Costco membership stores don't want to fall behind

The "Matthew effect" of membership stores has begun to emerge. This is a breakthrough contest of comprehensive strength of supply chain system, unique product system (private brand system), operation system, and member rights system.

Even a strong company like Costco has to struggle for its livelihood.

Since the second half of 2023, news about Costco's crackdown on membership cards has intensified. In the first half of this year, incidents of people being kicked out of Costco for using family membership cards frequently appeared on social media in the United States, Canada and other places.

One consumer said: "I use my mom's card and they won't let me shop, that's why I prefer to go to Sam's."

At the same time, Costco will begin to increase membership fees in the United States and Canada on September 1. Taking Canada as an example, the annual fee for its Gold Star members will increase from the current 60 Canadian dollars to 65 Canadian dollars, and the annual fee for executive members will increase from 120 Canadian dollars to 130 Canadian dollars.

It is worth noting that at the end of 2023, Costco's Chief Financial Officer Richard Galanti also made it clear that membership fees would not increase in the near future.

In just half a year, what happened to cause Costco to change its attitude?

Costco's third-quarter financial report for fiscal year 2024 showed that merchandise revenue was US$57.39 billion, up 9.1% year-on-year, lower than the expected US$58 billion, and membership revenue was US$1.12 billion, up 7.6% year-on-year, lower than the expected US$1.13 billion.

This report card of "year-on-year increase but lower than expected" is actually mixed, especially the "month-on-month decline" released a relatively dangerous signal, that is, compared with the total revenue of US$58.442 billion in the second quarter of fiscal year 2024, the quarter-on-quarter decline was 1.80%.

The core reason for the volatile performance is that the growth of the number of members has entered a stable period, but the external environment is full of uncertainties and the rapidly changing consumer demand has put Costco, which does business around goods and members, under great pressure;

If Costco wants users to continue to feel that its products and memberships are worth the money, it can only do so through continuous product innovation and supply chain optimization to meet member needs. This also means that Costco, which has already squeezed its profits to the extreme, does not have much "way out."

"Everything is changing so fast that companies don't know which consumer habits will remain and which will be abandoned." CNBC senior financial reporter Evelyn Cheng once pointed out the market challenges faced by the global retail giant.

As of fiscal 2023, Costco has 861 stores worldwide, nearly 600 of which are located in the United States.

Although Costco has been able to reduce costs and increase efficiency by leveraging its scale advantages in the United States and Canada, it has turned its focus from the global to the domestic market. Since entering China in 2019, it has only 7 stores, which is obviously lagging behind its peers Sam's Club and even the M membership store, which has opened 5 stores in just over a year (the Jiaxing store opened at the end of August).

Image source: Costco official website

At present, the challenges Costco faces in China are obviously greater than the opportunities. The recent news that Costco plans to install scanners in stores and take the lead in implementing card scanning in Shanghai stores also shows that it does not want to fall behind and is trying to select and leverage a larger space for membership growth.

1. Performance that did not meet expectations

Looking back over the past year, Costco's performance has repeatedly failed to meet market expectations. Specifically:

In the third quarter of fiscal year 2023, revenue was US$53.648 billion, up only 1.9% year-on-year, and net profit was US$1.302 billion, down 3.8% year-on-year;

In the second quarter of fiscal year 2024, revenue was US$58.44 billion, a year-on-year increase of 5.7%, and net profit was US$1.74 billion, a year-on-year increase of 18.36%;

In the third quarter of fiscal year 2024, revenue was US$58.52 billion, a year-on-year increase of 9%, and net profit was US$1.68 billion, a year-on-year increase of 29%.

Costco's performance trend. Chart by: Lv Xinyi

Although revenue fell short of expectations in each quarter, the reasons given by Costco were different: members' demand for high-profit products declined; non-essential items showed a weak trend; members began to buy more non-essential items, but sales of essential items fell slightly.

The paid membership system is a characteristic of warehouse membership stores, but it is not its core competitiveness. Costco's driving force for running a closed business loop is to "create incremental value for members", but if it wants to continue to attract new members and keep old members willing to renew their memberships, it is inseparable from the comprehensive competition of the supply chain system, the unique product system (private brand system), the operation system, and the member rights system.

Taking the creation of private brands as an example, Costco's private brand Kirkland was initially established due to the rising prices of brand-name goods, which provided an opportunity to develop private brands. So far, Kirkland has covered 14 major categories of goods, such as coffee, cheese, nuts, clothing, cleaning supplies, kitchen supplies, health products, hardware products, beauty products, etc.

Image source: Costco official website

Through cooperation with suppliers around the world, once high-quality products with market potential and room for price reduction are found, they will be developed by themselves. At the same time, the company adheres to the principle of low prices for its own brands, which are 20% to 30% lower than brand substitutes, and the gross profit margin will not exceed 14%.

Costco once explained that the reason for opening a chicken processing plant was that it observed that external suppliers could not meet the needs of members. Therefore, Costco, which failed to find a high-quality and core partner in the chicken field, had to do it itself at a high cost.

Similarly, "when we saw the price of optical lenses going up, we opened an optical grinding plant," said Costco CEO Ron Vachris.

Although creating private-label products can increase the gross profit margin of products, it is not the core logic of Costco's profitability. On the contrary, one-third of the products are private-label, which means that Costco must always keep in sync with its members in terms of consumer insights and product development and innovation. The investment in supply chain construction and business management cannot be underestimated.

In addition, Costco is also facing the current situation of increasing labor costs for value-added services. Currently, the price of home appliances and furniture sold by Costco includes the cost of the entire chain of services such as delivery, installation, and transportation.

Ron Vachris stated at the third quarter earnings conference for fiscal year 2024 that the reason for the sharp increase in net profit in that quarter was driven by the delivery of home appliances, furniture and outdoor products purchased by Costco members.

Costco's business model is undoubtedly successful. As the leader in the global membership store industry, thanks to its efficient operations and management, Costco has been able to ensure a low expense rate (basically fluctuating around 10%) for many years. Compared with its peers, Walmart's is 20.7%, BJ's Wholesale Club's is 15%, and Target's is 19.8%.

In other words, Costco's core competitiveness lies in its high operational efficiency and low operating costs.

However, at present, Costco is constrained by unstable operational efficiency and high operating costs in emerging markets, not to mention that today's consumers are more "picky" than ever before. The fleeting and diversified consumer demand forces Costco to be prepared for danger in times of peace. Only with forward-looking thinking and strategic vision can it better predict future trends.

2. Is the re-mentioning of price increases a helpless move or an inherent tradition?

In just 8 months, Costco's attitude changed dramatically from "not considering price increases" in December 2023 to "it's only a matter of time before prices increase" in March 2024 and then to clearly stating that prices will increase in July 2024.

Costco's tradition is to increase membership fees every 5-6 years. The last price increase occurred in 2017, which is 7 years ago. In the turbulent environment from 2020 to 2022, Costco has not mentioned the increase in membership fees. Now that consumer demand has entered a stage of gradual release, according to convention, it is indeed time to put "price increases" on the agenda.

But judging from the above performance, another main theme behind the price increase is: Costco needs to re-examine the net profit income brought by membership fees.

From the third quarter of fiscal year 2023 to the third quarter of fiscal year 2024, Costco's membership fee revenue was US$1.044 billion, US$1.509 billion, US$1.08 billion, US$1.11 billion, and US$1.12 billion, respectively.

In contrast, Sam's Club's membership hit a record high this quarter. It can be seen that, except for the sharp increase in membership fees due to holiday demand in the fourth quarter of fiscal year 2023, Costco's membership fee income also showed a fluctuating and slightly upward trend, and the curve was too stable.

Costco membership fee income performance Chart by: Lv Xinyi

Although membership income cannot cover operating costs, overall, the increase in membership fees is both an inherent tradition of Costco and a necessary condition for it to achieve profitability.

First, although Costco's revenue comes from commodity sales (on average) for more than 95%, its business model determines that the gross profit margin of this business remains at around 11%. In comparison, domestic chain supermarkets maintain a gross profit margin of more than 20% (taking A-share listed supermarket companies as an example). Although commodity sales cannot bring a higher profit margin, membership fees make up for the profit shortfall to a certain extent.

Secondly, Costco Asia President Zhang Sihan once shared that membership fees can reduce operating costs, and membership fees can be used to offset basic expenses, further helping to reduce product sales and attract more members.

It can be seen that membership fees are not only pure profit income, but also the core of feeding back the gross profit of commodity sales. The increase in membership fees will help Costco gain more cash flow "initiative", continue to create incremental value for members, and speed up the business flywheel.

It is worth mentioning that, judging from the current "loyalty" of Costco members, the impact of price increases on its scale may be "minimal." The third quarter financial report for fiscal year 2024 showed that global customer traffic or shopping frequency increased by 6.1%, and the average transaction price or customer traffic increased by 0.5%.

At the end of the third quarter, the renewal rate in the United States and Canada was 93%, up one-tenth from the end of the second quarter. The membership rate worldwide was 90.5%, the same as at the end of the second quarter.

Currently, the renewal rate of Costco members is stable, and the frequency of consumption has increased significantly, proving that the "binding" between members and Costco is becoming deeper and deeper.

But the challenge is that higher membership fees correspond to higher requirements. If Costco wants to continue to maintain a renewal rate of over 90% in the long term on the basis of price increases, it must show more sincerity and strength.

3. One step slow, every step slow

Costco’s current instability stems from frequent changes in demand, which lead to increasing back-end costs. Only by expanding the scale of the front end and continuously increasing the membership base can the performance pressure be alleviated.

This path is even more difficult to achieve in the country.

Judging from membership fees alone, although Costco has not yet announced the number of members in China, due to factors such as its late entry into China, slower expansion, and differences in population structure, the growth in the number of members in China is basically difficult to match that of Sam's Club.

First, Sam's Club has already entered Shanghai, Nanjing and other cities where Costco has expanded, and has gained first-mover advantage; second, since the domestic population structure and purchasing habits are quite different from those in Europe and the United States, domestic consumers basically do not "cross-hold cards", and Sam's Club's early expansion means that it has firmly bound most of the target groups.

From the perspective of localization, Costco's appeal to members is difficult to compete with Sam's Club. Currently, Costco still chooses to operate in "remote suburban" locations in China, opening larger stores at lower prices.

Zhang Sihan once said that Costco's ideal land area is about 50,000 square meters, of which 20,000 square meters are used for store operations, and the remaining 30,000 square meters are used as an open-air ground parking lot to meet the demand for 1,500 parking spaces.

Photo: Costco Suzhou store

However, shopping in the "external suburbs" does not conform to the domestic consumers' preference for "everything delivered to home" and "a quarter-minute convenience circle". This is one of the reasons why Sam's Club opened its new store in the central area of ​​Shanghai. Only by being more in line with local consumption habits can it accumulate more user groups.

Being a step behind Sam's Club, Costco missed out on a large number of potential members. A more dangerous signal is that starting late also means a slow process of supply chain construction. If the supply chain costs and terminal prices cannot be reduced in a short period of time, members will be lost.

In the end, one step slow means every step is slow.

The products currently sold in Costco's seven stores are highly dependent on imports. Only categories such as fresh food and produce use local supply chains. Its core large-format packaged categories, personal care, food, clothing, etc. all come from the global supply chain, the closest of which is also built in Taiwan, China.

The logistics and distribution costs from Taiwan to the world are high. Currently, most of Costco's stores are concentrated in the lower reaches of the Yangtze River, perhaps to reduce logistics pressure.

Perhaps due to supply chain constraints, or because it has not yet fully understood the Chinese market's demands and is unable to make local adaptations, Costco has been slow to release expansion signals in China.

On the surface, Costco will accelerate its domestic layout after 2023, opening its first stores in Hangzhou, Ningbo and Suzhou in 2023, and opening an authentic American-style store in Nanjing in 2024.

But in fact, the current 7 stores were confirmed as early as 2021. In July 2021, Costco China officials made it clear that the first store in Nanjing would open in Jiangning High-tech Zone, and also "spoiled" all Costco membership services.

However, there has been no official confirmation of store openings in the market since 2021. Judging from the previous store opening speed, it may be difficult to see Costco's eighth store in China in the next two years.

In other words, Costco cannot increase its membership through store expansion in the short term and reduce supply chain costs through scale development. Costco, which is already constrained, has released the signal of "Shanghai pilot card scanning to enter the store", strictly enforcing membership cards through multiple verification methods, aiming to increase the card application rate.

However, most of the limited middle-class customers will not choose ALL IN between Costco and Sam's Club, and will only pay for one. What's more, there are local players such as M Membership Store in the Yangtze River Delta region who are eyeing them.

In the United States and Canada, Costco and Sam's Club are competitors at the same table, but in China, Costco does not want to fall behind, and the first lesson is to speed up the resolution of supply chain and product localization issues.

Author: Lv Xinyi Editor: He Xiang Producer: Retail Business Finance ID: Retail-Finance
This article is written by the author of Operation Pie [Retail Business Finance], WeChat public account: [Retail Business Finance], originally created/authorized to be published on Operation Pie. Reproduction without permission is prohibited.

The title image is from Unsplash, based on the CC0 protocol.