- Costco is dependent on membership fees to turn a profit.
- Costco is experimenting with online discounts, Google Express, and organics.
- Costco keeps their business model simple but flexible.
Memberships Key Driver Of Costco's (NASDAQ:COST) Operating Profit
Costco's mission is simply to deliver extreme value to customers. Costco has achieved this goal by marking up items only 11%, on average. Costco's dedication to extreme value makes it difficult to turn a profit from product sales, alone. In fact, Costco made only $818 million in product operating income from $102 billion in product sales, in 2013. Yet, Costco's operating profit was $3 billion, for 2013. Membership fees were responsible for the remaining $2.2 billion, in operating profit. Without membership fees, Costco operating profit margin would be 0.8%. With membership fees, Costco's operating margin jumps up to a more reasonable 2.97%.
Costs + Admin
Product Operating Profit
Total Operating Profit
As shown above, Costco's net income growth can mainly be attributed to membership fee growth ($753 million). Although, net sales grew $32.9 billion. Product operating income only grew $516 million.
Costco's business model is simple. Sell products with as little mark-up as possible and make a profit by selling access to their inventory. This business model has enabled Costco to grow consistently, over the last several years. Costco's future success hinges on their ability to grow memberships. This is why Costco is focusing on attracting the next generation of consumer.
Younger Generation Needs Different Approach
Currently, Costco's target customer is a baby boomer. The baby boomer generation is starting to retire. As baby boomers retire, they won't be the main driver, of American consumption. Pew Research estimates the millennial generation is 77 million or 25% of America's population. The millennial generation will soon be the main driver, of American consumption. Costco understands the changing demographics and is trying several different approaches to attract this generation.
Costco is using online discount deals. Richard Galanti, CFO, stated during the Q3 conference call, "You've got a younger member signing up through LivingSocial and Zulily so. And it's a relatively attractive cost of acquisition." Costco's strategy is to get young people, into their warehouses. Costco believes their extreme discounts will keep young people coming back. Yet, Costco's attempts to get a younger generation of consumer would be worthless, without altering their store's SKUs.
Costco's organic push is one example of their willingness to adapt to younger customer's needs. Interestingly, Costco's decision to stock organic food had an added benefit. Costco can get "full margin" as Richard Galanti puts it, in the Q3 conference call. Costco's organic food has led to better margins and attracts a younger consumer. Costco's last experiment involves using Google Express. Richard Galanti stated in their Q3 conference call, "...the test that we are doing will roll now in three major markets into Bay area, L.A. and New York City. Arguably those -- if you look at the age breakdown of those, it's younger." Costco doesn't expect to deliver small quantities of groceries but wants to test the feasibility, of same day delivery.
Costco is one of the world's best run retailers. Costco has and will continue to focus on offering extremely low prices, growing revenue, and supply the customer with the right products. They aren't going to simply throw out their business model, for the millennial generation. However, the United States demographics necessitate adjusting to a younger generation. In order to keep growing US sales, Costco needs to keep working towards attracting the millennial generation.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.