Costco Wholesale Corp. (COST, Financial) has lost 19% of its market value this year as investors continue to cut back on stocks due to inflation and fears of a potential recession. The company reported weak sales in the first quarter of its fiscal year 2023, prompting a further decline in its share price earlier this month. Revenue increased by 8.1% year-over-year to $53.44 billion, just barely keeping up with inflation, and e-commerce comparable sales declined by 3.7%, which was one of the main reasons behind the negative market reaction recently.
Costco is one of the largest wholesalers in the U.S. It operates a membership-based retail chain that sells its goods via warehouses, mainly offering bulk quantities of merchandise at discounted prices to its members.
As of 2022, the company operates more than 800 warehouses in several countries around the world. While most of its locations are in the United States, it also has locations in Canada, Mexico, the United Kingdom, Japan, South Korea, Taiwan, Australia and Spain. Costco is known for its wide selection of products, including groceries, electronics and home and outdoor items.
The company's business model of offering low prices on bulk products has made it popular with consumers, especially those with large families, helping it become one of the most profitable retailers in the world.
The impact of inflation
Inflation can have an impact on any business, including Costco. When the general price level rises, the purchasing power of money decreases, which means that it takes more money to buy the same goods and services. In general, retailers suffer when inflation rises because they face higher operating costs and a decline in their customers' purchasing power.
Higher prices for necessities such as food, shelter and energy are forcing many people to seek out less expensive and discounted alternatives today. Historically, Costco has actually benefited from such trends because the company offers customers a wide variety of low-priced items as well as discounted gasoline. The company operates fuel stations at many of its warehouse locations, and it often offers gasoline at discounted prices to its members. The company often runs promotions offering even lower fuel prices. However, it's worth noting that the prices of gasoline can vary significantly depending on a number of factors, including location, market conditions and the price of crude oil. As such, the price of gasoline at Costco may not always be the lowest available in a given market.
Even for a business like Costco, inflation can affect the cost of the goods and services it sells. If the prices of the goods that Costco buys from its suppliers increase due to inflation, the company may have to raise end prices to maintain its profit margins. This can potentially impact the demand for Costco's products, as consumers may be less willing to pay higher prices, though this is lessened by one less step in the Costco supply chain compared to non-bulk retailers.
With higher labor costs and supply chain challenges, the prices of certain Costco products increased both last year and this year. For example, the price of eggs increased 47% in July 2022, resulting in a full dollar increase at Costco. The company also imposed a two-carton limit on customers due to an egg shortage caused by a bird flu outbreak. Some Costco food court items also saw price increases. Given the challenging economic situation, people have begun to prioritize food and other essential items, and they now appear to be spending less on Costco's other products such as appliances and furniture. A pivot in purchasing habits toward essential items will hurt Costco's margins eventually, although the company might experience stable revenue trends.
Costco so far this year has fared well under inflationary pressures. One of the key aspects of Costco's business model is its emphasis on efficiency and cost-cutting. The company operates on a low-margin, high-volume model, which means that it aims to keep its costs as low as possible and to offer low prices to its customers. Costco works with its suppliers to negotiate favorable prices and uses its large size and buying power to secure discounts. The company also keeps its overhead costs low by operating warehouses rather than traditional retail stores, and by minimizing expenses such as advertising and employee benefits.
Challenges and risks
Costco faces several other challenges and risks, including competition. Costco is a large retailer that operates in many different markets around the world, and as such, competes with a wide range of other retailers and wholesalers, both in the United States and internationally. Some of the main competitors of Costco in the United States include other membership-based warehouse clubs such as Sam's Club (owned by Walmart (WMT, Financial), BJ's Wholesale Club (BJ, Financial) and Amazon (AMZN, Financial). An example of an ex-U.S. competitor is Alibaba Group Holding (BABA, Financial). Although Costco has been able to thwart the threat of competition successfully in recent years, investors should closely monitor how the company retains its market share in a recessionary environment.
Costco's business is affected by economic conditions such as changes in consumer spending patterns, inflation and the availability of credit. The company may face challenges if there is a downturn in the economy next year, as consumers may cut back on their spending or opt for lower-priced options. Further, Costco and other retailers may charge more to shop if inflation doesn't slow down in 2023. However, I believe that inflation will ease in 2023 as a result of the Federal Reserve's aggressive interest rate hikes.
Costco relies on a complex global supply chain to bring goods to its warehouses. Disruptions in the supply chain resulted in higher freight and transportation costs earlier this year, as well as port delays in 2020 and 2021 resulting in price increases and a shortage of supplies. With the global supply chain still in the early stages of its recovery from the Covid disruption, investors should look out for further challenges in 2023 that may negatively impact the company’s profitability.
Costco benefits from its membership model
As a membership-based retail chain, Costco’s membership fees have been a consistent source of revenue making the majority of its profits. To become a Costco member, customers must pay an annual fee. Members can then shop at Costco warehouses or online and take advantage of the company's discounted prices on a wide variety of products. Costco also offers services such as optical, pharmacy and travel. The basic version's annual fee is $60, and the executive level's fee is $120.
Membership fee income in the first quarter of fiscal 2023 came in at $1 billion, up 5.7% year over year. Wall Street analysts anticipate some fee increases in early 2023, which should bode well for margin expansion. Membership renewal rates in the United States and Canada topped 92.5% at the end of the last quarter, and the global rate was at 90.4%. The company ended the quarter with 66.9 million paying household members and 120.9 million cardholders, both of which were up 7% compared to the previous year.
Paid executive memberships totaled 30 million, a 75,000-per-week increase during the most recent quarter. Executive members now account for 45% of Costco's paid membership scheme and slightly less than 73% of global sales. Although consumers may spend less than usual during a difficult economic period, they still need to purchase necessities, and they prefer good deals like those offered by Costco. The company, therefore, is in a good position to weather the current economic challenges despite a slight slowdown in revenue growth caused by weak sales of discretionary goods.
Takeaway
Costco may not have reported double-digit growth in the last quarter, but the company is showing no signs of financial distress. Membership growth and an increase in renewal rates demonstrate that people continue to return to Costco. Most Costco customers are upper-middle-income customers, which means they are willing to keep the membership fees. Even if prices rise in 2023, consumers will still likely still prefer to buy Costco goods over those from other retailers, as Costco will still be the cheaper option. Strengthening customer loyalty and a strong business model give reason to be optimistic about Costco's growth prospects. The company may face some short-term headwinds, but it is heading into the new year as one of the more solidly grounded retailers that is likely to weather economic challenges and deliver acceptable returns.
