Costco: One of the Leading Retailers Defying the Big Box Apocalypse

Costco's low product markups and cheap goods have enabled the warehouse retailer to continue growing its customer base and its sales at a healthy pace.

Jan 22, 2014 at 1:41PM

With so many retailing giants such as J.C. Penney (NYSE:JCP), Sears, and Best Buy (NYSE:BBY) falling by the wayside in what has aptly been named the "Big Box Apocalypse," it's very reassuring to see Costco (NASDAQ:COST), the leading warehouse retailer in the U.S., thriving in the midst of all the retail industry snafu. Costco is still posting healthy gains even as the once mighty Wal-Mart  and Target  struggle to remain afloat. So what makes Costco tick?

Despite the prevailing weakness in the U.S. retail sector, Costco has recorded impressive sales growth in the last few quarters. The firm's comparable-store sales grew at an average pace of more than 5% for the last three quarters. The biggest drivers fueling this new growth include the company's rapidly swelling membership base and the robust growth of the warehouse industry in the country. Costco's core value proposition, strong private labels, and ancillary businesses have also been at the helm of this progress.

Core value proposition
Costco operates as a warehouse retailer. The company offers its products at prices considerably lower than those of many of its competitors. It does this by keeping its product markups low, at around 15%. In sharp contrast, many department stores and supermarkets mark up their merchandise by 25% or more. The big box retailer displays its goods in simple boxes and on shelves to keep its costs low.

Costco is commonly referred to as the ultimate "anti-Walmart" due to its unique limited brands strategy that involves offering just a few brands for each product it stocks. For instance, you might find just four toothpaste brands in a Costco store, but several dozen brands in a typical Wal-Mart store. The company keeps it its product line ever-fresh by regularly changing its brands. Customers can always expect to find something new and unique at its stores. This makes shopping at Costco feel like an exciting treasure hunt.

Private labels and ancillary businesses
Costco's private label brands are in the pink of health. Labels such as Kirkland Signature are wildly popular and account for a whopping 20% of the firm's revenue. This brand offers a wide range of goods and competes fiercely with well-established national brands since it offers comparable quality, but it is 10%-20% cheaper. Costco has been bolstering its share of private label brands by growing its overall product range at around 0.7% per annum. The company plans to continue growing the portfolio until it reaches 30% of overall revenue.

Costco has a robust line of ancillary businesses that contribute to its bottom line in a big way. These include photo centers, food courts, pharmacies, hearing aid centers, optical dispensing centers, car washes, gas stations, and print shops. Although ancillary businesses account for slightly less than 20% of Costco's revenue, they have grown admirably in the past five years with their growth rate outpacing Costco's core business growth. Five years ago, they accounted for 13.5% of the firm's revenues; that figure has now grown to 19%. An average Costco customer spends $255 per year at the firm's ancillary businesses. That figure has been growing at 10% per annum for the last few years.

In contrast, the firm's average customer spending on general merchandise has been growing at just 1% per annum, which implies that customers have kept the size of their shopping baskets at about the same level. Costco gas stations have also been instrumental in attracting new membership signups.

Healthy growth in membership base
Costco has been recording ringing success with new membership signups. The firm signed up 2.3 million new members in 2009 -- that figure had grown to 4 million in 2011. More than 1.6 million new members signed up in the first half of 2013. New membership signups increased by 9% in the fourth quarter. Mind you, all of this has been happening with a backdrop of a tough retail environment.

The membership renewal rate has also been steadily improving. From a renewal rate of 89.7% in the first quarter of 2013, the rate improved to 90% in the fourth quarter of the same year despite a 10% rise in the membership fee. U.S. customers certainly seem to have a strong affinity for Costco.

The firm's proportion of executive members has also been growing from 33% in 2009 to 38% in 2013. Executive members fork out a $110 membership fee which is twice the $55 fee paid by other members. In return, Costco awards these members with 2% annual rewards on their purchases, capped at $750 per year. Although executive members account for about one-third of Costco's customers, they contribute a good two-thirds of the company's revenue. Growth in this segment is therefore a very welcome development for Costco.

E-commerce growth
The U.S. online retail market outlook remains bright for the long-term, with Forrester predicting that online sales in the U.S. will grow from $262 billion in 2013 to $370 billion in 2017.

Costco has a strong online presence and it has been recording healthy growth backed by website replatforming and mobile apps. The firm's e-commerce revenue grew by 20% in the third quarter and 15% in the fourth quarter of 2013. To make sure that its online stores do not cannibalize its physical stores, Costco has managed to keep its online products 80%- 90% unique from its stores' inventory.

Retailing peers
Meanwhile, ailing retailer J.C. Penney seem to be coming back from the dead with its reinvigorated product lines. Although investors were spooked by the firm's recent lack of disclosure on its latest sales figures, and have punished its shares, J.C. Penney is still a good turnaround bet as I outlined in this article.

Best Buy's stock had climbed by close to 300% in 2013 after the firm posted impressive sales growth. The latest announcement by its management that revenue growth would slow down going forward, however, led to a huge sell-off of the shares, and the stock tanked a jaw-dropping 35%. Its investors felt that the firm's 0.9% domestic sales decline during the Christmas holidays proves that it cannot compete successfully against Amazon and Wal-Mart.

Best Buy's holiday sales were, however, not bad enough to justify that huge sell-off. Investors were just rushing to take their profits (the shares are still 59% up from a year ago), and long-term investors should ignore the unfortunate herding behavior and hold their shares.

The Foolish bottom line
Costco has been defying the bugaboo of the retail industry and growing admirably at a time when many of its peers are struggling. The firm's low product markups and cheap goods provide the magnet that has been drawing in new customers like moths attracted to a light. The current secular trend of widespread bargain hunting in U.S. retail stores will ensure that Costco remains a hot favorite with shoppers for many years to come.

Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. 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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