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There’s More Than Meets the Eye to Costco

By Daniel B. Kline - Dec 3, 2017 at 10:32AM

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The company does not operate like a traditional retailer.

Investors seem to panic about Costco (COST 1.35%) every time another retailer adjusts its digital strategy. Whether it's Amazon or Wal-Mart (WMT 0.86%), each time a move gets made, shares in the warehouse club take a dip. This happens because many analysts believe that even successful retailers will eventually succumb to the so-called "retail apocalypse."

It's easy to see why investors and analysts would feel that way. Most department store chains have struggled, and even giants including Wal-Mart have had to make major changes to fight off Amazon and other digital rivals.

The reality, however, is that Costco isn't a typical retailer. It's a membership club that keeps its members on board as much through the promise of savings as through actually saving people money.

The exterior of a Costco store

Costco makes most of its money selling memberships. Image source: Getty Images.

How does Costco work?

Members pay either $60 a year for a Gold Star membership or $120 annually for an Executive membership, which offers 2% cash back up to $1,000. In exchange for paying the price of admission, Costco members get access to its warehouse and website. And in both the physical and digital worlds the warehouse club offers low prices -- it makes about 75% of its profit from membership fees, not from what it sells.

Because of its model, Costco's chief task is not to get its customers to shop. It's getting them to understand the money they could be saving in order to get them to keep renewing their memberships year after year.

In many ways, Costco's business works like many lower-cost gyms. The chain signs people up with the idea that if they shop there, then they will save money -- similar to how if you actually work out at the gym, you will get in better shape.

That creates two ways to keep customers on board, and both have worked for Costco. Executive members, who have more incentive to shop at the chain, account for about two-thirds of its sales despite comprising around 38% of its total membership.

The second group, the Gold Star members, may not shop as much, but they visit enough to see the savings they could be getting. Because of that, they renew their memberships each year, probably promising themselves that they will take more advantage of it in the future.

Does it work?

Costco has seen its membership renewal rates hover at just under 90%. That remained true even after the company raised the price of a Gold Star membership by $5 and an Executive membership by $10 in June.

"In terms of renewal rates, at year end, business members renewed at 94%, Gold Star members at 89.3%," said CFO Richard Galanti during the chain's Q4 earnings call. "These are numbers for the U.S. and Canada combined, which is over 80% of our company"

Total renewals for the U.S. and Canada came in at 90%, while the global total was 87.2%, "a slight tick down of a tenth or two from the last quarter," according to the CFO.

Costco is not a traditional retailer

While many department stores chains have suffered as more business has moved online, Costco has not. Its strength lies in both what it actually sells its members and the promise of what people could buy.

Unless something happens to cause the chain's members to stop renewing, Costco has a solid business model. It's a different model than that of most retailers, but it's one that has proven to be strongly resistant (if not immune) to the changes impacting much of the retail world.

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Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
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