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How Buying This Stock In Bulk Could Pay Off In 20 Years

By Jamie Louko – Sep 9, 2021 at 8:00AM

Key Points

  • Costco lures in members with cheap goods and razor-thin margins -- and profits from those members' annual fees.
  • Customer satisfaction helps Costco steadily increase membership fees.
  • The warehouse giant shares the resulting wealth with investors through frequent dividends.

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Costco's focus on a few customer-oriented objectives has handsomely rewarded patient shareholders for decades.

Since 1983, warehouse retailer Costco (COST -1.85%) has sold consumer goods in bulk, giving its customers deals at a fraction of the price of competitors like Walmart (WMT -0.10%) -- a business model that has paid off for customers and shareholders alike. Costco's growing base of customers still value its low costs, and they are willing to pay a recurring membership to get these deals -- giving Costco and its shareholders a tremendous opportunity to benefit from those fees' consistent increases in the years to come.

Savings galore

Costco sells items in bulk to provide consumers with quality goods for the cheapest prices. But while this lets customers buy everything from socks to candy bars at a lower per-item cost, passing along these savings also gives Costco relatively low gross margins of 11.2%.  In contrast, Walmart's gross margin has hovered around 25% since early 2020. Even with membership fees counted in, Costco's gross margin only approaches 13%. The same slim margins that help Costco attract customers leave its business less resilient financially.

Grocery bag full of groceries including produce.

Image source: Getty Images.

To recoup those low margins, Costco has customers pay a yearly subscription fee -- $60 in the U.S., or $120 for Executive Membership (which gives customers an annual rebate equalling 2% of what they've spent). This is where Costco earns nearly all of its income. Its customers are amazingly loyal to the business, with 88% worldwide renewal rates.Membership revenue has grown more than 10% year over year to $901 million in the most recent quarter of 2021, despite the COVID pandemic.

Membership growth drove 45% year-over-year net income gains in the most recent quarter, to $1.2 billion, alongside trailing-12-month operating income of $6.9 billion. Since 2019, operating income as a percentage of revenue has hovered around an average of 3.3% of revenue, suggesting that rising revenue and expenses have roughly kept pace with each other. 

Continual pricing power

Costco has slowly increased subscription fees for many years,  most recently in 2017, with $5 and $10 respective hikes for each U.S. membership tier. Renewal rates now are even higher than they were in 2017 -- suggesting that once again, Costco could increase its prices soon. 

If the company were to increase its membership prices, almost all of the extra money would fall straight to its bottom line. If the company charged another $5 for each membership, or its equivalent for fees in other countries -- an 8% increase -- it could add roughly $300 million a year to the company's $3.75 billion in trailing 12-month membership revenue.

As it has in the past, Costco could pass some of this extra cash on to shareholders. Since 2015, Costco has nearly doubled its dividend, from $0.40 a quarter to $0.80. And that's not counting any of its periodic special dividends, which it most recently paid in late 2020. 

Dedicated management

 Craig Jelinek, the company's CEO, has a rating of 4.1 stars out of 5 on Glassdoor and 90% approval ratings. This is remarkably strong for a retailer, especially when compared to Walmart's CEO, Doug McMillon, who only has 66% approval and 3.3 stars. Before becoming CEO in 2012, Jelinek worked for Costco for 26 years at holding various positions. 

Jelinek and the rest of the management team have been methodical when opening new stores, making sure they only get the best real estate. The company has only opened 16 new or relocated locations worldwide since the start of 2021, and it plans to open only five more for the rest of the year. This tactic has proved to be working. Compared to Walmart, Costco closes relatively few stores. Currently, Walmart has 58 fewer stores now than it did at the end of the year, whereas Costco has not closed any.  

This growth, however, could end up being a double-edged sword, as Costco's deliberate store additions could give competitors a wider opportunity to establish themselves and grow their footprint faster than Costco.

Investors should watch Costco's membership growth, and how the company flexes its pricing power. If Costco can grow memberships while increasing what members pay for that privilege, the business and its shareholders could continue to prosper for many years.

Jamie Louko owns shares of Costco Wholesale. The Motley Fool owns shares of and recommends Costco Wholesale. The Motley Fool has a disclosure policy.

Stocks Mentioned

Costco Wholesale Stock Quote
Costco Wholesale
COST
$494.53 (-1.85%) $-9.33
Walmart Stock Quote
Walmart
WMT
$153.22 (-0.10%) $0.15
Target Stock Quote
Target
TGT
$164.16 (-0.53%) $0.87

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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