When it comes to the retail sector, the best companies often connect deeply with their frequent customers. Those stores that understand that and foster their customer relationships tend to have enduring businesses. Retailers that forget what made them great, meanwhile, sometimes end up destroying their businesses. For an example of that dichotomy playing out today, consider the differing strategies of Costco Wholesale (COST -0.39%) and Dollar Tree (DLTR -2.41%).
Costco knows what its customers want
Costco is a warehouse club chain, which means that its customers pay annual membership fees for the privilege of shopping in its stores. To be fair, that changes the equation a little bit on the retail side of things. In its fiscal 2023 (which ended Sept. 3), Costco generated $237.7 billion in revenue from its stores and nearly $4.6 billion from membership fees. But the cost associated with the selling of products and services at its stores was around $234 billion, meaning that the stores actually generated a gross profit of only around $3.5 billion, excluding the earnings from membership fees.
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Those membership fees, which have virtually no costs associated with them, made up more than half of the company's $8.1 billion in operating income. Costco's big goal, then, is to keep its customers so happy that they continue to renew their memberships each year. And one key to that is offering them the best prices it can. Chief Financial Officer Richard Galanti said as much last month during Costco's fiscal 2024 second-quarter conference call, noting, "We always want to be the first out there trying to lower prices."
Basically, the retailer is passing along savings from lower shipping and material costs as soon as it can. The purpose is to make sure its customers, who tend to be fairly affluent, feel like they are getting the best deals. That's why they renew their memberships year after year -- Costco's global renewal rate in fiscal 2023 was a huge 90%. That's an annuity-like business model that long-term investors could easily come to love.
Has Dollar Tree forgotten what made it great?
Dollar Tree has a very different business model. It largely caters to lower-income individuals who simply need to buy lower-cost products. Those products may, in some cases, be the same brands that others buy from a chain like Costco, but packaged in smaller sizes or with slightly different formulations. The key, however, is that it offers low prices.
That said, economic uncertainty has brought more higher-income customers into Dollar Tree's stores. In fact, during the company's full-year 2023 earnings conference call, management noted, "Continuing recent trends, Dollar Tree added 3.4 million new customers in 2023, mostly from households earning over $125,000 a year." That's not bad news, but there are potential long-term issues here.
A few years ago, Dollar Tree increased its base price point from $1 per item to $1.25. That was a huge increase, on a percentage basis. Since that shift, it has been adding higher-priced products, some selling for as high as $5 per item. Part of the logic is likely that its newer, wealthier customers can afford the higher prices and will expect better product offerings. That's fine, but the company's core audience remains lower-income customers who come to its store for ultra-low prices. Raising prices likely misses the mark with these customers.
This is where the problem comes in. When those well-off customers start feeling more comfortable about the economy and their personal finances again, they are likely to return to their previous shopping patterns and reduce their trips to Dollar Tree. Then, Dollar Tree will be left with its core customer group, which may not be inclined to buy higher-priced items from it. From a profit-margin standpoint, Dollar Tree is probably improving its assortment by adding in higher-priced items. But from a business perspective, its model change could end up destroying the very thing that made it successful in the first place -- a strategy of selling every item in the store for $1 or less.
Is the market calling this one right?
Over the past year, Costco's stock has risen by around 45%, while Dollar Tree's shares have dropped by around 5%. Given the business trends noted above, with Costco leaning into what made it great and Dollar Tree shifting its business model, that probably makes sense. If you are looking at the retail sector today, Costco, despite being afforded a premium price, could be a better choice over the long term than Dollar Tree, which Wall Street has placed on the sale rack, relatively speaking.
