The business operates differently from most retailers out there.
To say that Costco (COST 0.11%) has worked out to be a wonderful investment would be pretty accurate. Including dividends, if you invested $10,000 in the business five years ago, you'd be sitting on more than $35,000 today. This meaningfully outpaces the Nasdaq Composite Index.
Of course, credit goes to strong fundamental performance. But there's another factor investors might not be aware of. Is this the one secret to Costco's success?
Keep the customers coming back
Costco isn't unlike any other general merchandise retailer. Through its network of stores, the business sells a wide range of goods, like electronics, apparel, jewelry, groceries, and even gas. At first glance, there's nothing unique going on.
Even more noticeable is Costco's gross margin, which has averaged just 12.7% in the last five years. This isn't anything to write home about. And it's a lower metric than what other big-box retailers are able to produce. Based just on this, Costco does not look like a special business.
But that's a wrong assumption. Costco's success is entirely dependent on operating an incredibly lucrative membership-based business model. Not just anyone can shop at one of the company's nearly 900 warehouses scattered across the globe.
In the U.S., individuals must pay $60 a year for the basic plan or $120 a year for the executive membership, the latter of which has added benefits. This gives them the ability to visit Costco's stores.
The membership model provides Costco with a high-margin, recurring revenue stream. In the fiscal 2024 first quarter, membership renewal rates worldwide were 90.5%. And membership fees totaled $1.1 billion, which was up 8.2% year over year. Just the membership portion of the business represents more than half of Costco's total operating income.
This is exactly what affords the company the ability to charge extremely low prices. Costco is playing the volume game, where its goal is to sell as much as possible. And this scale, exemplified by Q1 2024 net sales of $56.7 billion, allows management to flex its bargaining power with Costco's many different suppliers, thus obtaining favorable per-unit costs that are immediately passed on to consumers in the form of low prices.
Moreover, being a member helps to drive customer loyalty and repeat purchases, which is what any business would love to have. Because of the psychological effect of having paid $60 or $120 for a membership, consumers might favor shopping at a Costco location even if another retailer is closer to home. And even in one or two visits, a shopper can save more than the cost of the membership.
What's encouraging is that Costco has continued to post stellar financial results over the past decade, particularly at a time when e-commerce has become more popular. For example, the rise of Amazon has resulted in the death of retailers. But Costco continues to thrive, demonstrating just how much consumers love what the business has to offer. I don't see this changing anytime soon.
What should investors do?
There's no doubt that Costco has been incredibly successful from a financial perspective. And this has resulted in the stock rising almost sixfold in the last decade. As a result, the company carries a market cap of $308 billion today. Furthermore, Costco is the world's third-biggest retailer in terms of net sales.
While all the positive traits I just discussed might immediately prompt you to want to buy the stock, it's important to consider the valuation. Shares trade at a price-to-earnings ratio of 47.4, which is close to the highest it's been in the past 10 years. This is a high-quality business, but it's priced for perfection.
I think the best course of action for investors is to add Costco to your watch list, continue to follow the company, and wait for a better entry price.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors.Neil Pateland his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Costco Wholesale. The Motley Fool has adisclosure policy.
