Costco Wholesale Corporation's Best Move in 2016

By Daniel B. Kline Markets Fool.com

Costco's (NASDAQ: COST) best move in 2016 was also its riskiest. On June 20, the company parted ways with American Express (NYSE: AXP), its longtime rewards card partner. At that moment, not only did millions of cardholders see their cards go dead, the company also completely stopped taking American Express in its stores.

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That was a risk on two levels. First, it was possible that holders of the American Express rewards card would be less interested in the warehouse club's new Costco Anywhere Visa (NYSE: V) from Citigroup (NYSE: C). Second, there was a risk that new customers would not be as interested in the new card.

After some early problems with the switch where calls to Citigroup topped 1.5 million in the first few days, those fears proved to be unfounded asthe call numbers quickly settled down and what could have been a disaster turned into a very smart move.

Costco used signs in its stores to tell members about the change (along with letters). Image source: author.

Why is this a big win for Costco?

When Costco first decided to make the change, there appeared to be obvious benefits. It not only got a better deal for itself from Visa/Citigroup, customers got enhanced rewards like cash back on gas increasing from 3% to 4%. That all looked good on paper, but switching credit card providers is risky due to how consumers feel about their cards.

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"People do tend to be pretty brand loyal and hold onto their credit cards for a long time," Matt Schulz, a senior industry analyst for credit card website CreditCards.com told MarketWatch. "And AmEx, more than any credit card issuer has cultivated that sort of brand loyalty over the years."

That could have caused a problem for Costco, but according to CFO Richard Galanti, speaking during the company's quarterly earnings call in September, that simply was not what happened.

"Approximately 11.4 million American Express co-branded cards, representing about just under 7.5 million accounts were transferred over to Citi during the conversion," the CFO said during the call, which was transcribed by Seeking Alpha (registration required). "Nearly 85% of those cards were what we considered active, that is the card had been used for purchases over the previous 60 days. Currently, over 85% of the accounts transferred over have now been activated with Costco."

Basically Costco has moved the entire base of customers who actually used its credit card over to the new one. It has also, according to Galanti,seen 1.1 million members apply for the new Visa card with 730,000 new accounts being activated. "... we are beating our initial expectations in terms of conversion, usage and new sign-ups to the card," he said.

Costco threaded the needle

The warehouse club was able to pull this off because its customers are more loyal to the chain than they are to any credit card provider. It also helped that the new rewards program not only upped the gas giveback, but also moved the restaurant and travel cash back from 2% to 3%. Perhaps most importantly, the Visa card offers 2% cash back on all purchases at Costco, up from 1%.

People clearly liked it and while Costco did see its United States renewal rates tick down a very small amount in Q1 and Q2, it has still grown its overall membership base steadily. In addition, even those small declines have now been reversed and the CFO said during the call that the company is past any difficulty from the switch. He laid out how the move was a double win during the call.

"In terms of increased cash back rewards, the estimate is about a 40% to 50% improvement in the reward program," Galanti said. "And it's also great for us in terms of driving member value and sales over the next years and of course lowering our effective costs of accepting credit and debit cards."

Costco's customers get more cash back and the company makes more money while also having a more attractive product to offer prospective members. It was a risk, but it's one that paid off handsomely and will turn out to be not just the chain's best business moves of 2016, but one that should pay off for years to come.

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Daniel Kline has no position in any stocks mentioned. He enjoys the Tina Fey American Express commercials. The Motley Fool owns shares of and recommends Costco Wholesale and Visa. The Motley Fool recommends American Express. 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.