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Here's Why Costco Could (and Should) Raise Its Membership Fees

By Daniel B. Kline - Apr 30, 2016 at 8:45AM

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The company is not really a retailer since it makes its money from being a club.

Costco makes 75% of its profits from membership sales. 

Costco (COST -0.72%) does not operate the way a traditional retailer does. Instead of making money by marking up goods, the warehouse club essentially breaks even on sales while making a profit from its membership fees.

Even though the company had nearly $54.2 billion in retail sales for the 24 weeks ending Feb. 14, 2016, its entire net income was only about $1.6 billion pre-tax. Given that the company had just under $1.2 billion in membership fees for that period, subscriptions accounted for about 75% of Costco's total earnings.

That's in line with a June 2015 analysis of the warehouse club done by fellow Fool Demitrios Kalogeropoulos. He looked at 2014 numbers and found the membership revenue totaled $2.4 billion that year, up 6% from 2013. Given that the company had $3.2 billion in operating profit in 2014, subscriber fees hit the same roughly 75% ratio.

That's why, he wrote, it's better for investors to think of "Costco as a membership club rather than a retailer." This isn't Wal-Mart (WMT -0.91%), where more sales equal larger profits. It's a membership play, where the goal of the merchandise is to make it worth people's while to stay members. Because of that, it can be both lucrative and risky when the chain raises its membership prices, which a number of news reports suggest it's considering doing.

What is the company considering
While the numbers being bandied about are relatively small, Costco's customers make a conscious decision to join or not join each year. If Wal-Mart, for example, raises prices on a few consumer staples or commonly purchased items in order to make $10-per-year, per-customer more, people are not likely to notice. A Costco increase, however, comes in one fell swoop, and it could turn people away (which, conversely, could push them to a low-cost rival like Wal-Mart).

In this case, UBS analyst Michael Lasser has predicted the company will increase its membership prices in 2017, CNN Money reported.

"The conditions are in place for Costco to bump up its membership fee early next year," he wrote in mid-April. The analyst expects the chain will increase the price of a basic Gold Star membership from $55 to $60 while raising its Executive Membership price from $110 to $120.

Doing this would have a measurable impact on the company's profit, but as mentioned above, it does come with some risk.

This is a smart play
Given that it's still early 2016, Costco could likely get its customers to accept these increases if it announces them soon, but doesn't put them into effect until 2017. Perhaps the company could also allow existing members the opportunity to renew before the year ends at the old prices.

It seems like advance notice of a relatively minor price increase is not likely to lead to an exodus of members. Netflix did something very similar with its recent price increase, giving existing users a long time to get used to it while implementing the change for new customers sooner. Streaming and retail are different spaces, but consumers like a little warning and have generally been willing to pay small increases for products they like.

Costco should inch its membership prices up every few years, if not annually. This seems like a very mild change that should be accepted by most customers, perhaps with the exception of those who were considering dropping their membership anyway, without much complaint. It seems highly unlikely that $5 or $10 a year would send a loyal Costco customer to Wal-Mart or another discount retailer.

This, assuming it happens, is a smart play by the company that will pay off in padding its profits.

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