Costco Wholesale Case Study

Executive Summary

Costco Wholesale is recognized as the largest wholesale club operator in the US. Over the three-year time period of 2002-2004, this company has expanded its membership base while increasing its number of warehouses both in the U.S. and internationally. In 2004 alone, net sales increased 13.1% over the prior year, driven by an increase in comparable sales of 10% and the opening of twenty new warehouses; net income increased for fiscal 2004 by 22.4%, or $1.85 per diluted share; and for the first time, the Board of Directors declared a quarterly cash dividend, with the company issuing quarterly dividends in the third and fourth quarters of $0.10 per share. Costco's ROE remained stable year-over-year from .11 in 2003 to .12 in 2004. The company has maintained a steady profit margin, shown solid liquidity ratios, and experienced minimal solvency issues. These factors will continue to give Costco the ability to provide quality products at low costs to its customers, and as a result, we would recommend purchase of this stock because it presents a low risk opportunity to diversify one's portfolio.

I. Introduction

Costco Wholesale is the largest wholesale club operator in the United States. Operating 415 stores in 36 US states, Puerto Rico, Canada, Japan, South Korea, Taiwan, and the UK, Costco offers discount prices and on average, 4,000 products ranging from alcoholic beverages, appliances, pharmaceuticals, furniture, tires and fresh food. Select clubs also offer services such as car and home insurance, mortgage and real estate services, and travel packages. In 2004 alone, Costco opened over twenty new warehouses.

Costco Wholesale requires that its customers be members, a privilege requiring payment of an annual fee. At the highest tier of membership, "Executive" members can purchase additional Costco services such as insurance, mortgage services, and long-distance phone service at reduced rates. The company has had great success retaining its members - at all levels of membership - with an annual renewal rate of 86%. By charging a member fee, the company is striving to reinforce customer loyalty and provide a steady source of fee revenue.

Costco is constantly looking at other types of businesses that will fit well within the Costco model and as a result, it has opened two Costco Home stores featuring high end furniture and accessories. Costco is also regarded as the best priced pharmacy in the US market, and has experienced steady growth in its food courts. In addition, the Optical, 1-Hour Photo and Hearing Aid centers all showed double-digit gains last year.

The E-commerce business at Costco.com showed an increase of 66% over prior year's sales, and ancillary businesses continue to set Costco apart from the competition by bringing members in more frequently.

Since its initial public offering in 1985, Costco Wholesale has shown steady growth while at the same time maintaining strong performance. Its current model and projected activities leaves Costco poised for success.

II. Research Results

As mentioned above, Costco is recognized as the largest wholesale club operator in the US, ahead of its largest competitors Wal-Mart and Sam's Club. The three largest companies in the industry (including Costco) are all stable and have financially sound operations. This indicates the strength of a solid industry.

A review of the letter to shareholders shows a clear and concise statement of Costco Wholesale's current activity and future plans. It is clearly an exciting time for shareholders with fiscal year 2004 showing record sales and profits. The company has opened 20 new warehouses worldwide; and has declared its first-ever quarterly cash dividend. In addition, sales grew by 10% this year, which was an improvement from 2003's increase of 5%!

Paraphrased by Costco's Chairman of the Board and President as "To bring the highest quality goods and services to market at the lowest possible prices, and to obey the law, take care of our members, take care of our employees, respect our suppliers and reward our shareholders," Costco's mission statement exemplifies the way the company chooses to make decisions and conduct its daily operations. For example, one of the focuses this year was on adding staff at the front-end registers which makes for a more enjoyable shopping experience by its members.

The company has done extensive research into placement of its new locations. Research and history showed that its strong markets can successfully support many additional Costco warehouses and as a result, most new stores were added to existing markets.

In fiscal year 2005, Costco plans to open between 22-25 new warehouses worldwide, and hopes to double the number of warehouses within the next 10 years. In addition to the physical locations, Costco.com, its "virtual warehouse" is projected to become a $5 billion business, and if sales continue to grow anywhere near the 66% growth in 2004, this goal is entirely possible. In 2004 it also rolled out the E-commerce order stations in the warehouses to enhance the top-notch, special-order kiosk offerings.

Costco also plans to continue to be one of the leading dealers of fine diamonds nationwide. Its expansion of the Kirkland Signature private label, a label that has a reputation for quality and value among Costco members, is projected to continue, with the newest addition being the development of a Shiraz wine.

According to the letter to shareholders, all of Costco's merchandise strategies are designed to help it give its members the highest quality and best values in the marketplace. To exceed member expectations is a constant goal. With 23.4 million member households, this is a very important goal. Membership renewal has been extremely strong at 86% overall, and 93% for Executive members.

Even with all of the recent expansion, Costco has been able to maintain a solid bottom line with increasing sales and rising stock value. Management does not expect that the current expansion plans, although aggressive, will interfere with its cost-cutting initiatives. Expenses showed improvement in 2004 and are expected to also show improvement in 2005.

While considering an investment in Costco Wholesale, it is important to note the highlights and key items from the Management's Discussion and Analysis of Financial Condition. Costco's model can be summarized as a company with rapid inventory turnover, when combined with the operating efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in its model