Even though Costco Wholesale (NASDAQ: COST) has been one of the great success stories of American retail, it has some similarities to Walmart Stores Inc. (NYSE: WMT) that cast doubt upon its future.
Like Walmart, Costco operates big box retail stores and is heavily dependent upon the North American market. The majority of its stores, 474, are located in the United States, making the chain America’s third largest retailer. Like Walmart, Costco has experienced explosive growth for years. Its revenue has risen from $99.14 billion (€87.35 billion) in 2012 to $116.2 billion (€102.38 billion) in 2015, an increase of $17.06 billion (€15.03 billion) in just three years.
Yet as at Walmart, that growth has suddenly slowed. Costco reported a revenue growth rate of .72% on August 31, 2015, which is comparable to the .09% rate Walmart reported on July 31, 2015. That seems to indicate that both Costco and Walmart may have reached the limits of retail expansion.
One has to wonder if the North American retail market is now saturated. Several U.S. retailers, including the supermarket operator Kroger (NYSE: KR), Walmart and small box discount store operators Dollar General (NYSE: DG) and Dollar Tree (NASDAQ: DLTR), have all been expanding aggressively in recent years. Dollar Tree alone claims to operate 13,600 stores in the United States and Canada, and Dollar General, which operated 11,789 stores at the beginning of the year, has plans to open 730 new stores in 2015.
The brick-and-mortar expansion is matched and sometimes exceeded by the rate of expansion in online retail. Target (NYSE: TGT) alone is planning to spend $1 billion (€880 million) to increase its ecommerce capabilities. Walmart has added four giant new fulfillment centers to its distribution network in recent months. Some news reports claim each of those centers can hold up to 500,000 items for sale.
Why Costco Could Suffer Walmart’s Fate
Costco could suffer Walmart’s fate because it is heavily dependent on brick-and-mortar locations and big box stores. That goes against the prevailing trends in American retail, which are smaller neighborhood-based stores and ecommerce.
Costco’s standard business model is a large regional club store that requires a special trip to reach it. This makes for an efficient operation, but it is also highly inconvenient and requires the use of a car.
Foot traffic at U.S. retail stores in first quarter 2015 was 7% to 10% lower than it was in the same period in 2014, RetailNext reported. That’s ominous news for Costco, which depends heavily upon foot traffic. Costco uses a treasure hunt business model, in which it hopes customers will make additional purchases of items that they see in the store while shopping. Such a strategy only works if consumers actually enter the store.
One reason why customers are not coming in the door is the dramatic growth in online retail. Amazon.com Inc. (NASDAQ: AMZN) reported that its sales in the second quarter of 2015 were 20% higher than a year earlier. A big reason why Amazon’s sales are growing so fast is its deep discounting, which could make the Everything Store Costco’s biggest direct competitor. I recently searched online for a new printer and found the model I wanted for sale at Amazon.com for just $40 (€35.24); a similar printer at Walmart.com cost $120 (€105.73).
Costco is highly vulnerable to ecommerce because it lacks convenient neighborhood outlets like Dollar General, Dollar Tree, Walmart or Kroger. Customers that make large purchases online often turn to such stores for day-to-day shopping, such as picking up a bottle of laundry detergent. Business at such stores is increasing; Walmart reported that sales at its Neighborhood Markets increased by 4% in contrast to its overall revenue. Revenue at Dollar General was growing at a rate of 7.97% on July 31, 2015.
Costco’s big problem is that the growing segments of American retail are outside of its areas of expertise. The prospects for growth at its club stores are limited, and Costco’s online operations have lagged behind other retailers. Like Walmart, Costco could soon be forced to make expensive investments in ecommerce infrastructure and small-box locations just to remain competitive.
The situation could get worse in coming years as competitors like Walmart, Kroger and Amazon roll out new capabilities such as same-day delivery and click and pull. All three retailers have tested same-day delivery concepts in various U.S. markets. Kroger and Walmart are slowly out rolling click and pull, in which customers pick up online orders at stores in various American markets.
How Costco Could Avoid Becoming the Next Walmart
Despite the similarities, there are several reasons why Costco could easily avoid Walmart’s fate. Costco’s business model has a number of attributes that could shield it from some of the forces that are buffeting Walmart.
The crucial difference between Costco and Walmart is that Costco is a membership club. To shop at Costco, a person has to pay a yearly fee, in most cases around $55 (€48.46). In 2014 Costco had around 76 million members that added about $2.4 billion to its bottom line.
These fees provide a steady source of revenue that is not dependent on foot traffic or sales, what Warren Buffett would call float. Costco can generate this revenue without incurring expenses such as store upkeep, employee salaries or the cost of purchasing merchandise.
The membership fees are one reason why Costco was able to report having $6.419 billion in cash and short-term investments on August 30, 2015. That makes it easier for Costco to make major capital investments such as building ecommerce fulfillment centers without incurring debt.
Memberships create important psychological benefits, such as increased customer loyalty and lower rates of theft. Persons that spend money on a membership have a stronger reason to go to a store. Not surprisingly, Amazon has tried to duplicate Costco’s success with is Prime membership program.
Prime is a major threat to Costco because it increases customer loyalty and provides the convenience of shopping from home. Walmart has also hinted that it plans to launch a membership program similar to Prime in the near future.
Another critical difference between Costco and Walmart is size. Walmart operated around 4,177 stores in the United States in 2014, while Costco operated around 474 stores. This makes for far lower operating costs for Costco because of the smaller footprint. Costco’s logistics, real estate, utilities and other operating expenses are considerably lower because it generates its revenue from a smaller number of stores.
Costco also lacks some of the labor problems afflicting Walmart. The average Costco employee earns a wage of $21 (€18.50) an hour in the United States, while the average Walmart associate earns a wage of $8.81 (€7.66) an hour. Naturally, this generates bad publicity, high turnover rates and labor unrest at Walmart, which recently raised wages, while Costco enjoys good relations with employees.
Attributes such as the smaller retail footprint and membership fee income help Costco avoid cutting profits as Walmart did. Costco should remain profitable for years to come, but it will need to start changing its business model at some point if it wants to remain a major player in the world of American retail.
