What Is Costco's Competitive Advantage?

When a consumer pays $55 or $110 a year to join Costco (NASDAQ: COST) he or she has to actually shop there to gain value from the membership.

In most cases, once the new member spends a year actually doing that, he or she has saved enough money (or at least believes that to be the case) to make renewing an easy decision. Even when a customer does not actually take advantage of the membership, good intentions to do better next year can lead to a renewal as well.

It's a loop that has benefited the fitness industry for as long as gym memberships have existed. If a consumer actually uses the gym, the monthly fee is money well spent. If he or she does not, the same underlying logic that caused the person to join in the first place (weight loss, a desire to get fit, heath concerns, etc.) keeps him or her from quitting.

For the most part, you can't work out a gym where you are not a member and you can't save money shopping at Costco if you don't join. And yes, there are guest passes for gyms and backdoor ways to shop at the warehouse club. But in a broad sense, paying for membership strengthens the consumer's ties to the brand while the underlying value proposition either increases usage levels or produces guilt about leaving. That creates a competitive advantage for Costco that only a few other retailers can compete with.

People must join Costco to shop at its stores (though there are a few exceptions). Image source: Costco.

Costco is not alone in this model

The warehouse club's membership model works a lot like Amazon.com's (NASDAQ: AMZN) Prime program. Consumers pay the online retailer $99 a year (or $10.99 a month) to get access to free, two-day shipping, the company's streaming video service, and a host of other perks. Because those customers have to pay a fee up front, many are more inclined to buy from Amazon.com than non-members.

Research from Consumer Intelligence Research Partners (CIRP) shows that the 65 million United States Prime members it believes Amazon had at the end of Q3 2016 spent "on average about $1,200 per year, compared to about $600 per year for non-member customers." It's hard to know if people join Prime because they already use Amazon a lot or if the membership causes them to use it more, but it's almost certainly a bit of both.

Getting free shipping makes buying from Amazon feel like a better value and the more you use it (as long as you are buying things you would have purchased elsewhere) the more you save. The same is true of a Costco membership -- especially the $110 Executive Membership, which gives customers 2% back (up to $750 a year) on eligible purchases -- and the warehouse club has experienced something similar to what CIRP learned about Costco.

Executive Members represent a little over a third of Costco's membership base but account for about two-thirds of its sales. That's something CFO Richard Galanti brought up in the company's Q2 2017 earnings call when he also noted that the company had a 90.2% renewal rate in the U.S. and Canada, which he called "basically flat and certainly in line with normal results."

This keeps Costco strong

Costco does offer low prices, and joining, especially paying for the Executive Membership, is a good way to save money for many people. Once the chain has a customer, it's likely to hold onto him or her, because of the promise of what it offers, and the increased future savings it represents.

The more someone shops at Costco, the more he or she will value the membership. But even if a customer doesn't shop enough to get $55 or $110 in value (rising to $60 and $120 in June) he or she may still renew because the onus for not saving money falls on the individual, not the retailer (just like it's not the gym's fault you did not workout).

For a rival chain to break Costco's cycle it would have to offer similar pricing without charging a membership fee while also spending money to communicate it was doing that. It's hard to imagine anyone even trying that because most of Costco's profit, about 75%, comes from membership fees.

That means any competitor matching Costco's prices, while spending to market its brand without taking in membership revenue, would be a money-losing proposition until it built up a significant amount of market share. Costco likely has nothing to fear in that regard and its membership model should continue driving steady revenue and impressive renewal rates even as countless other retailers struggle.

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