The business outlook at Costco Wholesale Corporation (COST) is bright. The company has been reporting good results in recent quarters, as it is benefiting from strong demand from both U.S. and international customers, although the strengthening U.S. dollar has tempered international results. Standout categories include Fresh Foods, which reported low double-digit growth in the fiscal first quarter of 2015 (ended November 23, 2014), Food and Sundries (high single-digit), and Hardlines (mid-single digit). Lower gas prices have had a mixed effect on results. Gas makes up over 10% of COST’s total sales, and the company offers some of the lowest average gas prices in the nation. But with lower gas prices, many customers are not as concerned about finding the best deal.
Investors interested in the stock will see that its price has risen steadily over the past few years, thanks to the business’ stellar performance during that time frame. The question is whether the trend will continue, or if the ride will start to slow down in the coming quarters. We will address the short-term concerns, as well as long-term opportunities, that the stock offers. This will be done by performing an easy-to-follow SWOT analysis of the company, evaluating its Strengths, Weaknesses, Opportunities and Threats.
The business
Costco and its subsidiaries began operating in 1983 in Seattle, Washington. It engages in the operation of membership warehouses in the U.S., Canada, U.K., Mexico, Japan, Australia and Spain. It also has majority-owned subsidiaries in Taiwan and Korea. The company strategy is to offer its members low prices on a limited selection of nationally branded and select private-label products in a wide range of merchandise categories. This will typically produce high sales volumes and rapid inventory turnover. Too, the operating efficiencies achieved by volume purchasing, along with efficient distribution and reduced handling of merchandise in a no-frills warehouse, allows the company to operate profitably at lower gross margins than traditional wholesalers, mass merchandisers, supermarkets and supercenters.
Products sold include food (dry and packaged), sundries (tobacco, beverages, cleaning supplies), hardlines (major appliances, electronics, beauty aids), fresh food, softlines (apparel, home furnishings), and ancillary and other (gas stations, pharmacy, food court). By using a membership format, and strictly controlling the entrances and exits of its warehouses, Costco has lower inventory losses than those of other discount retail operators. The company had about 195,000 employees at the end of fiscal 2014. Its headquarters are in Issaquah, Washington.
Strengths
Pricing Authority: Costco’s philosophy is to provide its members with quality goods at the most competitive prices. It does not focus its efforts on maximizing prices in the short term, but instead focuses to maintain a perception among its members of “pricing authority”, or consistently providing the most competitive prices. These bring customers back to the warehouse, since they have the belief that they are in fact getting the best price on a wide array of products. The company also uses its gasoline business to draw members to warehouses. While this business is relatively lower margined than others, it again drives higher volumes of other higher-margined products.
Brand Loyalty: Costco’s relentless pursuit of offering high-quality products and offering great value has allowed it to attract a very loyal customer base. This has allowed the company to grow market share and increase its customer base over the years.
Weaknesses
Geographic Dependence: Costco’s performance is highly dependent on its North American business. Sales in the U.S. and Canada represented 87% of the total for 2014. The company is particularly dependent on California, which represented 32% of U.S. sales last year. As a result, any substantial slowing in demand in the state, for any number of reasons, could significantly hurt the company’s top and bottom lines.
Older Customer Base: While Costco has a fairly broad customer base, it is more skewed toward older baby boomers. As these customers age, they tend to spend less. The company needs to try and attract younger customers, including Generation X and Y, who are savvier e-commerce shoppers. We discuss this opportunity in more detail below.
Opportunities
Attracting Younger Customers: In recent months, management has taken steps to attract younger customers to its stores. These shoppers, between the ages of 19 and 34, should help to drive longer-term sales and earnings at Costco. The company is attracting these customers in several ways. It is making it more convenient for them to shop by using services such as Google Express and InstaCart. It is also offering better, higher-quality brands on the apparel side of the business. The company has also been using promotions, including Living Social, which should attract a younger customer base. It is also offering more organic foods, which will also appeal to a younger, more health-conscious consumer. As a result of these moves, Costco has been seeing a larger percentage of new sign-ups from these customers in recent quarters.
International Expansion: Costco plans to continue to expand, both domestically and internationally. Its current store base is around 670, but management hopes to reach 1,200 warehouses in the long term. It will likely continue to open about 30-35 stores a year over the next few years. Over the next 10 years, we think roughly 60% of these stores will be opened outside the United States, where margins are almost twice as high as they are domestically. The company has recently expanded in Spain, and plans to open up in France in due time. We also think Costco is planning to enter China within a couple of years, which would be a huge growth opportunity.
Threats
Competition: The discount warehouse services industry is highly competitive. There are several warehouse operators across the U.S. and Canada that offer similar merchandise quality, selection, and price. Primary competitors include Sam’s Club and BJ’s Wholesale Club. The company also competes on a worldwide basis with global, national, and regional wholesalers and retailers, including supermarkets, supercenters, department and specialty stores, gas stations, and internet retailers. Other regular retailers that don’t require membership, including Wal-Mart (WMT, Financial) and Target (TGT, Financial), also compete in the general merchandise category. Pressure from these companies will likely prevent Costco from raising prices too much, for fear of losing business.
Internet Retailer Giants: While not directly competing with Costco, some internet retailers like Amazon (AMZN, Financial) offer a range of low-cost, good-quality products with shipping options that are hard to beat. Companies like this have the scale and fulfillment processes already in place, so Costco needs to think how to leverage e-commerce and innovate in this space to better compete with these giants of industry, especially if they decide to compete more directly with Costco in the food industry.
Conclusion
Costco continues to successfully expand its operations, thanks to its low prices and strong customer loyalty. Its ability to deliver quality products, at an affordable price, should appeal to most consumers in North America and around the world. While competition in the market remains fierce, we think management is taking the right steps to lead the company into the future. All told, we believe Costco’s strengths and opportunities outweigh its weaknesses and threats. Subscribers interested in learning more about Costco should check out our full-page report in The Value Line Investment Survey.
At the time of this article’s writing, the author did not have a position in any of the companies mentioned.
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