Costco's Hidden Strategy to Combat Soaring Prices
In the present economic climate, numerous retailers are grappling with challenges. Despite low unemployment rates and robust growth in GDP, prolonged periods of high inflation have eroded consumers' purchasing power.
This situation has resulted in challenges for various stocks, including the food and beverage sector and general retailers.
Amidst this difficult spending environment, Costco Wholesale (COST -0.08%) has outperformed, reporting impressive growth and even expanding its margins. This success can be attributed to Costco's significant competitive advantage, which comes into play when times are tough.
Challenges faced by retailers
The challenging environment has affected a number of major retailers, especially "fast casual" dining establishments. For example, Starbucks (SBUX -0.89%) has faced headwinds despite the appointment of Brian Niccol as CEO. Consumers seem disinterested in high-priced coffee and are instead opting for cheaper alternatives, such as making coffee at home.
Meanwhile, retail giant Target (TGT 0.80%) saw its stock dip after reporting earnings. The earnings showed margins being squeezed due to increased discounting and escalating supply chain costs. Target appears to be experiencing heightened competition from discount retailers, as customers are still spending, but in a more price-conscious manner.
Even discount retailers like Dollar General (DG 3.40%) have faced difficulties, with lower margins due to their economically pressured customer base and increased "shrink" (primarily due to theft).
Costco's success story
However, Costco has managed to avoid these issues. In Q4, revenue grew by 7.5%, while diluted earnings per share increased by 12.8%, beating expectations. While Costco's comparable-store sales growth of 7.1% was impressive, its margin expansion in this competitive environment was even more noteworthy.
Costco's success can't be attributed to its status as a discount retailer alone; low-priced retailers like Dollar General would have benefited similarly if that were the case.
The difference lies in Costco's unique business model, which sets it apart from both high-end and low-end retailers.
The power of membership
Costco's business model is built around membership. As a "club," it charges an annual membership fee for access to its stores. Although the membership fee recently increased as of Sept. 1, a basic Gold Star membership still costs just $65 annually, offering customers access to a wide variety of deeply discounted items.
From a financial perspective, Costco's membership revenue constitutes more than half of its operating income, with membership fees accounting for 53% of its overall operating income in the recently completed fiscal first quarter.
This membership subscription revenue enables Costco to sell its products at extremely low margins, with product-only operating margins a mere 1.7%. This is a challenging margin to compete against.
The thin margins at which Costco operates are due to its low prices and its investments in security and customer experience. For instance, the company is known for paying its employees well above average wages, even raising them in July. This, in turn, enables Costco to offer hard-to-beat prices while also reducing shrinkage. Despite increased wages, overall margins actually went up as the company continued to attract more and more members.
The better customer experience provided by Costco also means it isn't just for cash-strapped, lower-income consumers. It also attracts wealthier consumers who appreciate a good deal, evidenced by its ability to attract retailers like jewelers and cruise lines, as well as premium brands like Peloton Interactive (which recently signed up as a vendor).
Why Costco reached $1,000
Despite its high valuation, trading at 58 times earnings, with its share price recently reaching $1,000, some may question Costco's sky-high valuation. However, the recent challenging economic period has demonstrated that when times are tough, Costco can continue to thrive by attracting price-sensitive consumers and stealing market share from other retailers. For example, as consumers have cut back on dining out due to higher restaurant prices, Costco has seen a surge in demand for premium meats and produce as more consumers cook at home.
This is just one example from one product line, but widespread inflation is undoubtedly benefiting Costco across its entire product range. With its "sticky" membership model, which ties customers to its incredible bargains, Costco's unique business model is nearly impossible to beat.
In this challenging economic climate, many retailers are struggling to maintain profits due to high inflation eroding consumers' purchasing power. Despite these challenges, Costco Wholesale has managed to outperform, with impressive growth and even expanding its margins, highlighting the power of its membership-based business model in investing in finance.
Starbucks, on the other hand, despite the appointment of a new CEO, has faced headwinds with consumers opting for cheaper alternatives due to high-priced coffee, demonstrating the impact of inflation on consumer spending habits in finance and investing.
