4 Problems With Costco's Business Model (COST)

Costco Wholesale Corporation (NASDAQ: COST) is a solid performer. Over the past five years, the company's share price has more than doubled. On top of this, Costco offers its investors a $1.60 dividend (1% yield), but there is more to the story. The company has a unique business model that could impact its long-term outlook. At its most basic, Costco's business model is to keep prices so low that they are barely above cost and make up on lost potential revenue by selling memberships. The company also sells some of its own brands and makes a little more on these items. In a nutshell, it makes its money off of those memberships. It offers some things online, but the bulk of its business is in-person, in-warehouse sales.

So far, Costco has been very successful in this regard. The company boasts a membership renewal rate of over 90%. Last year, its members paid roughly $2.5 billion in membership fees, which is about 17% of Costco’s $15.13 billion gross profit last year and over half of the earnings before interest, taxes, depreciation and amortization (EBITDA) of $4.78 billion. In turn, this means that Costco's revenues are fairly stable, but there are risks to using this business model.

One of the biggest problems with Costco's business model is its dependence on memberships. This strategy works well as long as its members keep coming back and continue purchasing items in bulk as they have historically, but several issues could affect that trend. Customers could choose to move their memberships to a competitor, such as Walmart's Sam's Club. The costs are roughly the same for membership, and the discounts are fairly similar. The only real difference is selection, and that is tied to consumer preference. If the range of products changes, Costco could lose out. Also, Costco competes against specialty retailers, such as Office Depot, Petsmart and Whole Foods. Customers looking for these products may prefer those retailers' products over those of Costco.

Right now, most retailers are adopting an omnichannel focus. Customers use different connected devices to shop online, research products and compare prices. While Costco's emphasis on the warehouse allows the bulk discount retailer to keep prices very low, it does not really translate to the type of omnichannel experience many customers expect now. Costco is making some investments towards that goal, but there is no guarantee that those efforts will be successful or that the changes will be implemented in time for the company to remain competitive.

When buying in bulk, transporting everything home can be a real problem. For people in urban areas who may be unable to park near their buildings or families with young children who may find transporting bulk goods too much to handle, it can be a real issue. Costco offers some online services, but there are other discount bulk providers such as Amazon's Prime service and the newcomer, Jet, that offer similar deals and free shipping. Amazon offers free two-day shipping and a Prime Pantry service for $99 per year (in addition to other benefits, such as streaming video), while Jet does not have a membership fee and has many deals that are similar to those Amazon offers.

Changing consumer preferences could affect Costco as well. The company uses a warehouse approach. It buys certain items in large quantities and tries to get them sold as quickly as possible, but it only works if it can maintain those high volumes. If customer preferences change, Costco could be left with large amounts of unwanted, and possibly perishable, goods.