Costco Wholesale Corporation's Worst Move in 2016

By Daniel B. Kline Markets Fool.com

Costco (NASDAQ: COST) continues to squander an opportunity by operating as if the internet has not become a major factor in retail.

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The company has proven resilient in the face of digital competitors led by Amazon (NASDAQ: AMZN). While other retailers are shuttering stores, losing sales, and generally fighting for survival, the warehouse chain has not had that problem.

Costco had a decent fiscal 2016, with comparable-store sales up 4% globally and 3% in the United States when the impact of falling gasoline prices is factored out. In addition, net income for the year was roughly the same as 2015, coming in at $2.35 billion, or $5.33 per diluted share, compared to $2.38 billion, or $5.37 per diluted share last year.

Those numbers dropped a little in the first quarter of 2017, which covers the period ending November 20. During Q1, comparable-store sales were up just 1% for the U.S., with the total company posting a 2% gain. Net income, however, came in a bit better, with the company reporting $545 million, or $1.24 per diluted share, compared to $480 million, or $1.09 per diluted share, in Q1 of fiscal 2017.

None of these results are spectacular, but in a challenging retail environment, they are acceptable. What's not seen in these numbers, though, is that by basically conducting business as usual, Costco has mostly passed up an opportunity to grow its digital business.

Costco values getting customers into its stores over having them shop online. Image source: author.

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What is Costco doing wrong?

As a membership-based business, Costco makes most of its profit (about 75%) by driving people to pay either $55 for a regular membership or $110 for a Gold Star membership, which comes with 2% cash back on purchases at the chain's stores or on its website. Once people join, they only save money if they actually shop at the chain, and those who shell out the extra $55 to be an Executive Member take that to heart.

"Executive Members now account for a little over a third of our base and a little more than two-thirds of our sales, where Executive Members are offered," said CFO Richard Galanti during the company's Q4 2016 earnings call.

That audience, a group that has a willingness to shop more at Costco, could easily be part of an expanded digital push by the company. Instead, Costco largely ignored the internet in 2016.

The warehouse club holds onto members in part because they see value in the chain's low prices and its merchandise mix. Online sales could be used to extend both of those propositions while also adding convenience as an added benefit. Costco doesn't appear to see that value, and rather than viewing digital as a way to take sales from competitors, it appears to look at online/app sales as giving its customers a reason to not visit its stores.

Galanti addressed the lack of digital focus during the earnings call. He acknowledged some issues with the company's website, but also implied that the company does not consider online sales a priority.

"You will see some differences and mostly the differences are from an offensive standpoint, not a defensive standpoint," he said. "But we look at our core business of getting you in the store still is paramount to what we want to do."

This is opportunity lost

During the call, Galanti said that in a broad sense, the internet takes sales "a little bit from everybody." That may be true, and Amazon has certainly done damage to most retailers, but Costco has a clear way to compete because its members pay to join and would likely be responsive to a better website, increased online deals, and perhaps even greater cash-back deals for Executive Members for digital spending.

Costco seems to view any effort to push customers to buy online as something that will cut down on store visits. Instead, it should be viewing any online sales it can make as a way to win business that's going to Amazon and other online retailers.

The warehouse club has done a good job of protecting its in-store business, but it has missed opportunities to leverage its user base online. Galanti said that should change at least a little in 2017 with the company improving the performance of its website and making it easier to check out.

That's a start, but it's the bare minimum for what the company should be doing. Costco could be a digital powerhouse greatly increasing overall sales by giving its members reasons to not go to Amazon or other online retailers. Not doing that just because it might cut down on store traffic was a short-sighted mistake in 2016. It needs to be fixed in the coming year, or at some point, the warehouse club may not prove to be as immune to online competitors as it has been.

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Daniel Kline has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com and Costco Wholesale. The Motley Fool has a disclosure policy.