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Costco: A Resilient Retailer Paying Higher Dividends Since 2004

Costco (COST) was founded in 1976 and pioneered the membership warehouse business model. The company is one of the world’s largest sellers of groceries, alcohol, diamonds, electronics, prescription drugs, tires, gasoline, and even travel services. Costco operates over 775 store locations, mostly in North America.
Source: Costco
While Costco is the world’s third-largest retailer by sales, the firm generates the majority of its profits from its annual membership fees which make up about 2% of total revenue but account for approximately 70% of operating income. The company has built up a base of 97.2 million cardholders around the world representing more than 53 million households. 

The company is gradually expanding overseas, but the vast majority of sales and operating profits continue to come from its core U.S. operations:

  • United States: 73% of revenue and 64% of operating income
  • Canada: 14% of revenue and 19% of operating income
  • Other International: 13% of revenue and 17% of operating income

Costco has increased its dividend every year since it began making payouts in 2004.

Business Analysis
The retail industry is notorious for being an incredibly competitive space with razor-thin margins and low customer loyalty. However, Costco has built an enduring business using a rather unique approach.

Simply put, the company's membership model and quality assortment of on-trend merchandise have created an extremely loyal customer base. In fact, Costco's membership renewal rate averages about 90% in the U.S. and 88% worldwide. 

Membership fee revenue has steadily grown each year, driven by a rise in new members as well as periodic hikes in membership fees. These fees provide a recurring source of high-margin revenue that allows the company to offer its customers near wholesale prices on merchandise. 

In fact, a Costco vendor we spoke with said that the company's policy is to limit the markup on almost all of its products to just 15%, passing on almost all of the value to its customers (remember that membership fees generate 70% of Costco's operating profit).

Costco is an expert at picking out merchandise that sells. While Walmart's supercenters offer more than 140,000 different items, Costco carries an average of 3,700 units per warehouse, significantly less than other broadline retailers.

By leveraging its massive size and frequently mixing up its merchandise assortment, Costco extracts favorable terms from its suppliers. The company generally sells inventory before it is required to pay for it, even while taking advantage of early payment discounts.

Selling products in no-frills, self-service warehouse facilities, engaging in volume purchasing, and maintaining efficient handling of a limited selection of merchandise keep Costco's operations very efficient.

The firm's membership model enables stricter controls of each warehouse's entrance and exit as well (employees are stationed to check for each member's card and receipt), resulting in lower inventory shrinkage compared to other types of retail models. 

Thanks to these efficiency benefits, Costco operates profitably at significantly lower gross margins than most other retailers. For example, Costco's gross margin (net sales less merchandise costs) regularly sits near 11%, less than half of Walmart's 25% gross margin. 

As long as the company continues offering its members low prices on high quality products, it's hard to imagine Costco being disrupted. In addition to offering competitive prices on products sold by popular brands such as Apple, Pepsi, Samsung, Hershey's, and Kimberly-Clark, approximately 28% of Costco's fiscal 2018 sales were made under its private label Kirkland Signature brand.

Costco makes higher margins on private label sales and has continuously improved Kirkland's quality and reach, expanding its offerings in apparel, sporting goods, and organic food items (Costco is one of the largest organic food retailers in the world). These exclusive, value-focused products create further reason for Costco's customers to keep paying their annual dues.

Thanks to its successful merchandising strategy and loyal members, Costco's average sales per square foot is about $1,250 compared to approximately $725 at Sam's Club. Its inventory turnover is also about 30% higher than Walmart's.

To sustain its success, Costco is focused on adapting its business model to the continued rise of e-commerce, an area which has disrupted many retailers. Online sales accounted for 4% of Costco's fiscal 2018 revenue and grew more than 30%. 

The company offers same-day grocery delivery and is working to make it even easier for customers to pick up items the same day that they are bought online. Impressively, unlike many of its peers, Costco has made these investments without sacrificing its profitability, another sign of its enduring moat.

Overall, Costco is a competitively advantaged firm thanks to its economies of scale, intentionally limited product selection, quality in-store experience, strong balance sheet, and loyal base of shoppers who provide high-margin, recurring membership fee revenue.

Key Risks
As impressive as Costco's unique business strategy has proven so far, there are still risks that investors need to keep in mind.

First, the company's business model is highly dependent on its membership base, whose recurring fees provide the majority of the company's operating profit.

Up until now, Costco has shown no signs that it's periodic membership fee hikes are hurting its retention levels. However, there is a risk that Amazon's popular Prime membership, which has surpassed 100 million members in the U.S., might eventually pose a threat.

That's because Costco's membership model is built around offering customers numerous avenues of value. Not just the ability to shop at highly discounted prices for bulk goods, but also purchase discounted gasoline prices, use its travel agency, pick up medications at the pharmacy, replace a car's tires, and use its popular co-branded credit cards.

However, Amazon Prime, which originally started out offering free two-day shipping, has expanded its offerings to include free video and music streaming, and even free two-hour delivery in certain markets. With Whole Foods under its wings, Amazon could increasingly encroach on grocery-focused retailers. 

Amazon is also raising its membership rates which means that Costco customers might eventually feel the need to decide between one membership or another. After all, the ultimate value proposition of each membership is to save money on low-cost merchandise.

Even as Costco gets more efficient, there is no guarantee that it will be able to maintain it profit margin as competition increases. In retail, cost savings often end up being passed onto consumers. That's especially true in the age of Amazon where CEO Jeff Bezos is famous for saying "your margin is our opportunity."

Another risk to consider is that most of Costco's biggest long-term growth opportunities are overseas. However, there are lots of risks associated with international expansion.

In new markets, Costco lacks the kinds of economies of scale that it enjoys in the U.S. where it's had decades to develop its supply chain. The popularity of the suburban warehouse shopping model is also somewhat unproven in other countries, where homes and vehicles are smaller.

While the company has done a good job with overseas growth so far, it's starting from a small base of stores. In other words, while the U.S. market is mature, we don't yet know how large Costco's overseas market potential really is.

Closing Thoughts on Costco
In a retail world that's being disrupted by the rise of e-commerce, Costco has proven that its membership-focused business model is a solid way to build enduring competitive advantages. 

The company certainly faces numerous threats from fast-moving rivals like Amazon, but management's long-term focus on customer satisfaction, compelling merchandise, and disciplined growth has proven to be one of best approaches to retail success thus far. 

Despite a low yield that makes the stock unsuitable for some investors, Costco appears to be a solid company to consider for most long-term dividend growth portfolios.

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