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What Makes Costco Successful?

By Dan Moskowitz – Jan 18, 2014 at 9:00AM

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Costco has enjoyed stock appreciation of 76% over a three-year time frame. Future stock appreciation is likely. But what makes Costco successful? You need to know what you’re investing in before choosing this retailer over competitors Wal-Mart Stores and Target Corp.

Much of the reason for Costco Wholesale's (COST -0.15%) success is differentiation. A Gold Membership at Costco costs $55 per year. This might turn off some consumers, but it shouldn't. It's highly likely that the $55 investment will be made up by a wide margin thanks to consistent savings. This, in turn, is what makes Costco so appealing to consumers. And if a retailer is appealing to consumers, it's going to be appealing to investors. 

Target market
On top of the average membership costing $55 per year, Costco only accepts certain forms of payment, including cash, checks, debit cards, and American Express credit cards. Since many consumers need to rely on credit cards for spending on everyday items, and being that American Express has a predominantly high-end clientele, most Costco customers (or members) are well off financially. Therefore, many of these customers have more discretionary spending power than customers at the average discount retailer, which is a big positive for Costco.

Outperforming Target and Wal-Mart
Though not a membership retailer, Target (TGT -0.02%) also attracts a higher-end customer base than most discount retailers. This has a lot to do with Target locations and the appeal of the store ranging from cleanliness to orderly shelving. Unlike Costco, Target doesn't take a warehousing approach to its business. Costco relies on volume in order to pass along steep discounts to its customers. This is why Target has a higher profit margin of about 3.3% compared to Costco at 1.9%.

That said, there's nothing wrong with either business model. They're just different. What really matters is growth, and while Target has seen top-line growth of 13.6% over the past five years, Costco has blown that number away, growing at a 45.9% clip over the same time frame.

The one real edge for investing in Target is that it currently yields 2.7%, whereas Costco yields just 1.1%. However, if Costco continues to grow at the rate it's growing now, stock appreciation potential for Costco will greatly exceed that of Target's. And while it's becoming an overly redundant topic, also consider Target's data-breach situation, which could negatively impact Target's business and stock price short term.

Wal-Mart Stores (WMT 0.43%) also sports a higher profit margin than Target, at 3.6%. And it has outperformed Target on the top line over the past five years, seeing growth of 17.5%. However, that's still nothing compared to Costco. The advantage to investing in Wal-Mart is consistent and trustworthy capital returns to shareholders. Wal-Mart currently yields 2.4%, and it's always buying back shares. Costco might not offer as much in the form of capital returns to shareholders, but it's steady across the board and it offers more growth potential.

A unique approach
We have established that Costco is all about volume. But what makes this company's approach so intriguing is that it literally drops its shipping pallets on the warehouse floor, which customers than explore, determining what products interest them most. For the record, a shipping pallet is a flat structure with goods on it that is transported from one site to another. By avoiding the process of unloading and opening boxes, and then shelving, Costco cuts out huge unnecessary costs, and those savings can then be passed on to customers.

Many consumers don't know this, but Costco also carries designer brands. While Costco shouldn't be seen as a go-to retailer for designer brands, it should be seen as a place where you can sometimes find substantial discounts on high-end merchandise.

It should also be noted that approximately 20% of Costco's products are the private-label Kirkland brand. Aside from being available on Amazon.com, Kirkland is exclusive to Costco. I'm not a Costco member since there is no convenient location, but I do own a Kirkland t-shirt. It's thick, durable, and comfortable, and of higher quality than most (possibly all) t-shirts you will find at Target or Wal-Mart.

All exciting, but the real traffic driver for Costco is food. Of course, some consumers shop in other areas of the store before or after they shop for food.  And for the record, Costco sells an average of 109 million hot dog/soda combinations per year. For $1.50 total, who wouldn't take advantage of that deal while shopping?

The bottom line
Costco's business model works well in today's economic environment. Not only does it target the value-conscious consumer, but this value-conscious consumer also brings spending power to the table. Barring any economic calamities, Costco should continue to outperform Target and Wal-Mart, both on Main Street and Wall Street. 

Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Walmart Inc. Stock Quote
Walmart Inc.
WMT
$153.07 (0.43%) $0.65
Target Stock Quote
Target
TGT
$163.38 (-0.02%) $0.03
Costco Wholesale Stock Quote
Costco Wholesale
COST
$533.66 (-0.15%) $0.83

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