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Costco's Long-Term Success Depends on This One Thing

By Neil Patel – Jun 18, 2020 at 10:54AM

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Why the warehouse club operator is not just in the retail business.

Investing in retail stocks can be a challenging endeavor. Margins are thin, competition is fierce, and any competitive advantage is difficult to maintain. Companies in this industry need some sort of differentiation in order to succeed for an extended period of time. This differentiation often manifests in delivering exceptional customer service.

Few retailers can sell truly unique products compared to competitors, but many can compete and win by focusing intensely on the customer experience. Costco (COST -4.26%), with its extremely loyal fan base, immediately comes to mind. 

Costco has fared well during the coronavirus pandemic. The stock is up 2% year to date, albeit with high volatility in March. Despite having negative comparable sales in April, the company finished its fiscal 2020 third quarter with comparable-sales growth of 4.8% year over year. After customers stocked up on essential goods to comply with shelter-in-place orders, sales softened in April before picking back up in May.

Woman shopping and walking with her cart in a warehouse.

Image source: Getty Images.

Membership means everything

The COVID-19 pandemic highlighted the importance of having a Costco membership. For as low as $60 per year, consumers have the ability to shop for thousands of products at attractive prices. While technically in the retail business, Costco generates most of its operating profit from these membership fees. In fiscal 2019, 71% of the company's operating profit was derived solely from membership dues with the remaining 29% coming from merchandise sales. On merchandise sales (which excludes membership fees) of $149 billion in 2019, the company generated operating margins of less than 1% after selling, general, and administrative expenses.

These razor-thin margins on actual products sold should come as no surprise, as the company's business strategy is to keep prices as low as possible for members. Costco flexes its massive bargaining power when purchasing from vendors and passes these savings on to customers. The objective is not to make money on retail sales but to drive membership growth.

Membership fee revenue showed no signs of slowing down during the past few months even as the COVID-19 crisis swept across the world. In the quarter ended May 10, 2020, membership fee revenue was up 5% year over year, consistent with the 6% growth logged in the first two quarters of fiscal 2020.

The success of Costco's membership model is easy to see. The psychological effect of having paid a $60 sunk cost incentivizes consumers to frequent the warehouse club chain more in order to recoup the annual fee. Couple this with a fantastic shopping experience, and it's obvious why they're eager to put Costco at the top of their favorite shopping locations.

E-commerce boost

In addition to sustained membership growth, the latest quarter saw e-commerce sales increase more than 64% over the prior-year period. This was lower than the numbers posted by competitors Walmart and Target during a similar time period. However, this might be because the large-sized and bulk goods that Costco sells are not quite as suited to an e-commerce setting. It also might be the first time that Costco has had to really focus on this channel. Nonetheless, the strong growth was broad-based with health and beauty, office, small electronics, and groceries in particular leading the way. As Costco continues investing in and building out its e-commerce capabilities to improve on delivery times and respond to volume increases, the company has proven that it can succeed in an online sales environment.

With the country slowly opening back up, consumers should once again return to their previous shopping patterns. This bodes well for Costco as the company has demonstrated that it can succeed in any economic environment. And with the popular food court back open (albeit with a limited menu), now might be the time to become both a member and a stockholder.

Neil Patel has no position in any of the stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$466.40 (-4.26%) $-20.77
Walmart Stock Quote
Walmart
WMT
$130.06 (-2.50%) $-3.33
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Target Corporation
TGT
$152.61 (-0.23%) $0.35

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