Why Costco Is Beating Wal-Mart

This is not a good year for big department store chains and retailers. J.C. Penney  (NYSE: JCP  ) lost more than half of its market value after the company's rebranding efforts failed to improve sales. Sears and Staples are burning cash, and could soon become mere entries in the archives of Wikipedia. To keep same-store sales growth in the 2% range, some companies are investing their gross margins and lowering prices even further, such as Wal-Mart Stores  (NYSE: WMT  ) .

The big exception here is Costco (NASDAQ: COST  ) . This year has been outstanding for the retailer, and with more than $100 billion in annual revenue, Costco keeps growing its top-line and making profits consistently. In the fourth quarter of 2013, the company saw 5% growth in U.S. same-store sales and 7% growth in international sales. Moreover, the company even managed to improve profitability by 1.3% despite the effect of negative currency fluctuations. So what is Costco doing different? Is Costco on its way to replace Wal-Mart and become the largest retailer in the world?

The Costco way versus the Wal-Mart way
Unlike Wal-Mart, Costco uses a paid-membership business model. Customers need to become Costco members in order to purchase merchandise at discounted price, paying at least $55 per year for the membership. This allows Costco to collect most of its profits 12 months in advance. Roughly 70% of the company's operating income is generated in this way.

Source: Costco Investor Relations, Costco Day presentation slides.

The best part of the story is that although membership fees have increased over time, Costco is having no problem in expanding its membership network. In the fourth quarter of 2013, new membership increased 4%, taking the number of members to more than 71 million. Furthermore, most customers are satisfied with Costco's discounts and decide to renew their membership, as evidenced by the recent upsurge in annual membership renewals. In this way, Costco's main profit source is not only improving, it is also recurrent.

Aware of the benefits of having a strong community of customers, Wal-Mart is expanding its Sam's Club subsidiary, which also uses a membership model. However, Sam's Club may be failing to capture market share from Costco. This is because Costco, apart from offering slightly lower price points on certain key products, is trying to improve its customer experience by implementing kind return policies, accepting several payment methods, and adding gift prizes. More importantly, Costco is always changing its brands and introducing new products in order to provide customers with a pleasant "treasure hunt" experience.

At this point, the main advantage that Wal-Mart has over Costco is its pricing power. With more than $400 billion in annual global sales, Wal-Mart can in theory impose the most favorable terms possible from its suppliers and vendors. However, if Costco continues opening 25-40 global warehouses per year, high-single-digit revenue growth rates should help to minimize the pricing power difference between Costco and Wal-Mart.

Lessons from J.C. Penney
The centenarian retailer J.C. Penney, which has not registered a quarterly profit in two years, is an example of how important it is to build and protect a loyal customer base in the competitive retail industry where differentiation is hard to achieve.

This year, the company replaced its famous sales and promotions to adopt an "everyday low price" strategy instead. Such a change may have contributed to build a new brand, but by suddenly abandoning a strong tradition -- last year the company offered more than 500 sales -- this policy also confused loyal customers.

Foolish bottom line
Costco is a great pick for one simple reason: the company excels at building a strong, loyal customer community. This allows Costco to enjoy recurrent, recession-proof revenue, and to get most of its operating profit 12 months in advance via annual membership fees. This competitive advantage should protect the company from competitors such as Wal-Mart and Target, which enjoy stronger pricing power.

Is Wal-Mart going down?
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.


Read/Post Comments (14) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 21, 2013, at 2:31 PM, hapuna wrote:

    Costco treats its employees better. They also treat the customers better. They do not owe their soul to China.

    They listen to customer suggestions and act on them. They carry mostly quality brands and merchandise. They do not just try to or succeed at providing items at the lowest price. But what they do offer is good. And it is what their customers want. Their stock is doing well because people know that they will grow because they have ethics and they provide quality. Costco is not about gimmicks and tricks. It is about providing value for your money. Yes, I have been a member for many years and plan to be for many more. There is a distinct difference to Costco. Go into one and you will notice the difference.

  • Report this Comment On November 21, 2013, at 4:34 PM, VegasSmitty wrote:

    Can hardly get into the parking lot at Costco and find a parking place. then the long lines at checkout. Sorry, not worth it for me to save a few bucks.

  • Report this Comment On November 21, 2013, at 8:12 PM, JuanaBee1 wrote:

    I work for Costco through one of their contractors and travel the country doing work in various stores. Without disclosing exactly what I do, which would disclose my employer, I can tell you that I am privy to a good portion of their financial information. Their primary driver of growth at this point is SNAP. Yes, sales are up per store and company wide, but all of that increase correlates with SNAP purchases. (The charts look like a layover.) They are hard-charging after Walmart's business and they are getting it--low-end buyers.

    Most of the original stores targeted high-income areas (upper-middle and middle). Virtually all of the new stores target lower-middle and even lower classes. If you want to see the face of the new Costco go to their store in Yakima, WA. They highest percentage of SNAP transactions per total sales of any retail location in the US.

    Costco is rapidly replacing hard-goods with lower-end Chinese products, included staid favorites like Little Giant. Once a mainstay of the Costco Roadshow circuit, you could only buy LG ladders during special events. Now they are always on the shelf but here's the difference: the LG ladders on the shelf are made in China for Costco. Any other LG ladder, including the ones sold during the Roadshows LG still does in Costco, are 100% American made. This holds true with Costco's "deep relations" with the Ninja Appliance series. The new (Chinese) blender being advertised on TV by Ninja is being hard-pushed by Costco as they squeeze their longtime American-made partners like Vitamix and Blendtec.

    Costco may be a good, sound bet (disclaimer: I own some stock--not a lot--and am holding, for now), but in it's zeal to take on the Waltons it will ultimately end up as another Sam's or, worse yet, BJ's and the "special quality" of it's stores will disappear. It's hard to tell unless you're in a lot of wharehouse, but there's a big difference in types and quality of offerings between some place like Novato, CA and El Paso, TX and the newer the store the less likely it has the higher-end goods that Costco used to attract it's original customers.

  • Report this Comment On November 21, 2013, at 11:21 PM, nohelmet wrote:

    Nobody goes to Costco anymore, it's too crowded.

  • Report this Comment On November 22, 2013, at 3:27 PM, Toxdoc09 wrote:

    This Costco rise is just temp , don't forget the forced tax of Obamacare will take huge percent of spending money from the middle class. There wont be any money to pay a $55 - $100 member ship fee. Costco's prices are not better than Walmart so how long do you think after the Obamacare tax will Costco not only be on top but also pay their employees at current levels?

  • Report this Comment On November 22, 2013, at 3:29 PM, jdmeth123 wrote:

    Let's see, nearest Walmart, 10 miles. Nearest Costco, 40. Going to Walmart.

  • Report this Comment On November 22, 2013, at 9:57 PM, Mathman6577 wrote:

    Excuse me. I have to take my 20% annual dividend growth rate from $WMT to the bank now.

  • Report this Comment On November 23, 2013, at 8:42 AM, Mathman6577 wrote:

    As Steve Jobs always said "one more thing":

    While Costco may be a "better" stock at this time and may treat their employees "better" according to some people (I don't think it's a majority and I don't happen to agree with it) it is best to be careful what you wish for when writing these articles or making positive comments about the so-called living wage protests. It could come back to bite you in the butt.

    If some of the 1.2 million Americans working at Wal-Mart -- which is 10x more than Costco -- suddenly didn't -- i.e. if the living wage protests resulted in some of them to lose jobs --- there would be even more of a burden on taxpayers and more would people require assistance. And also Wal-Mart's revenues are > 4x that of Costco and makes a bigger impact on the overall economy.

    And I don't think a company trying to help anyone, regardless of the circumstances, is a bad thing. I don't see the federal government lining up to help them. If WMT is criticized for that I think it is a bit hypocritical.

    My philosophy is if you don't like the company don't shop there, work there, or buy their stock. Just don't tell me what to do.

  • Report this Comment On November 23, 2013, at 7:32 PM, cmalek wrote:

    Comparing WalMart to Costco is apples and oranges. Different business models. You should compare Sam's to Costco or WalMart to Target.

    I have never found WMT prices to be as low as they try to make us believe that they are. With careful attention to sales and coupons I can get stuff cheaper at other retailers.

  • Report this Comment On November 24, 2013, at 6:41 AM, Mathman6577 wrote:

    Walmart should actually be compared to companies like Family Dollar. Target is probably a little more upscale. The companies all have their little niches.

  • Report this Comment On November 24, 2013, at 3:57 PM, mustbefriday wrote:

    I'm shocked! Shocked I say, that it took almost 24 hours for a phony anti-Obamacare argument to be posted. You would think the concern trolls would be better equipped to act! The time to complain about Obamacare was over three years ago when the president signed the law. You lost. Get over it.

  • Report this Comment On November 24, 2013, at 4:36 PM, taloft wrote:

    VegasSmitty wrote, "Can hardly get into the parking lot at Costco and find a parking place. then the long lines at checkout. Sorry, not worth it for me to save a few bucks."

    That means they're turning serious business. How is this a bad thing if you're holding a stock position in the company? I smile every time I drive by and see the lot full, and it's always full.

    Some people just go to graze on the free samples and impulse buy while doing so. I consider this conditioning them to associate spending money with getting a tasty treat. Operant conditioning at its finest, lol.

    Walmart didn't get to be the biggest retailer on earth by not being able to adapt to the current business climate. I wouldn't count them out quite yet. If Costco wants to ascend that throne, they have a tough row to hoe.

    People are talking as if you either shop at one or the other. Truth is many folks shop at both. I do because I want different things from each. While they compete directly on many products, there is enough variation in items carried to warrant visiting both retailers. Provided of course that both are readily accessible.

  • Report this Comment On November 29, 2013, at 3:28 PM, cmalek wrote:

    @mustbefriday:

    "The time to complain about Obamacare was over three years ago when the president signed the law. "

    We DID complain and write to our Congresscritters but Obamacare was jammed down our throats and we were sold down the river (or, in this case, to the insurance companies) by Obama and "our" Congresscritters.

  • Report this Comment On November 29, 2013, at 3:38 PM, cmalek wrote:

    @taloft:

    "If Costco wants to ascend that throne, they have a tough row to hoe."

    Not so tough. Since Sam Walton died, WallyWorld CEOs have been a succession of morons.

    WalMart only creates an illusion of success. Either accidentally or by design, they have only a few registers open, slowing down the customer checkout and keeping the parking lots artificially full. If WallyWorld staffed more registers, their parking lots would be much emptier.

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