Is Costco's Profit Model Viable In Today's Inflationary Economy?

Implications: As the leading membership club retailer, Costco looked to benefit as consumers looked for better deals to stretch inflation taxed paychecks.  Now declining margins from gasoline sales, higher operating costs, and increased product costs, may make the retailers fee based profit model irrelevant. 

Analysis: Costco surprised traders, warning that “4th quarter earnings would be well below analysts expectations”.  Until recently, Costco has benefited from the current economic slowdown as members bought more from the warehouse clubs to offset higher costs from inflation.  Now it seems that inflation is also eroding Costco’s profits as it fails to raise prices to offset higher product costs.  

According to Costco, earnings have been especially hurt by the escalating cost of gasoline at club stores operating gas station.  Once a profit center, gasoline reseller profits across the country have been marginalized as oil prices have more than doubled in the last 12 months.  The fact is gasoline resellers have little competitive advantage in gasoline distribution system where most of the profit is made at the wellhead.  

Higher food cost has also cut into Costco’s margins.  Evidently, the company has absorbed more of the cost increase than it passed along to its members; eroding margins in the process.  Why Costco would need to absorb that much of the increased food costs isn’t clear.  The original rationale behind the membership club profit model was that member fees in combination with low product margins gave the format a competitive advantage in the market.   

According to the Wall Street Journal, Costco’s CEO James Sinegal said company markups on non-branded products were about 14%, while branded items were marked up approximately 15%.  That was several years ago.  Now, if Costco has to absorb current cost increases to remain competitive, either the company’s ‘low’ sell prices aren’t really that low today or the fee income is inadequate.   

Given the consumer’s focus on saving, it would be logical to think club membership fees would be growing and new membership would be driving incremental sales.  However, if membership is either flat or declining, existing fee income may be insufficient to cover higher operating costs.  Either way, current consumer buying behavior and the changes in the company’s structure brings the long term viability of the profit model in to question.  

If Costco is having earnings problems, investors have to wonder what is happening to profit margins at Sam’s Warehouse Club.  A division of Wal-Mart, Sam’s operates on a similar membership profit model as Costco. While Sam’s has more outlets than Costco, it does less business.  In part the reason is Sam’s caters to a less affluent customer and sells lower price point products.  The question for Wal-Mart investors is whether Sam’s will experience the same margin problems as Costco.  

While Wal-Mart stores have clearly benefited from the bad economy, Sam’s makes up about 12%-13% of Wal-Mart’s total sales.  A material decline in Sam’s stores profitability could erase a good part of Wal-Mart’s new found earnings as gasoline, food, and other operating cost continue to increase during the 4th calendar quarter of 2008.