For decades, Costco Wholesale (COST 0.75%) has used its unique warehouse business model to garner steady, consistent success. Now, despite the current inflationary climate, this trendy big-box retailer has an arsenal of effective weapons to maintain its momentum.

How Costco keeps customers coming back

Costco built its business on buying in bulk, using its massive size and purchasing power to get cheaper prices from suppliers and passing the savings on to customers. To save money, it limits the number of items it carries. That approach turns shopping at Costco into a serendipitous scavenger hunt, with buy-now-before-it's-gone quantities of luxury offerings to lure in high-income customers and encourage them to spend generously. 

Meanwhile, fewer, simpler choices leave customers less stressed when deciding what to buy. Those reduced options include its high-quality, low-cost Kirkland Signature private-label brand, which accounts for more than 30% of Costco's sales. 

A shopper pushes a cart through a warehouse store.

Image source: Getty Images.

Keeping customers happy drives Costco's success. While most retailers make money by selling vast quantities of goods at tiny profit margins, the annual fees that members pay to shop at Costco supply 79% of its operating profits. In essence, Costco sells memberships, not goods; the difference between what it pays to buy products and what it charges customers when selling them rarely tops 15%. So far, that approach has worked well: More than 90% of U.S. customers renewed their memberships as of the end of 2021. And the company's setup looks well-situated to keep Costco afloat even as inflation surges for the first time in decades.

Adding lucrative millennials to refresh and expand its consumer base

Cheap prices and steep savings become even more appealing when inflation rises. Most of Costco's members are middle-aged or older; they've lived through inflation before, so they appreciate the value Costco offers more than ever. But as those shoppers age, Costco will need to replace them with younger customers.

Luckily, Costco has a few built-in advantages that appeal to millennial shoppers. Inflation is new in their adult lives and will likely prompt even more frugal shopping habits. These cash-strapped yet eager shoppers are typically more concerned with where their food is sourced and whether their clothing is sustainably produced, so Costco's lower prices for high-end staples, such as organic fruit and vegetables, electronics, and wine might particularly appeal to them. And millennials' lack of loyalty to national brands, which helps drive private-label sales growth – more good news for Costco and Kirkland Signature. 

If Costco can lock in their loyalty now, it can hang onto millennials as they start families, buy houses, and obtain more space for a "Costco closet" full of regularly restocked bulk goods. Just as Costco made sure that it provided the right goods for the ultimate quarantine, it is now making sure to fill its shelves for the growing proportion of new Gen X and Millennial homebuyers. "We're getting a good share of younger people," CFO Richard Galanti stated in the company's March 3 earnings call, emphasizing year-over-year e-commerce sales increases in patio, garden and home furnishings.

Finding opportunity online

Currently, the bulk of Costco's business comes from in-person, in-warehouse sales. Net sales for e-commerce, which represented approximately 7% of total net sales in 2021, increased an impressive 17.8% percent from the prior-year end period, compared to a 15.9% percent increase in U.S warehouse sales. The company's put great effort into getting warehouse and Instacart inventory online. And last year, Costco launched Costco Next, an online buying program that features products from its most trusted suppliers. 

The company should be able to continue increasing its online sales by appealing to those who prefer the online shopping experience, lest those shoppers turn to new or established competitors with better online offerings.

Why inflation could still deflate Costco

Inflation still poses some challenges for the company. Costco will not be completely immune to the rising prices in all categories of goods. But despite that headwind and other global challenges to retail, Costco continues to work with its suppliers "to explore methods to control costs and avoid or minimize price increases when possible," according to Craig Jelinek, President and CEO, in the most recent earnings call. 

As CFO Galanti put it on the same call, "Despite these inflationary pressures, we've tried to hold where we can." Though the company can't do that in every case, "we've worked with our suppliers to eat a little of it, and we eat a little of it," he said. 

A membership fee increase is looming – though in the past, this has not dented Costco's renewal rates. Chances are that consumers will still be determined to seek value at the popular warehouse.

Costco's business model seems thus far to have evolved alongside increasing competition online and in-store, and demand for value across generations. Its approach has prepared it for changing market demographics as well as inflations, but it's continuing to adjust its offerings and maintain pricing even in the face of worldwide financial and supply chain disruptions. Retail stock investors should keep an eye on how those improvements continue, and see how far the company stretches its negotiations with suppliers in order to keep the lower-priced, big-value items in stock.