In the current economic climate, many retailers are struggling. While unemployment remains low and gross domestic product (GDP) growth is solid, high inflation in recent years has eaten into consumer budgets.
This has created headwinds for many stocks, from restaurants to retailers.
However, in this unfavorable spending climate it is a large discount chain Costco Wholesale (NASDAQ: COST) has just achieved impressive growth and even margin expansion. Investors can thank the company’s strong competitive advantage, which allows Costco to capitalize when times get tough.
The difficult conditions have affected many major retailers, especially fast casual brands. To take Starbucks (NASDAQ:SBUX)for example; While the stock has done well thanks to the appointment of Brian Niccol as CEO, the company’s recent results have been dismal. It seems that consumers are fed up with €6 cups of coffee and are looking for cheaper alternatives, such as making coffee at home.
Meanwhile, retail giant Goal (NYSE: TGT) recently saw its shares sell off after an earnings report; The profit figures showed that margins were coming under pressure from high discounts and rising supply chain costs. Target appears to be seeing increased competition from discount retailers as customers are still spending money, but in a much more price-sensitive manner.
But it’s not just middle-class-focused retailers who felt the pressure from discount-seeking consumers. Even discount store Dollar general (NYSE:DG) has suffered lower margins due to its economically stressed core consumer base and the increased “shrinkage” (largely theft) it has experienced recently.
However, Costco has managed to avoid these pitfalls. Last quarter, revenue grew 7.5%, while diluted earnings per share grew 12.8%, with both figures exceeding expectations. While Costco’s comparable store sales growth of 7.1% was impressive, its margin growth was even more impressive in this cutthroat environment.
How did Costco do? It’s not just that the company is a discount retailer. Otherwise, low-priced retailers like Dollar General would have seen a similar benefit.
The difference lies in Costco’s winning business model, which sets it apart from its peers at both the high and low end of the retail world.
That business model revolves around membership. As a “club,” Costco charges an annual membership fee for access to its stores. But even though the membership price just increased as of September 1, a basic Gold Star membership still costs just $65 per year. That’s not a lot of money for an entire year of access to the wide variety of deeply discounted items that Costco sells.
From a financial perspective, Costco’s membership revenue accounts for just over half of the company’s operating income, assuming membership fees are pure profit. In the recently completed fiscal first quarter ended Nov. 24, membership fees accounted for 53% of Costco’s total operating revenue.
That membership subscription revenue, in turn, allows Costco to sell its goods at razor-thin margins. Excluding membership subscription revenue as part of operating profit, Costco’s operating margins on products were just 1.7%. That is Real difficult to compete against.
The thin margins with which Costco operates are of course a result of the low prices, but also of the investments in safety and a better customer experience. For example, the company is known for paying its workers much better than other low-priced retailers, even raising wages in July. That, in turn, not only allows Costco to offer hard-to-beat prices, but also prevent the theft that Dollar General faces. Even with higher wages for employees, overall margins increased as the company continued to attract more members.
The better customer experience also means that Costco isn’t just for cash-strapped and lower-income consumers. In fact, it also attracts affluent consumers, who still appreciate a good deal. This is why it has managed to attract traders you wouldn’t normally associate with a ‘discount’ store, including jewelers and cruise lines, and ‘premium’ brands such as Platoon interactive — who has just signed up as a supplier.
Some might take issue with Costco’s sky-high valuation, which trades at 58 times earnings, with its share price recently hitting the $1,000 mark. However, the recent challenging economic period has shown that when times get tough, the industry can continue to thrive by poaching price-sensitive consumers and stealing market share from other retailers. For example, while many people have retreated from dining out due to much higher restaurant prices, Costco management noted during its recent conference call that demand for premium meats and products has increased as consumers increasingly eat at home.
That’s just one example from one product line, but widespread inflation undoubtedly benefits Costco across its entire product portfolio. With its “sticky” membership model that locks customers into incredible bargains, Costco’s winning business model is nearly impossible to beat.
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Billy Duberstein and/or his clients have positions in Costco Wholesale and Starbucks. The Motley Fool holds positions in and recommends Costco Wholesale, Peloton Interactive, Starbucks, and Target. The Motley Fool has a disclosure policy.
This Is Costco’s Secret Weapon Against Inflation was originally published by The Motley Fool
