This Is Costco’s Secret Weapon Against Inflation

In the current economic environment, many retailers are struggling. While unemployment remains low and growth in gross domestic product (GDP) has been solid, the past few years of high inflation have eaten into consumers’ budgets.

This has resulted in headwinds for many stocks, from restaurants to retailers.

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However, in this adverse spending climate, big-box discount retailer Costco Wholesale (NASDAQ: COST) just posted impressive growth and even margin expansion. Investors can thank the company’s major competitive advantage, which allows Costco to capitalize when the going gets tough.

Retailer problems

The tough environment has affected many major retailers, especially “fast casual” brands. Take Starbucks (NASDAQ: SBUX), for instance; although the stock has done OK thanks to the appointment of Brian Niccol as CEO, the company’s recent results were dismal. Consumers appear to have soured on $6 cups of coffee and are seeking lower-cost alternatives, such as making coffee at home.

Meanwhile, retail giant Target (NYSE: TGT) saw its stock sell off recently following an earnings report; its earnings showed margins getting squeezed by high discounting and soaring supply chain costs. Target appears to be seeing heightened competition from discount retailers, as customers are still spending, but in a much more price-sensitive manner.

But it isn’t just middle-class-oriented retailers that felt the pinch of discount-seeking consumers. Even discount retailer Dollar General (NYSE: DG) has struggled with lower margins due to its economically pressured core consumer, and the heightened “shrink” (largely theft) it’s experienced recently.

But Costco is thriving

Costco, however, has managed to avoid these pitfalls. Last quarter, revenue grew a solid 7.5%, while diluted earnings per share grew 12.8%, with both figures beating expectations. While Costco’s comparable-store sales growth of 7.1% was impressive, its margin expansion in this cutthroat environment was even more so.

How has Costco done it? It’s not just that the company is a discount retailer. Otherwise, low-priced retailers like Dollar General would have seen a similar benefit.

The difference lies in Costco’s winning business model, which separates it from peers — on both the high and low ends of the retail world.

Image source: Getty Images.

Membership has its benefits

That business model is centered around membership. As a “club,” Costco charges an annual membership fee for access to its stores. But although the membership price just went up as of Sept. 1, a basic Gold Star membership is still just $65 annually. That isn’t very much money for an entire year of access to the wide variety of deeply discounted items that Costco sells.

From a financial perspective, Costco’s membership revenue accounts for just over half the company’s operating income, assuming membership fees are pure profit. In the recently completed fiscal first quarter, which ended Nov. 24, membership fees amounted to 53% of Costco’s overall operating income.

That membership subscription revenue in turn allows Costco to sell its goods at razor-thin margins. Stripping out membership subscription revenue as part of operating profits, Costco’s product-only operating margins were a mere 1.7%. That’s really hard to compete against.

The thin margins at which Costco operates are of course a result of low prices, but they’re also due to its investments in security and in a better customer experience. For instance, the company is known for paying its employees far better than other low-priced retailers, and actually raised wages in July. That in turn enables Costco not only to offer hard-to-beat prices, but also to avoid the theft that Dollar General is experiencing. Even with increased employee wages, overall margins went up as the company continued to attract more and more members.

The better customer experience also means Costco isn’t just for cash-strapped, lower-income consumers. In fact, it also attracts well-to-do consumers who still appreciate a good deal. This is why it’s been able to attract merchants one wouldn’t normally associate with a “discount” retailer, including jewelers and cruise lines, and “premium” brands like Peloton Interactive — which just signed up as a vendor.

This is why Costco recently hit $1,000

Some might balk at Costco’s sky-high valuation, trading at 58 times earnings, with its share price recently hitting the $1,000 mark. However, the recent challenging economic period has shown that when times get tough, it can continue to thrive by picking off price-sensitive consumers and stealing market share from other retailers. For instance, while many people have pulled back from eating out due to much higher restaurant prices, Costco management noted on its recent conference call that it’s seen a surge in demand for premium meats and produce as consumers increasingly eat at home.

That’s just one example from one product line, but wide-reaching inflation is no doubt benefiting Costco across its entire product portfolio. With its “sticky” membership model tying customers to its incredible bargains, Costco’s winning business model is nearly impossible to beat.

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Billy Duberstein and/or his clients have positions in Costco Wholesale and Starbucks. The Motley Fool has positions in and recommends Costco Wholesale, Peloton Interactive, Starbucks, and Target. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.