How Will Costco Expand Its Members’ Shopping Baskets?

Costco is looking into other ways of growing its revenue other than relying on its membership fees. This will give the giant retailer long-term and sustainable means to grow both its top and bottom-lines for many years to come.

Feb 22, 2014 at 10:00AM

Costco (NASDAQ:COST) has been basking in the limelight after President Obama recently made a public endorsement of its high-wage business model. The President panned the company as a "corporate exemplar" that other big box retailers such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) should borrow a leaf from. Costco pays its average worker $20.89. In sharp contrast, Wal-Mart pays its workers $12.67, or $8.89 when you include part-time workers. Meanwhile, the average Target employee takes home just $8.37 for every hour worked.

Aside from the ivory-tower jousting and demagoguery between right and left-wing economists regarding which business should pay its employees what, there are good reasons why Costco can afford to pay those kinds of wages. The leading warehouse retailer not only runs very profitable operations, but also employs only half as many employees per square retail foot as compared to other big-box retailers (which obviously helps it to cut its costs.) The firm also runs a very lucrative membership program, requiring shoppers to pay $55 per year for regular members (and $110 for executive members) for them to shop in its stores.

Costco relying too heavily on membership fees
Costco has about 72 million members, with a third of those being executive members. The giant retailer generated $2.29 billion in membership fees in fiscal 2013. Costco earned about $2.04 billion on sales of $102.87 billion in fiscal 2013. That gives you a good idea of just how much the firm relies on its membership fees to boost its bottom line.

What's even more worrying is that Costco's average sale per member has been growing at just 3% per annum. That's much slower compared to the robust same-store sales growth of 8%, or 9% growth in its membership base. It would therefore appear that Costco is primarily relying on membership growth to expand its top line.

Costco's management has been trying to get around this sticky problem by trying out new strategies and ensuring that the firm has good long-term and sustainable growth runways. Top among these is growing its average sale per customer. Here is how Costco will grow this metric:

Boosting its private labels
Costco's Kirkland Signature is its leading private label and currently accounts for 23% of the firm's overall sales. Costco says that its private labels offer comparable quality to national brands, albeit at cheaper prices. The firm intends to increase the percentage of private label sales to around 30%. This will also ramp up its margins considerably, since private labels on average sport better gross margins than their national brethren, by as much as 400 to 500 basis points.

Online sales growth
Costco saw its online sales increase by 24% in the first-quarter of 2013, which was a considerable improvement over last year's fourth-quarter and third-quarter growth which came in at 20% and 15%, respectively.

Online sales make up just 2.5% of Costco's overall sales, which implies that it can sustain the strong momentum in the coming quarters. The firm has been undertaking a rigorous website replatforming of its e-commerce site, launch of various new mobile apps, increased product categories, and strong inventory management. The firm is moving its e-commerce operations to more foreign markets. Costco has an online presence in the U.S., Mexico, U.K., and Canada.

To keep its online stores from cannibalizing its physical ones, Costco has a policy of ensuring its online products are 80%- 90% unique from those in its physical stores.

More private members
Costco's executive members, as a percentage of overall members, have been steadily growing. Executive members accounted for 33% of overall membership back in 2009; now they account for 38%. In the first quarter of fiscal 2014, Costco's overall membership grew 1%, while its executive members increased by 1.4% after more than 250,000 new executive members joined its ranks.

Executive members are extremely lucrative for Costco. They not only pay twice as much membership fee as regular members, but also spend almost four times as much. You can deduce this from Costco's latest earnings call where it says that executive members account for two-thirds of its revenue (despite making up just over a third of total members.) More executive members not only mean higher membership fee revenue, but much higher sales too.

Peers in comparison
Wal-Mart has, of late, been at the receiving end of a lot of flak for paying its employees so poorly, who at one time even took to the streets demanding better pay. Target's long-suffering employees have been a bit more persevering and have yet to vent their frustrations publicly.

Both Wal-Mart and Target primarily use everyday low prices to attract customers to their stores. Wal-Mart relies on the strategy to attract low and middle-income customers, while Target sets its sights on middle and high-income buyers searching for bargains. However, Costco manages to beat them in this game primarily because of its membership fee that quite naturally appeals more to higher-end customers. Costco stores are also mainly located in higher income neighborhoods than either Wal-Mart or Target.

Wal-Mart sports a low operating margin of 3.6% while Target's operating margin comes in at 3.3%. It would, therefore, be quite difficult for these giant retailers to significantly increase their employees' wages without either sacrificing their already low profit margins, or hiking their prices. Price hikes for both companies would be very detrimental to their businesses since it would most likely result in lower store traffic.

Foolish takeaway
Costco's not relying solely on its lucrative membership fees for its growth. It has also been ramping up its online business, focusing on private labels, and driving higher growth in its executive members. The firm has successfully defied the threat of many big retailers and continued to grow even as its peers struggle. The retailer is a great long-term investment.

Lon-term investors know the value of buying into great businesses and holding over the long haul. The retail industry has been littered with such great businesses that generated monstrous returns for their shareholders. Wal-Mart, the long crowned king of retail, was one of those very businesses. But times are definitely changing and Wal-Mart now finds itself treading water in a sea of fierce competition. To learn more about two companies with the potential to plunge the massive retailer into the abyss, 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.

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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