Retailer Deep Dive: Costco Wholesale
When thinking about Costco, it’s best to not overthink things. The company’s senior leaders certainly don’t, which helps explain how the operator of membership warehouses continues to pile on sales, the majority of which come from food and consumables, earning the trust and loyalty of members, an ever-growing number of whom pay a premium to shop with Costco.
The beauty of Costco’s strategy and effectiveness is that it’s rooted in simplicity, which is then executed by a veteran leadership team with the discipline to adhere to it, while others in retail are focused on grand digital transformations or three-year plans to restore growth. Frankly, the Costco story gets a little boring, which can sometimes be evident from the probing questions of financial analysts who hear a familiar message year after year about delivering member value, deliberate expansion, taking care of employees and delivering shareholder value. Costco does what Costco does, which is operate membership warehouses that offer low prices on a limited assortment of fewer than 4,000 branded and own-brand products in a wide range of categories to generate high sales and rapid inventory turnover.
The company’s approach continues to resonate with members. For example, in its fiscal year ended Aug. 29, Costco reported the following:
- Total sales increased 18% to $192 billion, driven by the addition of 22 new warehouses globally, and a 13% same-store sales increase, excluding the impact of fuel and currency exchange.
- Sales in the categories of fresh food and food and sundries that surpassed $100 billion.
- The addition of 12 U.S. locations as part of a $3.6 billion capital expenditure program that saw it end the year with 564 warehouses.
- E-commerce sales increased 44% and represented 7% of total sales in 2021. The company offers roughly 10,000 SKUs online, and its app has been downloaded 10 million times.
- Membership fee income increased 9% to nearly $3.9 billion, with renewal rates of 91% in the United States and Canada, and 89% worldwide.
- Net income and earnings per share increased 25% to $5 billion and $11.27, respectively
- Costco paid a special cash dividend of $10 a share in December 2020, and in April 2021 the company increased its quarterly dividend to 79 cents.
To keep the momentum going this year, Costco plans to open more warehouses than at any point during the past decade. Capital expenditures this year are forecast to range from $3.8 billion to $4.2 billion to open 35 new warehouses, of which five will be relocations, compared with last year’s 22 new warehouses, of which two were relocations, according to the company’s annual report.
The continued expansion from Costco means that traditional grocers face more competition and margin pressure from a retailer known for shaping consumers’ value expectations and price perceptions. A key reason for this is that Costco tends to be the last to raise prices and the first to lower them, even during an inflationary environment during which retailers and suppliers are looking to pass through price increases.
“We hate raising prices. We want to be the last to raise it and the first to lower it,” CFO Richard Galanti said during the company’s fourth-quarter earnings call in response to a question about inflation. “It’s really all about the value proposition. People would look at us relative to other retailers and say we’ve been more aggressive on holding prices than others – at least that’s how we feel. But we have to be pragmatic. As [inflationary forces] are permanent and consistent, you’ve got to raise the price.”
Costco’s Secret Sauce
A lot of retailers talk about how employees are their greatest asset, and in Costco’s case, it’s true. The company’s business model of operating highly productive warehouses is attributed to the commitment and efficiency of employees.
“We seek to provide them not merely with employment, but careers,” is how Costco describes in its annual report a philosophy of ensuring that at least 50% of its employees are full-time.
Expansion and growth create advancement opportunities, but Costco has long been regarded among retailers as one of the more desirable employers, due to its above-market wages. The company lived up to that reputation throughout the pandemic. For example, it paid $515 million in incremental wages during 2021 related to COVID-19. When combined with the prior year, the incremental wages paid totaled $825 million. Back in March, the company made some of those increases permanent, resulting in an estimated annual cost of $400 million.
The combination of these factors, which speaks to the career potential of working at Costco, is also evident in the fact that the company reported a 90% retention rate in 2021 among employees who worked for the company for at least a year.
The Second Ingredient
Combine quality employees with a value proposition that’s hard to beat and a commitment to satisfaction evident in the company’s liberal return policy, and Costco has a winning formula. It’s little wonder then that members pay a premium to shop at warehouses – and increasingly online – and renew at consistently high rates.
Costco ended its most recent year with 61.7 million total paid members, including 25.6 million executive members who pay an annual fee of $120, versus the standard membership fee of $60. Executive members earn 2% back on qualified purchases, accounted for 55% of members in the United States and Canada last year, and spend more and renew at higher rates than basic members, who are referred to as Gold Star.
Members renewed at a rate of 91% in the United States and Canada, and a slightly lesser 89% internationally.
Consistent Execution, Succession Concerns
One of Costco’s greatest strengths is the consistent execution of a highly effective strategy enabled by an experienced team of senior leaders. Each of the company’s 10 top senior executive officers identified in the company’s annual report have spent more than 25 years with the company. The stability of senior leadership has translated to rigid application of a member-first strategy of delivering value that has earned the company tremendous loyalty, especially among those who purchase the premier membership level.
However, this strength is also a potential weakness as the seasoned senior leadership team eventually gives way to the next generation of senior leadership. CEO Craig Jelinek is 69, and CFO Richard Galanti is 65. If either has lost a step, it isn’t evident in the company’s performance, and the issue of succession never comes up – at least not publicly – when analysts have an opportunity to question the company’s strategy during earnings calls.
That said, leadership changes are inevitable, given that the average age of the company’s senior executive team is 63.5 years, with the youngest member being Ron Vachris, 56, who is EVP, COO, merchandising.
Why Costco Can Keep Growing in the U.S.
Depending on how Costco resolves its future leadership situation, it’s conceivable the company could surpass 900 U.S. locations and gain an even larger share of the food and consumables market. Such a feat might seem improbable, considering that it already operates 564 highly productive U.S. locations, and given its stellar performance of late, it’s natural to question how much runway remains for growth. Insight into the company’s potential in the United States can be gained through a simple analysis of the company’s penetration in Canada and California, which shows that more than 900 U.S. locations are possible.
To arrive at that figure, consider that Costco operates 105 locations in Canada that encompass 14.9 million square feet and generated sales of $27.3 billion in a country of roughly 38 million residents. Conversely, the company’s 564 U.S warehouses encompassing 83.2 million square feet last year generated sales of $141.4 billion in a country of roughly 335 million residents that’s roughly 10 times the size of Canada.
By extension, some simple math shows that if Costco were to achieve a penetration rate in the United States comparable to that of Canada, where it operates one warehouse for every 362,000 residents, its U.S. footprint could someday surpass 900 locations.
Further evidence of even higher U.S. potential can be found by using California as a proxy for the nation. California is the nation’s most populous state, with roughly 40 million residents, and is home to 131 Costco warehouses, which account for 28% of the company’s U.S. sales. To apply the math used in the Canadian exercise, that means that there’s one Costco location for every 305,000 residents of California. If a similar population-to-warehouse ratio is applied to the remainder of the U.S. population, Costco’s U.S. count could reach 967 locations.
Another example of this growth potential can be seen by looking at its penetration rate in its home state of Washington. Costco has 32 locations in Washington, the nation’s 13th most populous state, which is the same number it has in Texas, the second most populous state. Florida and New York, the second and third most populous states, have 28 and 19 Costco locations, respectively.
