Costco, the third largest retailer chain in the U.S. and the seventh largest retailer in the world, has significantly grown in the last ten years, a critical period disrupted by the great recession, e-commerce revolution, and global competition. Although a big number of retailing enterprises failed to survive the difficult challenges of the decade, Costco demonstrated an outstanding revenue growth performance over its key competitors – Wal-mart (includes Sam’s Club), BJ’s, Target, Sears, and JC Penney. However, based on an analysis of the 10-year financials of Costco and its key competitors, the profit performance of Costco has not been at par with Wal-mart and Target, although better than Sears, BJ’s and JC Penney (Morning Star, 2014a-e).
In terms of net income as a percentage of revenue, Target leads with a 10-year average profit rate of 4.3% of total revenue, followed by Wal-mart at 3.5%, Costco at 1.8%, BJ’s at 1.2%, JC Penney at 0.7%, and Sears at (0.1%). This fairly low profitability rate of Costco has been the subject of both criticisms and debates on whether or not the very discordant pace of revenue and profit growth of Costco can support the company over the long-term. The situation has raised a key question: Does Costco face serious financial problem? This paper, through a research-based study, will analyze the external and internal factors affecting the strategic potential of Costco. Based on this analysis, the paper will establish whether or not Costco has the internal strength to address opportunities, mitigate threats, and correct weaknesses. In determining Costco’s strategic vitality and available strategic options, the paper will answer the key question and will address the thesis: Costco has the internal strength to address opportunities, threats, and weaknesses, and demonstrates the potential to significantly improve its profitability and meet long-term goals.
PEST and Competitive Analysis
PEST is the acronym for political, economic, social, and technological factors, which together with competitive factors, generally make up the external context of business (David, 2005, pp. 75-87). These factors can decisively make or break the strategic health of an organization, and for this reason, must be correctly addressed on a timely basis before any serious dysfunction bedevils business performance. The political factor, which encapsulates the legal aspect, is critical to Costco in both domestic and global operations. Costco has to contend with a broad variety of opportunities and issues encompassing labor, taxes, trade policies, zoning, intellectual property rights, and other environmental factors including peace and order and pollution. Costco’s operations in 172 international locations expose the company to major political and legal threats that may be more difficult to manage, including cultural and nationalistic sentiment that usually go against foreign companies in many host countries. The economic factor is an important element inasmuch as it bears on the purchasing power of the people. When any host economy deteriorates or stagnates, Costco faces the inescapable impact of depressed demand or business slowdown due to spending restraint caused by prevailing economic hardship.
The social element wields essential influence as trends, preferences, usage, attitude, image, and other demand attributes impact the expansion, alliances, product, pricing, distribution, merchandising, service, and other initiatives of Costco due to the inter-generational context of its business. The technological factor remains a paramount component that relentlessly brings about change as it integrates with what the consumers want in terms of product, service, and promotional values, or in the overall quality Costco offers in its relationship with the customer. The e-commerce phenomenon, and its online shopping adjunct, presents a strong technological imperative for Costco to manage and leverage on. Additionally, competition is another key external factor that can rock the business foundation of Costco considering the mix of equally capable and large retailers similarly strategizing for Costco’s extinction. Based on the overall PEST and competitive analysis, Costco competes in a volatile business environment that is highly susceptible to economic dysfunctions, vulnerable to political and legal risks, sensitive to social changes, contingent on technology, and wide open to fierce competition from existing players.
Porter’s Five Forces Analysis
The Porter’s Five Forces analytical model presents five basic competitive forces that can be analyzed to provide indicative signs of the nature of competition in a particular industry, and the profit potential in that industry (Porter, 1980, pp. 3-33). The model provides an index of the strategic attractiveness for the warehouse club industry where Costco operates.
Potential entry of new competitors
In the warehouse club industry where Costco operates, the potential for entry of new competitors is low because of high entry barriers. To create market impact and a highly competitive start-up operation, a new industry entrant will have to put up massive capital investments, satisfy large requirements for economies of scale (Calstatela 2012), and build strong but expensive product differentiation platform to neutralize the market ascendancy, brand equity, and customer loyalties held by existing industry players. Huge inventory, sizable store, warehousing, and parking spaces, and robust IT and storefront infrastructure are just some of the initial investments required, apart from maintaining heavy working capital provisions.
Intensity of rivalry among competing firms
Costco operates in an industry characterized by intense rivalry among equally capable and large competing firms. There is high degree of competitive rivalry because of slow industry growth at a 10-year average of just about 6.2% based on the analysis of Costco financials (Morning Star, 2014), which makes the competition a market share race; high fixed cost and storage cost each industry player needs to assume, exerting capacity and pricing pressures; lack of differentiation as products are perceived as a commodity; buyer’s purchasing decisions prompted by price and service, creating pricing pressure, with Costco using a 15% maximum gross margin (Dilworth, 2014); low switching cost that makes it easy to migrate from one retailer to another; and, high exit barrier imposed by use of specialized assets with low liquidation value, high fixed cost to exit, and major strategic agreements like business alliances and joint ventures (David, 2005).
Pressure from substitute products
The threat for substitute product is high because Costco offers a limited selection of products and services, while other retailers offer a much larger variety of goods and services customers can choose from. People going to Costco represent small business owners and individual consumers with plenty of alternative shopping options to exercise. Shoppers can instead go to other retailers like Wal-mart, Sears, Target, Ralph’s. Albertson’s, Vons, or Dollar Tree, where many items not available from Costco, or products which are equivalents or substitutes of those in Costco, can be bought. The online option by Amazon incrementally impinges on Costco.
Bargaining power of buyers
The bargaining power of buyers in Costco’s industry remains low for the following reasons: customers are numerous and not concentrated; customers are small businesses and individual consumers with purchase volumes that cannot exercise undue control over Costco, and are just a portion of the buyer’s buying portfolio; products are of the standard type and without notable differentiation; and there is low switching cost. In essence, no single buyer or groups of buyers can influence or control the business operations or results of Costco. However, buyers’ online access constitutes a threat because of the potential to gain full information about anything associated with merchandise purchases, including relevant and available buying alternatives.
Bargaining power of suppliers
The bargaining power of suppliers, usually manufacturers of goods, is weak. Suppliers do not exercise any form of control or superior bargaining position over wholesale clubs like Costco, the latter being volume buyers and have significant influence over suppliers. Even if suppliers are large organizations, not one company can impose on wholesale clubs because the latter can exercise the option to source warehouse stocks from equally large alternative suppliers.
Porter’s Five Forces Evaluation
While it is significantly difficult to enter the warehouse club industry due to high entry barriers, the industry, however, remains characterized by intense competitive rivalry and strong pressure from substitute products coming from the ranks of numerous retailers. These two overarching forces heighten the degree of competition within the industry, overwhelming the weak factors of the bargaining powers of buyers and suppliers. In the overall, the profit potential in the industry remains fairly acceptable, if not totally attractive, as demonstrated by Wal-mart and Target. What becomes evident in this analysis is that, if Costco intends to maintain its 15% maximum gross margin to support its low-price positioning strategy, it has to increase revenues much more significantly both from local and foreign operations. Costco needs to build enormous cash reserves to fund its strategic requirements.
SWOT analysis is a model that identifies the external elements, in terms of key prospects for growth and success (i.e. opportunities) and the major problems and obstacles (i.e. threats), including internal issues (i.e. weaknesses) that confront an organization. SWOT indicates whether the organization has the internal capacity (i.e. strengths) to address such opportunities, threats, and weaknesses. The following presents a SWOT analysis for Costco.
As it appears in its SEC (2014a) 10-K filing, one of the greatest strengths of Costco relates to its massive global population of cardholders totaling 76.4 million, with 86% across the globe and 90% in U.S. and Canada renewing annually and giving Costco annual revenue of at least $2.4 billion. Costco has 663 warehouses worldwide, with 70% located in the U.S., 13% in Canada, and 17% spread in Mexico, United Kingdom, Japan, Korea, Taiwan, Australia, and Spain. Costco represents a powerful brand that commands public approval, patronage, and loyalty. Costco enjoys very low employee turnover, with employees demonstrating motivation, loyalty, respect, and pride about the company (Caitlin, 2012); as a result, employees perform at high levels of productivity. Costco has the unique capability to manage costs and keep overhead low, while fulfilling the shopping needs of loyal and affluent customers (Siwakoti, 2007) thrilled with selected products and services mix. Costco demonstrates solid financial performance, registering continuing revenue growth and consistent profitability on an annual basis (Global Data, 2014).
Based on the locations of Costco’s warehouses, the total business generation capability of Costco is 88% dependent on the U.S. and Canada market, which situation exposes the company to concentrated risks in the North American markets (SEC, 2014a). Costco operates within a small 15% margin (Dilworth, 2014; Lutz, 2013), which is exactly the reason why its net income as a percentage of revenue has averaged 2.7% only over the last 10 years (SEC, 2014; Siwakoti, 2007). Costco does not run advertising and promotional campaigns to attract new customers, and it lacks visible presence in urban communities because most of its warehouses are located in suburban areas (Shields, 2012). Costco’s online business presence appears not as popular as that of Amazon and Wal-mart.
Costco has 172 international warehouses that contribute 50% of Costco’s total revenue (Campos, 2013), a revealing productivity mismatch demonstrating much higher level of revenue power in overseas warehouses than Costco outlets in the U.S. The mismatch also accentuates significant and glaring opportunity in international expansion. Offering online membership application presents an opportunity that can bring in substantial incremental revenues, apart from building a huge add-on subscriber base to neutralize the online presence of Amazon (Shields, 2012), as well as Wal-mart. E-commerce represents a 2013 $16 trillion transaction value, which is just 7% of global retail sales and as such, indicates broad opportunities for strategic growth (Moore, 2014). The improving economic situation in the U.S. and many other countries served by Costco defines renewed opportunities for incremental business.
Walmart, and its ownership of Sam’Club, which is the closest competitor of Costco, remains the most significant competitive threat to Costco; Amazon likewise stays as a very strong force to reckon with because of its leading online business presence. Amazon can always capitalize on its online superiority at the expense of Costco, which has yet to develop and build respectable presence in the online business environment (Shields, 2012). Although the international markets generate the needed revenues and cash flows, these markets nonetheless poses political and legal threats, including competitive risks from local or other international wholesale club players.
Costco has the needed internal strengths to address available opportunities, impinging threats, and identified weakness. For the last decade, Costco has proven that it can effectively leverage into a leading industry position its superior value proposition, customer acquisition know-how, market development capacity, and infrastructure, strategy, and human resources endowments. It should be noted that the 10-year financials of Costco confirm that it has the internal capacity to compete, grow, and aspire to achieve sustainable competitive advantage. Costco’s devotion to its customers and employees continues to work well as a game-changing strategy that underpins investors’ interest (Ferry, 2013). Costco, however, needs to improve profitability significantly because it is the key to achieving its desired future in an industry rocked by intense rivalry. Costco clashes with equally capable and large competitors that necessitate quick and ample logistical capability when the rivalry further intensifies to critical dimension. It is this strategic impetus that raises the issue of Costco’s low pricing margin and lack of marketing intensity.
History and Business Concept
The history of Costco chronicled simple ways of doing big business. Based on one illuminating account (Corona, 2012), after gaining knowledge about the business of high-volume warehouse club operations with limited number of products from Price Club, Jim Sinegal left Price Club in 1983 to start Costco in Issaquah, Washington, with partner Jeff Brotman. In 1993, Costco merged with Price Club after years of competition with each other, and the new organization was named PriceCostco; in 1997, Sinegal bought Price out, changed the name of the business to Costco Companies, Inc., and remained Costco’s Chief Executive Officer; in 1999, the name Costco Wholesale Corporation was adopted (Corona, 2012; Trewin, 2011). Based on the account of Trewin, the overseas operations of Costco started in Canada in 1985, then Mexico City in 1992, United Kingdom in 1993, in South Korea in 1994, Taiwan in 1997, Japan in 1999, Puerto Rico in 2002, and in Australia in 2008-2011. According to Corona (2012), in Sinegal’s casual conduct of managing Costco, Sinegal stayed guided by a central philosophy: keep low prices in a no-frills warehouse of carefully selected merchandise. The Costco portfolio consists of new, seasonal, regular, and special products, including expensive and branded personal items like handbags, jackets, and jewelry for the affluent members. Costco’s regular products include food, health and wellness, wines, groceries, consumer electronics, and home improvement items, including services like insurance, travel, roadside assistance, and online investments. As compared to supermarkets with normal load of 40,000 items, and Wal-mart supercenters with around 150,000 products, Costco stores carry just around 4,000 products.
Over the years, up to the present, Costco has remained steadfast in leveraging the same business model both in the U.S. and global markets: low prices, limited product lines, quality products and services, and efficient and reliable processes. These values are enshrined in Costco’s mission statement, which states: To continually provide our members with quality goods and services at the lowest possible prices. The mission statement is circumscribed by Costco’s code of ethics, which stipulates: obey the laws, take care of our customers, take care of our people, and respect the suppliers -- to realize the ultimate goal of rewarding shareholders (Costco Wholesale, 1998).
Culture and Leadership
The organizational environment at Costco reflects a perfect symbiosis of culture and leadership, a productive interdependence where culture is heavily influenced by the brand of leadership of Jim Sinegal – simple, organized, employee-caring, customer-focused, interpersonal, forward-looking, developmental, collaborative hands-on, conscientious, honest, humble, inspirational, passionate, and transformational (Penn State, 2014; Weinmann, 2014; Brown, 2012; Tice, 2011; Ruggeri, 2009). These key leadership attributes of Jim Sinegal built a seemingly indestructible culture of customer care, accountability, transparency, belongingness, initiative, collaboration, learning, productivity, confidence, and trust. Costco is a culture that places great value to each employee as it allows workers to decide, solve workplace problems, and assume higher duty responsibilities in the absence of controlling superiors – a job context that motivates, heightens productivity, and molds character (O’Toole, 2009). As it appears, Costco believes in having the best employees in the warehouse club industry, and to lead the company into its desired future, Jim Sinegal believes that Costco has the fundamental responsibility to treat, pay, train, develop, and inspire employees well in a culture that befits the future. In the words of Jim Sinegal: “Culture is not the most important thing, it’s the only thing” (Brown, 2012, p.1). To reinforce a culture that is truly Costco, the leadership development strategy of Costco involves the training, educating, inspiring, harnessing, and promoting internal talents, without hiring from outside, as Costco takes the initiative to invest in the continuing education of its employees, including sponsorship to post-graduate business studies (Geier, 2013; Quest 2012).
Financial Analysis of Costco
Based on the examination of published financial information on Costco (Morning Star, 2014; Daily Finance, 2014) and on the interpretation of relevant financial ratios (David, 135-137), the company appears to be generally in good financial condition. As shown in Table 1 below, Costco rates significantly stronger than competition in all parameters of corporate growth: in revenue increase Costco posted an index of 9.1 while the industry had 5.9; in earnings per share, Costco had a high 13.9 while the industry chalked just 5.4; and in capital spending made to boost business generation, Costco registered 14.2 against 0.9 of the industry. In terms of liquidity and leverage, which are key determinants of financial strength, Costco excelled over the industry. On the two parameters of liquidity, Costco recorded a current ratio of 1.2 over the industry’s 1.0, and in quick ratio, Costco registered 0.6 while the industry had 0.2., indicating that Costco assumes a better position to meet maturing short-term obligations. On leverage, Costco had a debt to equity ratio of 0.4 and the industry managed 0.6, which means that Costco is less reliant on borrowings than the industry in financing business needs. The efficiency ratios indicate a superior Costco performance over competition; in receivable turnover it took less time for Costco to collect from customers, with Costco’s index at 95.9 and industry at 96.2; in inventory turnover, Costco achieved 11.9 while the industry got 6.9, which means Costco moves its inventories much faster than the industry; in asset turnover, Costco made $3.6 in sales for every dollar employed in the business, while the industry produced $2.3 only for every dollar; and in revenue per employee, Costco had a high productivity of about $1.0 million revenue per employee, as against the $0.2 million of the industry. In net income per employee, Costco attained $19, 306 as compared to the $7,688 of the industry.
Source of Indices: Daily Finance (2014, p.1)
As indicated in Table 1, it is in profitability performance that Costco lags competition, more particularly in gross margin provision that fundamentally impacts the bottom line. The average gross margin of Costco stood at 13.5% while the industry hovered at 25.7%, a wide disparity that serves as a hurdle for profit improvement. In terms of pre-tax margin, Costco had 2.8% and the industry posted 5.1%. While the pre-tax margin shows an inferior position for Costco, it gives an idea though on Costco’s better cost utilization as the disparity significantly narrows after the application of expenses. The match-up on financial returns similarly shows inferior positions for Costco: in return on assets, Costco garnered 6.2% while the industry had 7.9%, and in return on equity, Costco charted 12% while the industry yielded 12.9%. In terms of free cash flows and working capital endowments (Morning Star, 2014), Costco shows positive indications. In terms of free cash flow availability, Wal-mart has the largest free cash flow volume at $10.1 billion, followed by Target at $3.1 billion, and then Costco at $1.9 billion as at the end of fiscal year 2014. While all three leading companies in the industry depict common capacity to undertake business improvement with free cash flow, Costco, however, appears to be the most restrained to undertake high profile expansion. In terms of working capital endowments, Costco demonstrates superiority over Wal-mart and Target, with Costco having $3.2 billion in positive working capital, which build-up, as a matter of policy, was designed to gain competitive advantage (Mullins, 2009). Wal-mart had a negative working capital of $8.2 billion and Target also had a negative working capital of $1.2 billion. Although the negative working capital balances of Walmart and Target could be a timing issue, it must be noted, however, that a negative working capital obviously means the company is heavily indebted. In the overall, Costco presents a solid and robust financial health. While Costco tails key competitors in profitability performance, it is undeniable that Costco has been consistently profitable at the same low margin, at least for the last 10 years. Costco has effectively managed its costs, while investing significant premiums in employee welfare -- a strategic move that appears to work well for the company.
In the context of external factors, competitive forces, and the net internal capacity of Costco, and sustaining the company’s current strategy of low price, low margin, and high employee welfare, Costco can adopt the following strategies: (1) market development, which involves introducing existing products and services into new geographic area (David, 2005, p.163); this strategy calls for the continuation and intensification of Costco’s international expansion because it has proven to generate significant incremental business that Costco needs to offset by volume its low price margins; (2) market penetration, which prescribes increasing market share for existing offers of products or services in existing markets through greater marketing efforts (David, p. 163); in this strategy, Costco can maximize in-store advertising and promotion and co-branding for selected lines, apart from strategic marketing alliances with suppliers; this strategy includes offering online membership subscription and intensifying online business presence and web marketing; (3) diversification, which includes concentric diversification that seeks to add new but related products and services, conglomerate diversification that adds new, unrelated products or services, and horizontal diversification that adds new, unrelated offers for existing customers (David, p.163); and (4) product development, which boosts sales by enhancing present offers or creating new ones.
Discussion and Conclusion
Based on the financial analysis of Costco and its key competitors, including the comparative availability of free cash flow and positive working capital, there is ample reason to conclude, in answer to the key question, that Costco does not face serious financial problem. While it is true that Costco’s gross margin remains small as compared to the industry, for the last 30 years, it has been that small; and yet, Costco has remained consistently profitable. Building cash reserves for strategic expansion represents a valid issue which Costco needs to address because if rivalry heightens, Costco has a dependable war chest. Considering the spending regimen that Costco has exercised, which illuminates its distinct competence in managing costs and acting on correct priorities, the likelihood of serious financial issue appears to be remote. If the heavy premium that Costco places in treating and paying its employees well contradicts standard financial norms, then Costco appears to have proven the norms erroneous. It is clear that Costco’s capacity to survive, especially the last decade, has been significantly a function of employees’ productivity, loyalty, competence, initiative, energy, and pride. The prospect of international expansion highlights a strategic option that can centrally provide Costco the power to offset its low pricing margin. In view of the foregoing representations of the study, it is then submitted that the thesis: ‘Costco has the internal strength to address opportunities, threats, and weaknesses, and demonstrates the potential to significantly improve its profitability and meet long-term goals’ has been aptly argued for and adequately addressed.
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