Why It Will Be Difficult For Costco To Improve Its Gross Margins

The largest warehouse club in the U.S., Costco (NASDAQ:COST), has seen its gross margins fluctuate around the 10.6% mark over the last four-five years. From 10.87% in 2010, the company’s gross margins fell to 10.59% in 2011 and 10.57% in 2012. In 2013, the margins recovered to 10.64% and they further increased to 10.77% in 2014. While the historical change in margins has been a little wayward, we expect margins to decline slowly going forward through to the end of our forecast period. We forecast a negative 0.02% change in Costco’s gross margins every year, which will take down the figure to 10.63% over the next five-six years.

We believe that given its business model, it will be extremely difficult for Costco to increase its product markups. In fact, rising competition from the second largest warehouse chain Sam’s Club, which has a cheaper membership fee, wider reach and similar level of customer service, can push Costco to go further easy on prices of certain categories. Moreover, the gradual increase in share of groceries in overall revenues, will put a downward pressure on net gross margins, thanks to the nature of the business.

Note that Costco’s margins have been calculated by excluding membership income from its net revenues and assuming that only 0.01% of cost of goods and services is associated with it.

Our price estimate for Costco stands at $147, implying a discount of about 5% to the current market price.

See our complete analysis for Costco

Hard To Increase Markups

While most supermarkets and department stores markup their goods by more than 25%, Costco keeps its markups low at 15%, that allows it to offer products at lower prices than its competitors. ^[1] This is its unique selling point, and by increasing its product markups, Costco risks losing it. In fact, the warehouse retailer needs to be extremely careful with its prices, because it already has a higher membership fee than its close competitor Sam’s Club, who has a wider reach in the U.S. Although Costco’s overall product quality is better than Sam’s Club, they are comparable in customer service. Understandably, Costco needs a balance of price and quality to convince customers to pay more for its membership fee and ignore Sam’s Club. This makes it all the more difficult for the warehouse giant to increase its product markups and thus, significant improvement in gross margins appears somewhat unrealistic. In fact, we believe Costco would not look to increase its markups because it is more focused on generating cash through membership income, which more than compensates for its low gross profits.

Shift Towards Groceries Puts A Downward Pressure

Consumer spending on groceries can be classified as non-discretionary as they come under basic necessities. Grocery sales are less correlated to macroeconomic factors. This is evident from the fact that during the 2008-2009 recession, consumer spending on food and beverages remained more or less stable, according to economic data provided by the Bureau of Economic Analysis (BEA). Also, groceries are a big market segment, accounting for annual sales of over $560 billion. ^[2] Groceries are also important for retailers because customers are 10 times more likely to visit a grocery store than a pharmacy or a general retail store. This improves cross-sell and increases the overall basket size for the retailers.

This explains why Costco has been focusing extensively on improving its groceries business. Share of groceries (food, sundries and fresh foods) in Costco’s overall revenues increased to 56% in 2014 from 55% in 2011. Although the increase was not intense, the figure has grown nonetheless and is on the higher side, which indicates that the company wants groceries to be its main business segment. While groceries help drive store traffic, it puts a negative pressure on overall margins, since it is a low margin business. Going forward, we believe that the company will look to increase its push into groceries, which can drive margins down.

What If Margins Improve

We currently forecast Costco’s gross margins to decline slowly and reach 10.64% by the end of our forecast period. However, there is a possibility that the company can improve its margins going forward by aggressively increasing private label penetration in its overall product portfolio. A couple of years back, private label merchandise accounted for about 20% of Costco’s overall portfolio. The company stated that this figure is increasing by about 0.5%-0.75% annually, and it is shooting for a target of 30%. Private label brands are cheaper as compared to national brands, comparable in quality and generate better gross margins.

At the current rate of increase, private label brands are unlikely to have any significant impact on net gross margins. However, if Costco decides to ramp up private label launches in new and existing categories, encouraged by promising customer response, its margins can in fact increase. Assuming that Costco’s net gross margins increase to 11% instead, there is less than 5% upside in our price estimate. It must be noted that even if Costco succeeds in improving its gross margins in the future, the rate of increase will be very small, given the retailer’s business model. Hence, Costco’s price sensitivity with regard to its gross margins is minimal.

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1. Costco’s Unorthodox Strategy To survive The Big Box Apocalypse, Business Insider, Mar 7 2013 [↩]
2. What’s Behind the Rush Into the Low-Margin Grocery Business, CNBC, Jun 6 2013 [↩]