Costco: The Opposite of Wal-Mart

Costco.com

If Wal-Mart Stores (WMT -1.75%) is oil, then Costco Wholesale (COST 1.01%) is water. They're both retailers, but their approaches to generating revenue and profit differ greatly. 

Wal-Mart's approach of offering a broad array of merchandise and food at everyday low prices is simple. With Warren Buffett recently adding to his position, and Wal-Mart's small-box stores performing well, there are reasons to be optimistic. But what about Costco? Is the company's business plan sustainable in an ever-changing consumer environment? 

The Costco approach
The best way to understand Costco is to eliminate the thought that it's a store and realize that it's a warehouse. This plays a key role in the company's ability to keep costs low. For example, while you will see some sections (i.e. grocery and clothing) sorted and manged by employees, most other sections don't require management/shelving. Items come in on their shipping pallets and remain there for member browsing. Costco's goal is to drive customers to its warehouses by offering value. And by offering value, Costco must rely on volume and an effective product mix.

Costco also relies heavily on membership fees for profitability. In the third quarter, membership fees grew at a 6% clip. Membership signups at new warehouses played a role, but Costco also managed to increase penetration of its Executive Membership, which comes at an annual cost of $110. In the past, customers would receive 2% rewards on purchases up to $500 per year. Now customers receive 2% rewards on purchases up to $750 per year. This likely played a role in the increased membership fees.

Thanks to those increased membership fees, which leads to increased profitability, Costco is even more capable of passing on value on selected merchandise for members. Wal-Mart's Sam's Club has a similar business plan.

Sam's Club 

Sam's Savings and Sam's Business membership fees are $45, which is $10 less than Gold and Business membership fees at Costco. Sam's Plus also costs $100, which is $10 less than the $110 fee for the Executive membership at Costco. For Sam's Plus, members earn $10 for every $500 in qualifying Sam's Club purchases, up to $500 annually.

By charging membership fees and acting as a buying agent to eliminate unnecessary costs for for its members, Sam's Club is also able to pass along savings to its members. However, with 649 warehouses around the world and consistent comps growth, Costco remains the membership warehouse leader. 

Offering value = comps growth
If Costco continues to offer value to its customers, then it should drive comps growth, and Costco puts comps growth above all other factors in regard to measuring success. If comps sales are increasing, then it presents an opportunity for Costco to leverage selling, general, and administrative expenses. Reducing these expenses also leads to improved profitability.

However, unlike Wal-Mart, Costco will never lower pay or reduce headcount to make up for increased costs. Costco firmly believes in enhancing employee satisfaction and above-average industry compensation. Costco believes this leads to increased production. The one negative here is that this can impact net income. Fortunately, Costco has a strong history of driving comps growth by selling quality merchandise at the right prices. 

Comps performance
Costco measures comps as sales at stores open for at least one year. Below is Costco's comps performance in the third quarter on a year-over-year basis:

Source: Costco 10-Q

Comps are seen as the most important metric in retail. Therefore, if you're considering an investment in Costco, then you might want to consider ignoring the current Wall Street noise and focusing on these numbers.

Furthermore, Costco won't hesitate to lower prices if it needs more traffic to drive sales. This could negatively impact the gross margin, but Costco has consistently delivered on the bottom line over the past five years. Top-line performance is also included in the chart below. If the chart looks confusing to you at first glance, this might make it easier: those top two lines belong to Costco, not Wal-Mart:

Wal-Mart revenue (trailing-12 months) data by YCharts

This isn't to say Wal-Mart is a bad investment. In fact, it's likely to perform well going forward thanks to the advent of its small-box stores. But it's going to take time. Costco is already where it needs to be. If you fear that Costco doesn't have as much growth potential as in the past, then you should be aware that Costco has seen a higher rate of square footage sales growth in foreign markets, and according to its 10-Q filing, it expects that trend to continue.

Also consider memberships. Total paid cardholders have moved up to 40.9 million versus 38.3 million in 2013. When members pay their $55 or $110 annual fee, they have more incentive to shop at Costco. Why shop at Wal-Mart or another big-box retailer when you already paid for a membership at Costco and you're receiving discounts? That said, Sam's Club is a viable option. 

The Foolish bottom line
As far as Wal-Mart is concerned, it might be a mature company, but it has found a new high-potential growth avenue. It's often underrated by investors. In regard to Costco, the company should remain a quality investment for years to come.