Costco (NASDAQ: COST) has always believed in operating at low margins and transferring the benefit to its customers. Over time, Costco bearers have feared about the company's profitability and growth, but overcoming all such apprehensions its performance has been overwhelming. There are certain concrete reasons as to why the company should still be a good buy despite its supposedly high valuations.
The prospects look good
Costco in its recently reported comps sales for June, accounted a stellar performance. In the U.S. and International markets the comp sale has improved 6% and 8%, respectively as compared to the previous year. Apparently the company's performance in the U.S. market looks weak, but in being compared to Wal-Mart Stores' (NYSE: WMT) Sam's Club's performance which declined 0.5% in the first quarter, Costco has done a fair job, keeping in view the condition of the economy.
The growth in revenue is mainly due to the distinguished products it offers over competitors at a very low margin. The company has always been a little more innovative than its peers and is currently offering limited-edition Disney canvassed images. The canvases available are hand-signed by artist Noah and have only 300 copies globally.
Costco also provides various vacation packages at different price points, such as a seven-night summer cruise to Alaska, starting at $565, and for the ones looking to indulge in a lavish vacation, the company also offers a trip to the Caribbean and Bahamas starting at $4,149 per person.
The company further offers private labels like Kirkland Signature products, which are of the same quality as other brands, but comparatively at a much more economic rate. Costco further offers a wide range of juices, cookies, coffee, house wares, luggage, clothing and detergent too.
It also maneuvers self-service gasoline stations at various stores across the U.S. and Canada. Costco deems sale of gas as its ancillary business, and hence sells it at a lesser margin than the other products. The company's tactic is to attract customers to its store to buy gas and attract them to other products which carry higher margins. Not only is it a unique offering compared to competitors like Wal-Mart, but with gas prices rising the warehouse giant's revenue should go north too.
Costco's gross margin (excluding membership fees) is around 12.5%, much lower than other players in the industry, such as Wal-Mart, which operates at a gross margin of 24.57%. Operating margins of Costco and Wal-Mart are 2.9% and 5.6%, respectively. Costco's prices are, by far, the lowest in the industry as it passes its entire savings to its customers and thus its operating margins are shrinking.
Wal-Mart's gross margins are much higher than Costco's because of lower costs and comparatively higher price. Virtually Wal-Mart can reduce its margins to take away Costco's market share, but as the basic store format of both the companies and income of consumers is different, the threat gets eliminated.
Costco might not be facing much of a competition from the industry giant, but its thinning margins is a matter of concern for the investors. Every year, the revenue increase is not equally complemented by the increase in profit. Let's evaluate whether going forward, margins will be a concern or not.
Unique model comes to its rescue
It's a known fact that Costco's business model is structured on high volume and tight margins, and that is why the company always focuses on revenue in its earnings release. The model is a success for two reasons: firstly, low prices and secondly, membership fees. Costco is able to offer lower prices as it operates on lesser number of SKUs and incurs very low operating expenses on salespeople, fancy buildings, and other decorations to attract customers compared to other retailers. The company keeps its customers happy by transferring these savings to them as discounts.
The most unique thing about Costco is its membership fees, which all its customers have to pay upfront annually. This fee binds customers to shop more frequently at Costco and not switch to other retailers, which takes care of the revenue, further, the entire amount received as membership fees is its profit. As of 09/01/13 the company had 71.2 million cardholders, which is continuously increasing. As evident from a hike in revenue, membership fees have gone up from $531 million to $561 million compared to the same quarter last year. Further, with around 90% membership renewal rate over the last half decade, the company has clearly created a strong customer base.
Expansion should lead to further growth
The company is currently concentrated in the U.S. and Canada in their metropolitan cities. In the domestic market, Costco still can grow in the areas where its presence is still not there. In the international market, the company has stores mainly in the U.K., Taiwan, Korea and Japan, which gives it a lot of scope for expanding globally. The company has also opened a store in Spain and given the weak condition of the economy in most of the parts of the world, Costco's low prices should help the company acquire a good customer base.
In the last decade and especially in the last five years, online shopping has grown faster than any other business model. Keeping the same in mind, Costco has upgraded its website and as the world is moving towards adoption of latest technologies, it has come up with several new mobile applications. The company has been judicious in differentiating the products that it offers online compared to what it offers in its stores which helps it in preventing cannibalization. Currently, around 80%-90% of the products available on Costco's website are different from those available in its store.
Costco's online channel currently generates only 2.5% of its net sales and as the company is adding new products and working to improve its shipment timing and inventory management, the sales should improve in taking it further.
Despite the tight economical situation, Costco is still performing well as it passes on the savings to its customers by keeping its own margins very thin. This approach seems to be working well for the company, which is evident from the fact of growing members and a superb 90% retention of members every year. With a decent comps growth in June and a positive expansion plan, Costco seems to be well positioned to benefit itself in going forward.
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.