What Do Membership Fees Mean To Costco?

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More than any other retailer,Costco Wholesale(NASDAQ: COST) has come to define the membership model. Its giant warehouses are only open to members who pay $55 a year for the privilege of shopping at its bargain-priced, bare-bones depots.

Thanks to its membership model, Costco has become the #2 retailer in the country, with 2015 revenue of $113.6 billion. Membership fees contributed $2.53 billion in its most recent fiscal year, or just 2.2% of its total revenue; however, the power of its membership model goes well beyond the top-line fees it generates.

A loyal customer base

Costco has one of the most dependable customer bases in retail. Its membership renewal rate was 91% in the U.S. and Canada last year and 88% globally. Those members spend about $2,500 on average.

Costco offers individual and business memberships for $55, and executive memberships, which come with additional benefits such as 2% cash back, for $110. It closed last year with 34 million individual members and 10.6 million business members. 39% of cardholders are executive members, up from 38% the year before, and executive members spend more than regular members, making up two thirds of sales, a trend that should help profitability in the future.

Straight to the bottom line

The most important factor about membership fees is that they go straight to the company's bottom lines. Costco operates its warehouses on essentially a breakeven basis, making its profits on memberships instead of merchandise. Last year, for example, net income was $2.38 billion, just shy of the $2.53 billion it brought in in membership fees.

Costco's bargain-basement prices are also visible in other parts of its financial reports. The company's gross margin, or the percentage of its sales it keeps after accounting for direct costs like the cost of products, labor, and occupancy, was just 11.1%. By comparison, low-priced rivals likeAmazon.comandWal-Marthave much largers gross margins than Costco. Amazon's is 34.4% and Wal-Mart's is 25.3%, illustrating the uniqueness of Costco's model.

The membership fee also incentivizes Costco customers to spend more at its stores and increase the frequency of their visits to take advantage of their memberships. Amazon has found similar success with Prime, its own membership program.

Unlike Amazon, however, Costco's entire business model is built on memberships. Costco considers membership loyalty and growth to be "essential to our business model."

The company's best strategy for driving profits higher may be to sell more executive memberships. At $110 a pop, those memberships bring in twice the revenue of standard Gold Star memberships, and encourage customers to spend more.

One additional benefit of the membership model may be that the attractiveness of Costco's low prices means it doesn't need the same store footprint as Wal-Mart, which has blanketed the country with Supercenters. Costco's advantage can be seen in the fact that its stores generate double the sales per square foot that Wal-Mart's do.

For now, Costco's membership model seems solid, with a North American renewal rate of 91%, but the rise of e-commerce could present a threat. The company has resisted basic features like in-store pick-up, as management wants to drive traffic through the store rather than encourage a trip to a single counter -- but as Amazon Prime continues to gain in popularity, it could present a threat to Costco.

Going forward, membership renewal rates and fee growth will continue to offer a window into the company's future. If renewal rates begin to slide, Costco may have to rethink its value proposition.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com 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.