How Costco Has Maintained A Steady Growth Rate In The U.S.

Costco (NASDAQ:COST) is the leading warehouse retailer in the U.S. earning close to 70% of its revenues from the region. The company’s U.S. business has been growing at a steady pace for the past several quarters despite the prevailing weakness in the retail industry. Over the past three quarters, its comparable store sales increased by more than 5% on average. On the other hand, retailers such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have struggled to match their previous year’s levels.

In this analysis, we’ll look at some of the factors that are helping Costco’s growth. The main driver is the increasing membership base which has been influenced by a number of factors such as rapid growth of the warehouse industry in the U.S., Costco’s core value proposition, ancillary businesses and strong private label brands. Additionally, its e-commerce strategy and anticipated growth in the online retail market brighten its future outlook.

Our price estimate for Costco stands at $125, implying a premium of 5% to the market price.

See our complete analysis for Costco

Warehouse Industry Growth

A warehouse retailer charges an annual membership fee to its customers and provides a wide variety of merchandise at discounted prices. The U.S. warehouse club industry comprises of three main players – Costco, Wal-Mart’s Sam’s Club and BJ’s Wholesale Club – with Costco being the strongest of the lot. Some consumer reports suggest that buyers can save up to 55% while shopping at warehouse clubs. ^[1] Due to these bargains, the warehouse club industry sales have grown at a higher rate than general merchandise store sales over the last decade. Costco’s annual comparable store sales growth has averaged around 6% for the past three years, thanks to new membership signups. ^[2] We do not expect any significant slowdown in the industry growth in the future as pricing benefit is something that buyers will always welcome as long as they are offered good quality products.

Costco’s Core Value Proposition

As a warehouse retailer, Costco offers products at lower prices than its competitors. It does so by keeping the product markups low at 15% while most supermarkets and department stores markup their goods by more than 25%. ^{[3] [4]} The retailer displays its products in simple boxes and shelves on concrete floors to keep the costs to minimum. Also, it changes the brands it offers regularly, and therefore, customers always find something new at its stores and get a ‘treasure hunt’ experience. To add more appeal, the retailer offers high-end products such as Coach (NYSE:COH) purses and Dom Perignon champagne from time-to-time. ^[5] Costco is also focused on serving its customers based on the local tastes and demand. It grants its local store managers some discretion over the products that are kept in stores. For instance, demand for salsa is highest in the Southwest region as compared to other U.S. markets. ^[6]

Ancillary Businesses & Private Label Brands

Costco’s ancillary business or in-store services include its food courts, photo centers, pharmacies, optical dispensing centers, gas stations, hearing aid centers, print shops and car washes. Although the ancillary business accounts for less than 20% of Costco’s revenues, it has grown at a faster rate than its core business. Its revenue share has increased from 13.5% to 19% over the last five years, and we expect this trend to continue. This growth can be attributed to the fact that Costco’s members are increasingly using its ancillary services. An average Costco member spends about $255 on ancillary services annually, and the figure has risen by about 10% every year over the past few years. ^[7] On the other hand, the average spending by a Costco member on general merchandise has increased by just 1% annually. This clearly implies that while the customers have kept their shopping basket size more or less the same, they haven’t been hesitant in spending more on Costco’s low-priced ancillary services. Costco’s gas stations have also played a valuable part in influencing new membership signups. Last year, the company launched a pharmacy benefit program called Costco Health Solutions, that provides discounted prescription medicines to the employees to small and medium-sized businesses. ^[8] The idea behind the program is to make these employees familiar with the cost benefits of shopping at Costco and attract them to become its members.

A key selling point of Costco is its private label brands such as Kirkland Signature. According to the company, these brands are comparable in quality to national brands and are often cheaper. The company launched Kirkland Signature in 1995, and currently it accounts for about 20% of total revenues. ^[9] The brand offers a wide range of products, competes with well established national brands and is approximately 10%-20% cheaper than them. ^[9] Costco has been increasing the share of its private label brands within its overall product range by 0.5%-0.75% annually and plans to push to figure to 30%+ range. ^{[10] [11]}

These Factors Lead To Growth In Membership Base

Costco has seen a noticeable increase in the number of new members over the last few years. While the retailer added 2.3 million members in 2009, more than 4 million customers signed up in 2011. ^[7] Over 1.6 million new members joined Costco during the first two quarters of fiscal 2013, and it saw almost 20% growth in new signups in the third quarter as compared to the previous year. ^[12] During Q4, new membership signups at Costco increased by a healthy 9%, when the overall retail market in the U.S. was going through a rough phase. ^[13]

Even the membership renewal rates are on the move and customers are visiting Costco more frequently. From 89.7%  in Q1 fiscal 2013, the renewal rate in North America improved to 90% in the fourth quarter. ^[13] The improving renewal rate despite a 10% rise in membership fee (November 2011) indicates strong customer affinity towards Costco. Interestingly, the proportion of executive members in the overall membership base has been rising historically. Back in 2009, they accounted for 33% of Costco’s total members and the figure increased to 38% in fiscal 2013. Even in Q2 fiscal 2013, while the total number of members increased by 1%, executive members grew by 1.4%. In Q4, more than 250,000 customers joined the warehouse retailer as executive members. These members pay $110 as membership fee (as opposed to $55 paid by the other members) to get 2% (maximum of $750) annual rewards on their purchases. They represent one-third of Costco’s overall customers and two-third of its revenues. With their growing proportion, Costco will be able to generate higher membership fee and revenues.

E-Commerce Channel Holds Promise For Long-Term Growth

The online retail market in the U.S. has grown rapidly since 2004 and the long term outlook remains optimistic. Forrester forecasts that online sales in the U.S. will grow 13% to $262 billion in 2013 and reach $370 billion by 2017. ^[14] This presents a huge growth opportunity for Costco’s online sales, and it has been going with the trend. The retailer’s e-commerce revenues increased by 20% and 15% in Q3 and Q4 respectively, backed by its e-commerce strategy, website re-platforming and mobile apps. Costco’s main strategy for its online business is to offer distinct products on the e-commerce site to keep its customers interested. About 80%-90% of its products offered online do not overlap with the stores inventory, which enables to retailer to prevent some cannibalization of its store sales. ^[15] Moreover, online sales account for just 2% of Costco’s net sales indicating that there is a huge room for growth. ^[13]

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Best Warehouse Store: BJ’s, Costco or Sam’s Club?, Yahoo Finance, Jan 6 2013 [↩]
2. Costco’s SEC filings [↩]
3. Costco’s Unorthodox Strategy To survive The Big Box Apocalypse, Business Insider, Mar 7 2013 [↩]
4. How Costco Became The Anti-Wal-Mart, The New York Times, July 17 2005 [↩]
5. Costco’s Unorthodox Strategy To survive The Big Box Apocalypse, Business Insider, Mar 7 2013 [↩]
6. Why Costco And Other Warehouse Club Retailers Matter, L.E.K Consulting [↩]
7. Costco’s SEC filings [↩] [↩]
8. Costco Launches Pharmacy-Benefit Manager Program, Wall Street Journal, Jan 18 2013 [↩]
9. Why Costco And Other Warehouse Club Retailers Matter, L.E.K Consulting [↩] [↩]
10. Costco’s Q1 fiscal 2013 earnings transcript, Dec 12 2012 [↩]
11. Costco’s Q2 fiscal 2013 earnings transcript, Mar 12 2013 [↩]
12. Costco’s Q3 fiscal 2013 earnings transcript, May 30 2013 [↩]
13. Costco’s Q4 fiscal 2013 earnings transcript, Oct 9 2013 [↩] [↩] [↩]
14. U.S. Online Retail Sales To Reach $370B by 2017, Forbes, Mar 14 2013 [↩]
15. Costco’s Q2 fiscal 2013 earnings transcript, Mar 12 2013 [↩]