How Does Costco Make Money?

Costco ( COST ) is the largest warehouse retailer in the U.S. with over 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. With over 50% revenue contribution, Costco U.S. is the most important business segment for the retailer, followed by its international operations. In 2011, Costco generated around $90 billion in revenues, significantly more than its direct competitor, Wal-Mart's ( WMT ) Sam's Club. Since Costco provides merchandise at discounted prices, its margins remain quite low (in the range of 10%).

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So 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.

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 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.

Costco U.S. Growing Amid Slow Economy

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. Most of Costco's customers are small business owners and individual customers, who prefer buying in bulk.

Amid the weak economy and sluggish consumer spending growth, U.S. consumers prefer warehouse clubs for shopping for most value for money. And Costco has benefited from this trend. In its recent quarterly results, the retailer reported 7% increase in the comparable store sales in the U.S. Moreover, the annual comparable store sales growth has averaged around 6% for the past three years.

As long as the economy remains weak, consumers will continue to look for cost saving options, which will drive them to warehouse clubs such as Costco. Even if the economic growth picks up, Costco's customers might still continue to buy from it due to attractive bargains. Additionally, with the improvement in the economy, more businesses will emerge thereby, widening Costco's bulk buying customer base.

Costco's International Business 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%. As a result, the revenue contribution of Coscto's international business has increased from 18% in 2008 to 22% in 2011. We expect this figure to further increase to 30% by the end of our forecast period.

Costco is performing better in international markets due to is unique and distinct cost-saving shopping model. Moreover, the absence of 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. We believe that it makes sense for Costco to expand more aggressively in international markets, given their potential and expansion opportunity, since warehouse shopping model is relatively new in these regions.

Executive Members And Private Label Brands Helping Costco

Executive members, who account for about one-third of Costco's total members, and two-third of its sales, are the most valuable customers for the retailer. 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 $500). The percentage of executive members enrollment increased from 33% in fiscal 2009 to 38% at the end of fiscal 2012. An increase in executive members will provide strong support to Costco's future growth. The fact that these members pay a higher membership fee implies that they tend to buy a lot more in order to take advantage of their 2% annual rewards.

Another reason behind Costco's success is its private label brands. These products have low prices, higher margins and are comparable to national brands in terms of quality. One of the latest additions to Costco's pool of private label brands is Green Mountain Coffee ( GMCR ) coffee cups. The retailer has been increasing the penetration of private label brands within its merchandise by about 0.5% to 0.75% annually. This will not only attract more customers who are looking for blend of quality and price, but will also help Costco's thin margins, which are already subjected to food price inflation risks.

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

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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