When legendary investor Warren Buffett looks for stocks to own, he emphasizes businesses that possess some sort of competitive advantage. This key characteristic is important for long-term investors because it signifies a company does things better than its rivals, resulting in improved financials, faster growth, and hopefully a rising stock price.
Taking a look at Costco (COST -0.24%), we'll see a successful business that has gotten even stronger over time. The operator of warehouse clubs has one critical advantage that has allowed it to thrive throughout its history: its scale.
Let's take a closer look at what makes this company so special.
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Costco is a massive business
For the second quarter of fiscal 2022 (ended Feb. 13), Costco posted net revenue of $50.9 billion. This is a gargantuan amount, and it makes the business, which today has 829 warehouses worldwide, the third-largest retailer in the world. Costco's sheer scale is why it has been such an outstanding investment.
Because a Costco location carries fewer than 4,000 stock-keeping units (SKUs) -- compared to tens of thousands at typical general retailers -- it is able to place bigger orders with its vendors. This bargaining power results in favorable inventory costs. A smaller retailer that sells toilet paper, for example, would pay more to its supplier on a per-unit basis than Costco does. This is a huge advantage.
"Costco is able to offer lower prices and better values by eliminating virtually all the frills and costs historically associated with conventional wholesalers and retailers, including salespeople, fancy buildings, delivery, billing, and accounts receivable," said CEO Craig Jelinek. "We run a tight operation with extremely low overhead, which enables us to pass dramatic savings to our members."
In summary, higher revenue translates to greater buying power with suppliers. And these savings attract more members, which ultimately results in higher sales. This virtuous cycle is unstoppable, and it's what makes Costco a one-of-a-kind business.
Focusing on the customer
Amazon founder Jeff Bezos built his company with a focus on customer obsession. I think Costco operates with the same playbook. The mentality is to always be trying to find ways to add more value.
As of Feb. 13, Costco counted 114.8 million memberships. In the U.S. and Canada, the renewal rate of 92% last fiscal quarter is excellent. This underscores the unquestionable value that consumers see in being a Costco shopper. Especially throughout the past couple years, having a membership during the pandemic has been a no-brainer, as people could purchase all of their necessities, like cleaning products and groceries, in one stop.
The company offers up a treasure-hunt atmosphere, where shoppers can find rare, unique deals on items that encourages visiting frequently, walking the entire store, and purchasing urgency. Costco is also known for its superb customer service, helping to drive more revenue.
Costco's relentless focus on the customer is clear by the fact that the average markup on merchandise is just 11%, far lower than 24% at Walmart and 35% at Home Depot. Because most of the profit comes from membership fees, which totaled $4 billion over the trailing 12 months, the business is able to keep a lid on prices. Again, it all goes back to Costco's colossal size.
This scenario has resulted in an unmatched customer value proposition. And when shoppers form habits around a business and what it offers, it's hard for that momentum to stop. Costco's massive scale has allowed the company to take care of its employees, customers, and shareholders. This powerful situation is why the stock has climbed 500% over the past decade.
While I think Costco shares are currently on the expensive side, with a price-to-earnings ratio of 40, it still remains one of the most outstanding businesses out there. Investors should keep the stock on their watch lists for now.
