Why Membership Fees Are So Important to Costco Wholesale Corporation

By Markets Fool.com

Source: Costco

Continue Reading Below

Costco moves an amazing $110 billion of merchandise through its 700 warehouses around the world. It is the second biggest retailer in the United States, below onlyWal-Mart -- despite the fact that Wal-Mart has 10 times as many stores.

And Costco has been snatching market share from that retailer, in addition to other rivals, for years now. Costco grew comparable-store sales by 5% or better annually since 2011.

But those retailing wins are secondary to Costco's real goal: building up its lucrative membership income.

A club, not a retailer
Membership revenue totaled $2.4 billion last year, up 6% from 2013. Meanwhile, Costco booked $3.2 billion in total operating profit. So, subscriber fees accounted for 75% of earnings, which shows why its more useful to think of Costco as a membership club rather than a retailer.

The company can boost its fee haul by just raising the annual membership price. But there are severe limits to that strategy, and the company doesn't employ it very often. Instead, management raises membership income through three complementary goals: growing the subscriber base, increasing the penetration of executive members, and improving member renewal rates. Let's take a look at how Costco is doing on each of these metrics.

Continue Reading Below

Many more members
The membership base is growing at a healthy clip. Paid cardholders stood at 31 million in 2009 and reached 42 million last year, for a 37% gain in just five years.

Source: Costco financial filings

The biggest driver of membership growth is new warehouses. And the company has a busy year ahead on that score. It is opening 14 locations this quarter, including four in the United States. After that, Costco is scheduled to open as many as 18 new warehouses from September through the end of 2015.

The executivetreatment
Executive members pay twice the standard annual fee, or $110 per year. In exchange, these customers get a rebate of 2% on all their Costco spending. That kickback shows up as a drag against the company's sales. However, Costco's business still benefits overall as executive members pay more for their subscription and also spend more per year than do regular members.

The percentage of Costco shoppers who are executive members climbed to 39% last year, up one percentage point over 2013. This customer group made up less than 25% of the shopper base as recently as 2007. Management expects the penetration of executive members to keep rising toward 50%.

Spiking customer loyalty
But membership renewal rate is the one metric that best reflects the strength of Costco's business. That's because members will cancel their subscriptions if they aren't receiving enough value for their membership. It's more or less a direct measure of shopper satisfaction.

And Costco's renewal rate is nothing short of stellar. In fact, the percentage of customers who are reupping has risen in each of the last five fiscal years. It now sits at a record-high 91%.

Source: Costco financial filings

Keep in mind that those five years also included a dramatic shift in Costco's membership base toward executive membership. So, not only has a large portion of customers volunteered to double their annual fees, but the shopper base as a whole has at the same time become significantly more loyal.

Foolish bottom line
With record growth in these three metrics, it's clear why Costco's stock is sitting near an all-time high while other retailers are struggling. These membership wins have powered hefty sales and profit gains over the last few years. But more importantly, the trends point to strong, predictable growth in fee income over the decade ahead.

The article Why Membership Fees Are So Important to Costco Wholesale Corporation originally appeared on Fool.com.

Demitrios Kalogeropoulos owns shares of Apple and Costco Wholesale. The Motley Fool recommends Apple and Costco Wholesale. The Motley Fool owns shares of Apple and Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.