Where Is Costco’s Store Productivity Heading?
Costco’s (NASDAQ:COST) revenue per square feet rose from $804 in 2007 to an estimated $907 in 2012 due to a customer shift to warehouse clubs in addition to inflation supporting higher prices. This growth was accompanied by Costco’s strengthening presence in the U.S. as its share of the U.S. retail market steadily increased from 7.5% in 2007 to 8.5% in 2011. [1] We expect this trend to continue and forecast Costco’s revenue per square feet to reach close to $1,100 in the next 6 to 7 years. In addition to the customer shift to warehouse clubs, other factors driving this growth include rising raw material prices, an improving economic environment in the U.S. and increasing penetration of executive members.
It should be noted that Costco already generates the highest revenue per square feet among its peers such as Wal-Mart (NYSE:WMT), Target (NYSE:TGT) and BJ’s Wholesale Club. The figure for Costco is about 30% higher than that for Sam’s Club and more than twice that for BJ’s Wholesale Club.
See our complete analysis for Costco
Low Price Advantage Will Attract More Customers
As a warehouse club, Costco offers merchandise at lower prices compared to the other retailers. For instance, a regular cotton dress shirt at Costco is priced at around $17, whereas customers have to pay around $45-$50 for similar shirts at Macy’s. [2] While there may be a different selection of brands between the two, a value oriented shopper knows that he can find much more compelling prices at Costco.
Let’s create a simple scenario to highlight how Costco’s prices compare with the world’s largest retailer, Wal-Mart based on their differences in gross margins. Let’s assume that Costco buys product A for $100 and sells it for $110 given its 10% gross margins. Let’s further assume that Wal-Mart buys the same product for $90, leveraging its huge buying power to get a higher discount and prices it at $130 given its near 30% gross margins. This implies that despite paying higher prices to vendors than Wal-Mart, Costco’s final prices to the customer could ultimately be competitive or lower than Wal-Mart’s. Costco can afford to do this because of its business model is different than Wal-Mart’s in that it has memberships and has a no frills approach to sales. This is just a theoretical scenario to better understand Costco’s value to customers.
How Does Costco Keep Its Prices Low?
The retailer keeps its product markups (the amount added to cost of goods to cover overhead and profit) relatively lower at 14%-15% while the same figure for most supermarkets and department stores is over 25%. [3] Moreover, with concrete floors, simple shelves and display boxes (same boxes that products arrived in), Costco keeps the costs to a minimum. [4] The retailer possesses strong negotiating power over its vendors as it buys large quantities of fewer SKUs. Additionally, Costco does not hold onto a particular brand but buys brands that have larger inventories to get more discounts. [5]
Due to the sluggish growth in the U.S. economy, buyers have been shifting to Costco and other warehouse clubs to get more value for their money. During 2007-2011, the retailer’s comparable store sales rose by 4.5% annually. [6] This healthy growth can be attributed to its expanding customer base since the average spending per Costco member has grown by only 1% annually. [3] Moreover, the retailer has seen an increase in the number of new membership signups over the recent years. In 2011, over 4 million buyers signed up for Costco membership, which was significantly higher than the previous four years’ average.
Inflation And Rising Raw Material Prices Will Drive Costco’s Prices Higher
Inflation is one fundamental factor that drives revenue growth for same sales volumes and will continue to aid growth in Costco’s revenue per square feet. The Consumer Price Index (CPI), a measure of inflation, steadily rose from 200 in 2006 to 224 in 2011 in the U.S. [7] Higher raw material prices will prompt Costco and others to raise its prices.
Since more than 50% of the retailer’s revenues come from groceries, food price inflation will have the largest impact. As a recent example, last year’s drought in the Midwestern United States resulted in limited supply of food products, leading to higher prices. [8] Moreover, the prices of beef, veal and poultry also rose in 2012. [9] Costco reported a healthy comparable store sales growth of 9% in December 2012 complemented by food price inflation. [10]
Rising Penetration Of Executive Members Will Help
Costco’s executive members account for one-third of its total members and two-third of sales. These members pay around $110 annually as opposed to $55 paid by the other members. For the higher fee, executive members are given 2% redeemable reward against their annual purchases (maximum limit of $750). [11] The fact that these members pay a higher membership fee implies that they tend to buy a lot more to take advantage of their 2% annual rewards. The percentage of executive member enrollment increased from 33% in fiscal 2009 to 38% by the end of fiscal 2012. This trend will help Costco’s revenue per square feet going forward.
The Significance Of This Growth
Costco’s revenue per square feet has increased by an average of 3.5% over the past three years. We expect it to follow a similar trend and reach $1,100 by the end of our forecast period. It is worthwhile measuring the sensitivity of this business metric to Costco’s price estimate to better understand how a change in the growth trajectory can affect the retailer’s value.
To show the sensitivity of Costco’s productivity on its stock value, if Costco reaches revenue per square foot of $1,200 by the end of our forecast period aided by aggressive membership signups and higher growth in average prices, there could be 5% upside to our price estimate. On the other hand, if persisting unemployment and consumer spending overall drops limiting Costco’s revenue per square feet to less than $1,000 by the end of our forecast period, there could be around 5% downside.
Overall, we are positive on Costco because the retailer is likely to continue to drive membership signups due to its competitive prices. Even if the economy picks up, we don’t see any reason for Costco’s customers to shift to other retailers given the value they receive. Cost savings will always attract buyers irrespective of the economic conditions.
Our price estimate for Costco stands at $111, implying a premium of about 10% to the market price.
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Notes:- Estimated using the general merchandise sales data available with census.gov [↩]
- Costco’s and Macy’s websites [↩]
- How Costco Became The Anti-Wal-Mart, The New York Times, July 17 2005 [↩] [↩]
- 8 Tips For Business Success From Costco’s Jim Sinegal, youngentrepreneur, Aug 8 2012 [↩]
- Inside Costco: Secret’s Of America’s Favorite Stores, abc news, March 29 2010 [↩]
- Costco’s SEC Filings [↩]
- Archived Consumer Price Index Detailed Report Information, Bureau Of Labor Statistics [↩]
- US drought will lead to inflation and higher food prices says report, the guardian, Aug 20 2012 [↩]
- Food Price Outlook 2013, United Stated Department Of Agriculture [↩]
- Costco December Sales Tops estimates, Supermarket News, Jan 3 2013 [↩]
- Costco’s SEC filings [↩]