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How Costco is surviving in the age of Amazon

Kiplinger logo Kiplinger 6/8/2017 Daren Fonda
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Video by CNBC

Warehouse giant Costco continues to prosper despite the growth of internet retailing. 

Taking on Amazon.com seems foolhardy these days. The company is expanding so fast that it could gobble up more than half of online retail sales in the U.S. by 2021, up from one-third in 2016, according to brokerage firm Needham & Co.

Yet even with Amazon raking in sales, some big retail chains are flourishing. One of the most successful is Costco Wholesale. Appealing to millennials and baby boomers alike, the warehouse club has homed in on a surprisingly effective way to keep Amazon at bay: selling food.

See Also: 6 Retailers That Can Stand Up to Amazon

Although Costco's lineup spans everything from jewelry to appliances, more than 80% of its members go specifically for the groceries, according to a recent survey by investment firm Barclays. Customers pile in to buy household goods in bulk, at prices that are tough to beat online. Costco also sells fresh meats, produce and baked goods. Add it all up and the warehouse club's "mousetrap" looks well protected against Amazon, Barclays says.

Groceries are just the bait, though. Many customers also fuel their cars with Costco's discounted gasoline or purchase other items that catch their eye. "You go in for tires and wind up buying a generator," says David Marcus, manager of Evermore Global Value Fund, who views Costco as one of the few retailers that can fight off online competitors.

Granted, Amazon is pushing into the food business. Its grocery delivery service, Fresh, offers more than 500,000 items, including perishables and prepared meals. Amazon is testing robots and automation in Fresh warehouses to lower labor costs, says Barclays, and it could deploy "robot vans" for home deliveries. A decade from now, Barclays estimates, Fresh could reach 15% of U.S. households.

Yet Amazon and Costco should be able to coexist. Costco members shop on Amazon mainly for electronics, books and clothing, with groceries accounting for just 25% of their purchases, says Barclays. That could change as Fresh expands. But Costco may still beat or match Amazon's prices because shoppers who buy in bulk already get deep discounts. Costco offers a grocery delivery service through Instacart.com, available in 24 states and Washington, D.C., and is testing another delivery service, Shipt, in Florida. Moreover, Fresh costs $15 a month, on top of the $99 annual membership for Amazon Prime. One other advantage for Costco is that it sells things you still can't find on Amazon, such as prescription drugs, vacation packages and car rental services.

Profit boost. Costco members tend to be loyal, too, renewing their annual memberships at a roughly 90% rate. An increase in annual fees was slated to take effect in June, generating cash that will go straight to the bottom line. Membership fees, in fact, account for 72% of pretax profits, and the increase in fees will add 42 cents to earnings per share over the next two years, about a 7% lift, estimates UBS. Another avenue for growth: Costco continues to expand worldwide, opening new stores this year in Korea, Taiwan and other locales

For investors, the major drawback is Costco's pricey stock. It trades at 30 times estimated year-ahead earnings, well above the 10-year median price-earnings ratio of 22 and the stock market's overall P/E of 18.

But analysts argue that Costco deserves a rich valuation because it's one of the few retailers that can thrive in the age of Amazon. Costco is also doling out hefty cash payouts to try to keep shareholders happy. The company was set to pay a "special dividend" of $7 per share on May 26, on top of the regular quarterly dividend, which it recently hiked from 45 to 50 cents per share. 


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