Is This Costco's Biggest Competitive Advantage?

There's no doubt that one of Costco Wholesale's (COST -0.12%) defining traits is its super-successful membership model. Customers must pay $60 a year (for the basic Gold Star plan) to be able to shop at one of the company's 847 warehouses. In the quarter that ended November 20, the membership renewal rate in the U.S. and Canada was a superb 92.5%. 

Paying a yearly fee certainly creates high switching costs for customers, who will prefer to shop at a Costco because of the sunk cost of the membership. By helping to drive repeat visits, it provides an important benefit to the company. 

But I think Costco's biggest competitive edge is something entirely different. Let's take a closer look at what exactly this is. 

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In my opinion, the most important competitive advantage that Costco has comes from its massive scale. In fiscal 2022, the business generated net revenue of $223 billion, making it the third-largest retailer in the world. That's hard to wrap your head around. The only retailers bigger than Costco are, unsurprisingly, Walmart and Amazon. 

Being so massive allows Costco to leverage its buying power over its suppliers to lower the prices it pays on merchandise. The average Costco warehouse is about 146,000 square feet in size, and it carries 4,000 different stock-keeping units (SKUs). The typical Walmart Supercenter, on the other hand, is 187,000 square feet in size, with 142,000 various SKUs. This means that by focusing on a select number of items, Costco is probably the single largest customer for all of its suppliers. 

To avoid losing Costco as a key customer and distribution partner, these suppliers will usually offer very favorable terms. The result is lower costs for Costco, and these savings are then immediately shared with its members. In fact, the average product markup is around 11%, so customers know they are getting the best deal around, something that increases loyalty. 

As Costco is able to grow its membership base, which stands at 66.9 million households, this leads to higher revenue for the business. And with higher revenue, Costco can purchase even larger quantities from suppliers, once again passing savings on to customers. It's a virtuous cycle. 

A fitting description of Costco's competitive advantage is something called "scale economies shared." This term was popularized by Nick Sleep, who ran a successful investment fund, called Nomad Investment Partnership, that crushed the stock market for 13 years. 

Simply put, Costco's business model is centered on sharing its size advantages with its most important stakeholder, the customer. 

A durable business 

Costco is the perfect example of a boring, but beautiful, business. Compared to high-flying tech companies that are always on the cutting edge of innovation by introducing new products or services, at a high level, Costco is just a general merchandiser that sells quality items at the lowest prices around. 

From an investment perspective, this is an incredibly favorable situation. That's because Costco doesn't invite much in the way of technological disruption. The industry is mature, so it isn't constantly changing. And customers will always want a wide selection, low prices, and a great experience. Why would anyone try to compete with Costco's dominance? 

This gives the company a critical characteristic for successful investing -- durability. There's probably a very high likelihood that Costco will be doing the same thing 50 years from now that it's doing today. While it's impossible to forecast what the world will look like that far ahead, predicting what Costco's operations will be seems like an easier task. 

The durability of this business model could make up for the stock's high valuation. As of Jan. 20, Costco's shares traded at a price-to-earnings (P/E) ratio of 36. While this is down significantly from a P/E of nearly 50 a year ago, it's still meaningfully higher than Costco's trailing 10-year valuation. Based on the company's long and successful operating history, it's probably not that big a surprise that the stock is usually on the expensive side. 

Nonetheless, given the state of the economy right now -- one where uncertainty is sky-high -- paying a premium for such an outstanding business with a huge competitive advantage might be something you're comfortable doing.