Costco Boosts Membership Fees, Hoping to Reverse Sliding Profits

By Dan Caplinger Markets Fool.com

Retail giant Costco Wholesale (NASDAQ: COST) has been an innovator in the big-box retail industry, pioneering and refining the warehouse-shopping concept and honing it into a hugely successful business. Yet even Costco has run into some challenges lately, and coming into Wednesday's fiscal second-quarter financial report, Costco investors wanted reassurances that the warehouse retailer would be able to sustain its growth. On that front, the retailer disappointed its investors, posting a substantial decline in net income that spurred the company to take action to shore up its main profit center going forward.

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Let's look more closely at Costco Wholesale to see how it did and what's ahead for the warehouse retail industry.

Image source: Costco Wholesale.

Costco's bottom line moves in the wrong direction

Costco's fiscal second-quarter report shocked many investors. Total revenue was up almost 6% to $29.77 billion and was only slightly below what most of those following the stock had expected to see from the retailer. But the big problem came from its net income, where Costco suffered a 6% drop to $515 million. That took earnings down to $1.17 per share, falling well short of the consensus forecast for growing earnings to $1.36 per share.

Looking more closely at the report, comparable-store sales figures improved from past quarters but remained more sluggish than most would prefer. Systemwide, comparable sales were up 3%, with the core U.S. market matching the overall figure. Canada remained the strong part of the system, posting an 8% rise in comps, but other international locations had to deal with a 2% drop that pulled down the company on the whole. Gasoline prices and foreign currency impacts have become a less severe headwind against Costco, and even after adjusting for them, the retailer saw 3% gains in comparable sales across the board except in Canada, which saw a 2% rise.

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Membership fee revenue growth also slowed slightly, marking a troubling concern for Costco. The company said that fees climbed 5% to $636 million, just barely keeping up with a similar 5% jump in overhead expenses.

The pace of expansion at Costco slowed during the quarter. The retailer opened just five new locations, including two in the U.S. and one each in Mexico, Korea, and Taiwan. The move brings Costco's total store count to 728.

What's ahead for Costco?

Perhaps in response to the sluggish growth in membership fees, Costco said it would implement a fee increase effective June 1. The new pricing scheme will include a $5-per-year annual price increase for U.S. and Canadian Gold Star, Business, and Business add-on members, bringing the new rate to $60 per year. Executive memberships in the U.S. and Canada will rise at double that rate, climbing $10 to $120 per year. Costco estimates that the increases will have an effect on 35 million members, with half of them being executive members at the higher rate. That corresponds to a potential $260 million to $265 million increase in annual revenue if all of the warehouse giant's current members stay on after the price increase.

Yet in recognition of the need to keep its executive members happy, Costco also said that it would boost the maximum limit on the 2% reward that executive members get from $750 to $1,000. That will obviously more than make up the difference in membership fees for Costco's most frequent shoppers, and the retailer hopes that the move will make those who spend the $3,000 to $4,000 per month necessary to produce that level of rewards more likely to hang onto their memberships.

Investors were not pleased about Costco's failure to produce earnings growth, and the stock fell between 4% and 5% in after-hours trading immediately following the announcement. Difficult retail conditions are bad for companies throughout the industry, but what Costco will have to prove is that it won't see a membership exodus stemming from the decision to boost its membership fees by 9%. If it can hold onto most of its members, then the move should help Costco get its bottom line moving in the right direction again.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Costco Wholesale. The Motley Fool has a disclosure policy.