A Breakdown Of Costco’s Business And Key Drivers

by Trefis Team
-8.34%
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142
Market
130
Trefis
COST
Costco
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Quick Take

  • Costco is the largest warehouse retailer in the world, generating more than $100 billion in revenues.
  • The retailer attracts customers with its low prices, good quality private label brands, discounted gasoline and occasional high-end products.
  • Warehouse clubs have been gaining popularity in the U.S. as shoppers can save up to 55% on their purchases. The warehouse industry has grown by more than 130% in the U.S. over the past decade, and Costco has been a part of this.
  • Costco’s revenues have seen strong growth in international markets, and the retailer is looking to speed up its international expansion.

Costco (NASDAQ:COST) is the largest warehouse retailer in the U.S. with more than 400 warehouse clubs across the country. Apart from the U.S., the retailer also operates around 170 international stores in countries such as Canada, Mexico, United Kingdom, Japan, Taiwan, Australia and Korea. [1] Accounting for more than 50% of its revenues, Costco U.S. is the most important business segment for the retailer. In 2012, Costco generated around $100 billion in sales, significantly higher than that for Wal-Mart‘s (NYSE:WMT) Sam’s Club. Since Costco provides merchandise at discounted prices, its gross margins are low and in the range of 10%. [1]

See our complete analysis for Costco

How Does Costco Make Money?

Since Costco offers discounts on its merchandise, it attempts to make up for it via a membership fee. The retailer charges an annual membership fee of $55 for business and business add-on membership, and $110 for executive membership. [1]

A warehouse club’s true value lies in its ability to attract bulk buyers. Thus, despite low margins, a warehouse club can generate significant amount of dollar profits due to rapid inventory turnover. Such a value proposition is lucrative to customers who tend to buy large amounts of merchandise, and thus despite paying a membership fee, members save money due to discounts. Costco offers a variety of merchandise categories such as groceries, hardlines and softlines, and ancillary services such as gas station, pharmacy, food court etc. Groceries account for more than half of Costco’s revenues. [1]

What Attracts Customers To Costco?

The retailer keeps its markups low at around 15%, thus offering good quality products at compelling prices. It offers a number of private label brands such as Kirkland Signature that have high value associated with them. [2] It regularly changes the brands its offers and customers always find something new at its stores. Besides this, Costco brings in high-end products such as Coach (NYSE:COH) purses and Dom Perignon champagne from time to time, which keeps buyers interested. [2] It also provides gasoline at discounted prices, which enhances its appeal to value-conscious customers and is another reason that drives customers to its stores.

Costco U.S. – Strong Growth With Growing Customer Base

Costco’s U.S. operations account for about 55% of its total revenues. The retailer operates around 448 stores in the U.S. and Puerto Rico. [1] Most of Costco’s customers are small business owners and individual customers who prefer buying in bulk. The U.S. buyers have been increasingly switching to warehouse shopping due to its attractive bargains.

According to some consumer reports, buyers can save up to 55% while shopping at warehouse clubs. [3] As a result while the U.S. general merchandise store sales increased by 47% during the period of 2001-2011, warehouse clubs saw their sales jump by more than 130%. [4] Costco’s strength in the $390 billion warehouse industry is evident from the fact that it reached $1 billion in revenues within its first three years and is still growing quickly. [5] In Q2 fiscal 2013, the retailer reported a 5% increase in the comparable store sales in the U.S. [1] Moreover, the annual comparable store sales growth has averaged around 6% for the past three years driven by new membership signups.

We believe that due to its cost saving structure, warehouse clubs will perform well irrespective of the economic conditions. Since a significant number of warehouse clubs’ customers are small businesses, better economic conditions will encourage bigger purchases. On the other hand, a tough economic environment can still provide an incentive to shoppers to buy in bulk from warehouse stores to get more discounts. This is why both Costco and Sam’s Club registered positive revenue per square feet growth in the recessionary environment. [6]

Costco’s International: Growing Fast

The retailer’s international business growth has been significantly faster than its growth in the U.S. Looking at the average revenue growth for the past four years, we note that Costco’s international revenues have increased by almost 15% annually. In comparison, the annual growth in the U.S. has averaged around 5%. [1] As a result, the revenue contribution of Costco’s international business has increased from 18% in 2008 to 22% in 2012. We expect this figure to grow past 25% by the end of our forecast period.

Costco is performing well in international markets due to its distinct cost-saving shopping model. The limited competition from its U.S. counterparts such as Sam’s Club and BJ’s Wholesale Club is also working in its favor. Over the past five years, Costco has opened only five international stores annually. However, given the success and the growth potential, the retailer plans to open 16 such stores in fiscal 2013. [7]

We believe that it makes sense for Costco to expand more aggressively in international markets given their potential spending power and under-penetrated markets since the warehouse shopping model is relatively new in many of these regions. At some point, the retailer could look to China for its expansion as the retail market growth has been substantial in this region, but that could be a few years off at best. [8]

Our price estimate for Costco stands at $111, implying a premium of about 10% to the market price.

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Notes:
  1. Costco’s SEC filings [] [] [] [] [] [] []
  2. Costco’s Unorthodox Strategy To survive The Big Box Apocalypse, Business Insider, Mar 7 2013 [] []
  3. Best Warehouse Store: BJ’s, Costco or Sam’s Club?, Yahoo Finance, Jan 6 2013 []
  4. Warehouse store showdown: Should you join Costco, Sam’s Club, or BJ’s?, The Christian Science Monitor, Jan 5 2013 []
  5. Priced to grow: How Costco got started, CNN Money, Aug 19 2009 []
  6. Companies’ SEC filings []
  7. Costco’s Q1 fiscal 2013 earnings transcript, Dec 12 2012 []
  8. How Wal-Mart is changing China, The Atlantic, Dec 2011 []
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