Motley Fool Stock Advisor pick. Wal-Mart is a Motley Fool Global Gains selection and a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart. The Fool owns shares of Costco and Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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