Costco (NASDAQ: COST) is the largest warehouse club retailer and the second largest general retailer in the United States.[1] Costco sells food and general merchandise, including appliances and other household goods, in bulk and at heavily discounted prices. It operates 527 membership warehouses, 80% of which are located in the United States.[2] Costco's two main competitors are Sam's Club and BJ's Wholesale Club (BJ), both of which have similar business strategies to Costco. The company earned $76.3 billion in revenue in 2010, a 9% increase from a year earlier. This increase in growth was driven by a 7% increase in comparable store sales.[3]

Costco's business strategy providing items in bulk and at low prices help the retailer maintain positive growth during slow economic times. Price conscious consumers gravitate toward discount retailers like Costco, hoping to get the most out of their money. As a result, Costco's bottom line has fared well since the economic slowdown. For example in Q2 2010, despite increasing signs that the economy was emerging from the recession, Costco's sales increased 11% with a 9% growth in comparable store sales.[4]

Costco's biggest concern is over expansion and cannibalization of existing store locations, which the company claims was part of the negative comparable store sales growth in 2009.[3] As a result, the company has announced it will slow its domestic expansion plans, opening 7 domestic stores in 2010, down from a peak of 25 new domestic stores in 2005.[2] Costco will instead look to international markets for future growth -- in 2009 the company opened its first store in Australia and opened several new stores in already existing markets in Taiwan, Korea, Japan, UK, and Canada.

Contents
1 Company Overview
1.1 Business Segments
2 Business Growth
2.1 FY 2009 (ended August 30, 2009)[6]
2.2 FY 2010 (ended August 29, 2010)[9]
2.3 Q1 Fiscal 2011 (ended November 21, 2010)
3 Trends and Forces
3.1 Low Prices Attract Customers During Weakened Economy But Costco Faces Challenges In Recovering Economy
3.2 Mall Strategy Aids Costco's Urban Expansion
3.3 Consumers Looking For More Than Just Bulk
3.4 Overexpansion Leads to Cannibalization of Sales
3.5 Copyright Supreme Court Case Spells Trouble for Costo and Discount Retailers
4 Competition
5 References
Company Overview

Costco operates 527 locations stores of its membership-only warehouse club[2] that sell general merchandise including fresh and packaged foods, appliances, and apparel. Slightly more than 80% of the company's stores are in the U.S., with additional stores in Canada, Korea, Japan, Taiwan, and the United Kingdom.[2] The United States also accounted for almost 79% of the company's sales, followed by Canada at 14% and other international sales representing 7% of its 2008 revenue.[5]

The company focuses on selling high volumes of its merchandise at low prices at its warehouses worldwide, which together earned $71 billion in revenue in 2009.[6] This represents a 1.5% decrease in sales from 2008, which the company attributes to an 4% increase in comparable store sales and the opening of 24 new warehouses.[3] In 2010, Costco plans to open 7 net new stores all in the US.[2]

Business Segments
Costco's merchandise categories include:[7]

Sundries (23% of Net Sales): Sundries is Costco's largest segment by revenue and includes the sales of candy, snack foods, tobacco, alcoholic and nonalcoholic beverages, and cleaning and institutional supplies. In 2009, sundries represented 23% of net sales, which was a 1% increase from 22% of net sales in 2008.
Hardlines (19% of Net Sales): The hardlines segment sells major appliances, electronics, health and beauty aids, hardware, office supplies, garden and patio, sporting goods, furniture, and automotive supplies. In 2009 and 2008, this segment represented 19% of net sales.
Food (21% of Net Sales): This segment is responsible for the sale of dry and institutionally packaged foods (oatmeal, rice, cereal, etc.) The food segment is Costco's second larget segment and in 2009 represented 21% of net sales, which was a 1% increase from 2008.
Softlines (10% of Net Sales): Softlines is Costco's smallest business segment and is responsible for the sale of apparel, domestics, jewelry, housewares, media, home furnishings, cameras, and small appliances (toasters, microwaves). In 2009 the segment only represented 10% of net sales, which was the same as in 2008.
Fresh Food (12% of Net Sales): The fresh food segment is responsible for the sale of meat, bakery goods, deli and produce. It represented 12% of net sales in 2009 and in 2008.

Ancillary and Other (15% of Net Sales): The ancillary and other business segment is in charge of the company's gas stations, pharmacy, food court, optical, one-hour photo, hearing aid, and travel products. From 2008 to 2009, Costco has heavily increased the number of ancillary businesses including the addition of 16 gas stations, 15 food courts and hot dog stands, and 13 pharmacies. However due to the economic downturn and lower gas prices compared to levels in 2008, net sales of the segment decreased 2% in 2009 to 15% of net sales.
Business Growth

FY 2009 (ended August 30, 2009)[6]
Costco's net income fell to $1.09 billion in 2009, a 15.3% decrease from 2008 due to a decrease in net sales and higher SG&A costs.
Costco earned $71.4 billion in net sales, a 1.5% decrease from 2008. This was the first time that the company faced negative sales growth since 2004. The decrease in sales can be attributed to the economic downturn.
Operating margin fell to 2.5%, down from 2.7% in 2008, which was mainly due to higher SG&A costs.
Costco operated at a 10.81% gross margin, up slightly from 10.53% in 2008 due to 0.24% increase in sales higher margin categories, primarily food and sundries.[8]
Comparable store sales decreased by 4% in 2009 compared to an 8% increase in 2008. The decrease in comparable store sales were primarily due to lower average amounts spent by consumers as well as lower gas prices -- average sales price per gallon fell by 30% during the year.
The company reduced its domestic expansion plans, opening 8 domestic stores in 2009 and 7 planned openings in 2009, down from its peak of 25 new domestic stores in 2005.[2] Similar to its main competitor Wal-Mart, Costco is also vulnerable to cannibalization from existing stores because of overexpansion. For example, Costco attributes cannibalization to its slowing growth in comparable store sales since 2005. Costco's domestic comparable store sales have increased an average of 5% annually from 2005 to 2009, down from 9% in 2004.
U.S. sales decreased 0.6%, revenue from Canadian operations fell 7.5%, and Costco's other international sales increased by 1.7%.[5] This growth was primarily driven by a 6% and 15% increase in domestic and international comparable store sales each respectively.
FY 2010 (ended August 29, 2010)[9]
Costco's 2010 net income increased by 20% to $1.3 billion, a 20% increase from 2009. The higher profits were due to higher sales and strong international growth.
Costco earned $76.3 billion in net sales, a 9% increase from 2009.
Operating margin increased to 2.7%, up from 2.5% in 2009. Higher operating expenses were offset by substantially higher net sales.
Comparable store sales increased by 7% in 2010 compared to an 4% decrease in 2009. The company's rapid international growth lead to a 19% increase in international comparable store sales, compared to a 4% increase in domestic comparable store sales. Excluding the positive effects from gasoline inflation and the strengthening of foreign currencies, the company's comparable store sales increased by 4% company-wide.
The company operated 573 warehouses at the end of FY 2010, with 417 in the United States and Puerto Rico, 79 in Canada, 22 in the United Kingdom, seven in Korea, six in Taiwan, nine in Japan, one in Australia and 32 in Mexico.
In Q1 2010[10], the company's net income increased by 1.1% to $263 million. Net sales increased 5.5% to $17.3 billion while Comparable store sales increased by 3%. The total number of cardholders increased to 56 million from 54 million
In Q2 2010[11], an 11% increase in net sales to $18.4 billion lead to a 25% increase in net income to $299 million. Comparable store sales grew by 9% overall, with 5% growth in the US and 26% growth overseas.
In Q3 2010[12], Costco's net income increased by 46% to $306 million. The company's net sales grew by 12% to $17.39 billion, from $15.48 billion. Comparable store sales increased company-wide by 10%, with 6% growth domestically and 26% growth internationally.
In Q4 2010[13], the company's Comparable store sales growth was 6%, with 4% growth domestically and 14% growth internationally. Total net sales increased by 8% to $24.13 billion, leading to a 16% increase in net income to $432 million.
Q1 Fiscal 2011 (ended November 21, 2010)
Compared to Q1 fiscal 2010, net sales increased 11% to $18.82 billion.[14]
Comparable store sales increased 7%, with a 5% increase in the U.S. and a 14% increase internationally.[14]
COST realized similar growth in net income, which increased from $266 million to $312 million.[14]
Financial growth in the new fiscal year can be attributed to increased membership sign-ups, as membership fees increased from $377 million to $416 million.[14]
Trends and Forces

Low Prices Attract Customers During Weakened Economy But Costco Faces Challenges In Recovering Economy
Because of its low prices and bulk product offerings, Costco is an ideal place for customers to stretch their dollars during slow economic times. For example, the 2007-2008 recession drastically reduced the levels of dispensable income for many consumers. In 2008, Costco's sales grew by 12.5%, driven primarily by a 8% increase in comparable store sales as consumers gravitated towards Costco's low prices in the weakened U.S. economy.[15]

However, as the economy started to rebound in 2009 and continues to rebound in 2010, Costco faces the challenge of keeping the customers it gained during the recession. As consumer confidence increases and as they are more willing to spend more money on higher quality items, they will opt not to travel to Costco, or other discount retailers to buy items sold in bulk. Costco felt the negative effects of this trend as its net sales and net income decreased by 1.5% and 15.3% respectively in 2009.[6]

Mall Strategy Aids Costco's Urban Expansion
The sluggish economy and weak housing market caused many companies, especially department stores, to vacate space in shopping malls -- the vacancy rate at the end of summer 2010 was 11%. As a result, Costco has stepped in and has been buying up these empty spaces previously occupied by department stores. Although this mall strategy is in contrast to Costco's current strategy of big box retailing in stand-alone stores, Costco stands to benefit from the switch. First, it allows Costco to expand at a quicker rate because the company won't have to worry about setting up infrastructure or have to deal with community opposition in building warehouse stores. Second, it brings Costco's stores to more generally populated areas and to high-traffic areas like malls. So instead of having to drive a long distance to a strip-mall to get Costco's low prices, consumers will now have easier access to the low prices while still being able to shop at other stores under the safe roof. Costco's bottom line stands to benefit from higher traffic and more sales.[16]

Consumers Looking For More Than Just Bulk
Consumers prefer not to have to travel to different places in order to shop. One of the biggest reasons why giant retailers like Wal-Mart (WMT) are successful is because their stores are more than just a place for people to buy food -- these stores provide ancillary services like places to eat or get a hair cut. Many of Costco's stores already provide ancillary services like in-store food service, one-hour photo centers, optical dispensing centers, pharmacies, gas stations, hearing-aid centers, printing/copy centers and car washes.[1] Costco uses these services to attract customers into their stores for more than just buying bulk items -- by the end of 2009, 96% of Costco warehouse stores had food courts, optical dispensing centers and one-hour photo centers. Costco was voted as the best place to shop in the US[17] and improving on these services will help to increase traffic flow into Costco stores and will help generate sales.

Overexpansion Leads to Cannibalization of Sales
Costco's domestic comparable store sales have increased an average of 6% annually between 2005 and 2009, down from 9% in 2004.[6] Like most retailers, Costco's long term sales and net income growth depends primarily on opening new stores and expansion into new markets. However, Costco's overexpansion domestically risks cannibalizing the sales of preexisting stores, essentially competing with itself. For example, if Costco builds a store relatively close to one if its already existing stores, the new store might take away customers from the old store (a reason could be convenience) thus hampering comparable store sales -- this is cannibalization.

As a result of domestic overexpansion, Costco reduced its expansion plans since 2008 and switched focus to opening new stores in new markets internationally. For example, Costco opened 15 new stores in 2009, compared to its 2007 of 35 new stores.[18] Furthermore, in 2009 the company opened a new store in Australia and an additional 6 stores in new international markets.[19] However, due to the economic downturn and consecutive quarters of decreasing sales, the company does not plan to expand internationally in 2010.

Copyright Supreme Court Case Spells Trouble for Costo and Discount Retailers
On April 19, 2010, the US Supreme Court agreed to hear Costco's appeal in a copyright infringement dispute with The Swatch Group Ltd (UHR) unit over imported Swiss-made watches. Swatch sued Costco on claims that Costco violated copyright law in 2004, when it dealt Omega Seamaster (a Swatch Group) watches bearing an emblem that Omega had registered with the U.S. Copyright Office. Costco had purchased the watches from a series of foreign third-party sources ("grey market") and sold them for $1,299, compared to Omega's preferred $1,999 retail price.[20][21]

Luxury retailers don't want their items sold in discount stores like Costco because the lower prices take away from the high margins these luxury goods are expected to generate. Although this Supreme Court Case is based on copyright infringement, a ruling in favor of Swatch could be detrimental for Costco and other discount retailers because it may prevent them from purchasing luxury items from third-party sources. Without these third-party sources, Costco won't be able to provide luxury items at the same low prices that they are being sold for now, and would ultimately hurt the company's bottom line.

Competition

Costco is the largest retailer in the warehouse club market in terms of sales.[6] Costco's main competition is Wal-Mart's Sam's Club. BJ's, a smaller retail warehouse chain, also competes with Costco and Sam's Club. The three companies share a similar business model, selling high volumes of merhandise at low prices in a membership-only warehouse club. Each company sells a similar array of general merchandise, including food, apparel, and gasoline.

Sam’s Club is Wal-Mart's membership-only warehouse club, the second largest in America after Costco by sales. Under the membership-only system, customers pay $40 and business owners pay $35 annually for memberships to shop at Sam's Club stores. Like its parent company, Sam's Club main strategy is price leadership. The core customer base of Sam’s Club is comprised of small businesses, including convenience stores, restaurants, offices, daycares and schools, and motels. Sam’s Club management remains focused on growing this foundation and improving its relationships with small business owners. To this end, the company has expanded its offerings of office furniture and restaurant supplies. The company also has services geared towards small business, such as prescription drug plans and worker’s compensation claims billing. Sam's Club operated 596 warehouse clubs nationwide and earned $46.7 billion in revenue in FY 2010.[22]
BJ's Wholesale Club (BJ) sells food and general merchandise, including appliances and other household goods, in bulk and at heavily discounted prices. Unlike its competitors, Costco and Sam's Club, which serve small-business customers, BJ's focuses on retail shoppers and offers more grocery items as well as smaller quantities of packaged goods. BJ's operates 187 warehouse clubs across the eastern U.S.[23] In 2009, the company earned $10.0 billion in total revenues.
 
Top