What Makes Costco So Appealing to Consumers?

You read about Costco’s superiority in the membership warehouse space, but do you know why it’s superior? It’s the same reason why so many savvy investors flock to Costco.

Jul 6, 2014 at 10:08AM
Costco

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It's not easy to find an uplifting retail story in the United States, but it's possible. Just look at Costco Wholesale (NASDAQ:COST).

In the company's third quarter, sales increased 7% year over year to $23.5 billion. If you exclude sales at stores opened within the past year, comps sales increased 4%. Costco also delivered on the bottom line. Profit increased 5.6% to $561 million.

There are many reasons to like Costco from an investment standpoint. Prior to investing, though, you're going to want to understand how Costco manages to deliver in this way without being an e-commerce leader.

How it works
Costco's warehouses are approximately three acres in size, and they sell over 3,000 items each. Food is the primary traffic driver, but in order to get to the food you have to pass brand-name merchandise that might pique your interest. Many of these brand-name items never leave their shipping pallets, which keeps overhead low for Costco. The company is able to deliver exceptional value on these high-quality items because it buys in bulk.

In order to further pique membership interest in merchandise, the brand-name merchandise is changed often. This way, you (the member) always have a new shopping experience that allows for a treasure-hunt-like atmosphere. Only one brand name can be found with absolute consistency, which is Kirklands. The Kirklands brand accounts for 20% of all Costco sales, and members want more and more of it thanks to its high quality at affordable prices. To give you an idea on value, Costco's average markup across the board ranges between 10% and 11%, depending on the quarter.

That's not the only reason that members are so pleased with Costco. For December 2013, GoBankingRates.com rated Costco as the No. 1 retailer for Best Return Policy. If you return an item, no questions will be asked, and the refund will be offered in cash or put back on your American Express card. 

Impressed yet? If not, then take a look at new member growth and membership renewal rates.

Getting on board and not jumping ship
Gold Star memberships increased to 30.6 million from 30.1 in the previous quarter. Business Memberships increased to 6.8 million from 6.7. Costco also averaged an increase of 26,000 new Executive Members per week throughout the third quarter.

In the third quarter, Gold Star Membership renewal rates also increased to 89.7% from 89.6% sequentially. Business Membership renewal rates increased to 94.4% from 94.3%. Worldwide membership renewal rates increased to 87.3% from 86.8%.

That's all good news, but it's still not the best news.

Crushing the competition 
Wal-Mart Stores'
(NYSE:WMT) Sam's Club is arguably Wal-Mart's weakest segment. It targets a lower-income consumer, which has been a negative due to a lack of wage growth and reduced government benefits. Sam's Club is clearly trying to do something about it. In its most recent conference call, the company stated that it wants to aim for more differentiation in order to bring parity to the warehouse club channel. In other words, it wants to catch up to Costco. Well ... that's not going to be easy.

On the same conference call, Wal-Mart stated that Sam's Club member ticket and traffic numbers have been soft. In order to change its image (slowly, so that it doesn't alienate its current members), it's aiming to enhance its private label offerings by offering more higher-quality items – like Costco.

Sam's Club has made its merchandise more unique over the past year, which it states has led to positive results. This might be the case for fresh food and on-trend activewear, but it still wasn't enough. In the first quarter, overall inventory grew 7.6% due to softer sales, especially because of buildups in Home and Health & Wellness.

Going forward, Sam's Club expects operating margin headwinds due to recent investments. When you look at the chart below, keep in mind that Sam's Club is only 12% of Wal-Mart's sales, but Sam's Club certainly isn't helping the company's overall operating profit. Costco, on the other hand, has seen continued growth for this key metric.

COST Operating Margin (Annual) Chart

COST Operating Margin (Annual) data by YCharts

While Wal-Mart's overall prospects are good thanks to new high-potential channels (e-commerce and small-box stores), Costco has also consistently been heading in the right direction for another key metric, return on invested capital:

COST Return on Invested Capital (Annual) Chart

COST Return on Invested Capital (Annual) data by YCharts

The bottom line
Costco is doing everything right. If you were really digging for a negative, it could be that it's behind in the omnichannel space, which could hurt the retailer's ability to attract Millennials down the road. However, some might argue that its omnichannel strategy matches its exclusive membership model. For now, Costco is making all the right moves. Whether you're looking to invest in quality or shop for bargains, Costco is a great place to hunt. 

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Dan Moskowitz 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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