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At Costco, Lower Prices, Higher Club Fees May Stoke Competition

Until recently, Costco charged US$16.99 for a 24-pack of San Pellegrino. Now, that same item retails for US$14.99—a 12% reduction.

Sparkling water isn’t the only product looking cheaper at Costco these days. During a quarterly earnings call in March, Chief Financial Officer Richard Galanti seemed to signal an inflection point when he rattled off a variety of goods for which prices were being lowered: Kirkland batteries (from US$17.99 down to US$15.99) and reading glasses (US$18.99 to US$16.99), as well as sporting goods and lawn-care products. A bag of frozen fruit was even reduced by US$4. Plus, there was a more subtle clue about the direction of retail pricing: inflation was mentioned just seven times on the call, compared with 35 times during the March 2023 earnings call. (As for the recent trade disruptions in the Panama Canal and Red Sea, management said this hadn’t pushed up prices because of the long-term nature of shipping contracts.)

Costco’s results for the quarter were healthy, but they also contained signs that industry dynamics are beginning to shift. For example, given that overall inflation was flat across the retailer’s product categories, growth in same-store sales was dependent on increased customer traffic.

Shifting Dynamics

As inflation moderated in early 2024, increased traffic to Costco’s stores was the source of same-store sales growth

Source: Company filings

To be sure, the US Federal Reserve’s battle with inflation is continuing. A Commerce Department report last week showed that the central bank’s preferred inflation gauge unexpectedly reaccelerated in March, throwing into question the interest-rate cuts that were projected for later in the year, as well as providing a more complicated backdrop for Costco’s pricing strategy.

As consumer prices surged the last few years, Costco thrived by offering relative discounts. Its Kirkland Signature private-label products tend to be at least 20% cheaper than national brands, and at the height of inflation, Kirkland’s market penetration increased by 2%. One item in particular has become a symbol of Costco savings: its iconic food court hot dog. Even after inflation on food set multidecade records in 2022, the hot-dog-and-soda combo still costs just US$1.50, the same price it’s been since 1985.

Costco has an advantage in setting prices because of its limited assortment of products. Each store carries only about 4,000 stock-keeping units, or SKUs—the scannable barcodes assigned to each type of product. In contrast, SKUs at other big-box retailers, such as Target and Walmart, can number in the tens of thousands. By purchasing fewer products in enormous quantities, Costco’s purchasing power often exceeds that of its rivals, which enables it to set lower prices than the market.

“We always want to be the first out there trying to lower prices,” Galanti said in March. But if the economic environment is such that other retailers begin to lower prices, competition may increase.

The prospect of rising competition leaves investors to wonder if that’s why Costco seems hesitant to raise membership fees. Only members can shop at Costco’s warehouses, and the fee to be a member has traditionally gone up every five to six years. However, the last increase was nearly seven years ago in June 2017, suggesting the retailer is overdue for another bump. Currently, the two membership options cost US$60 and US$120 a year.

Last May, Galanti said that he felt “very good” about the ability to increase membership fees without hurting renewal rates or signups. But it’s easier to raise prices when prices in general are going up, and harder to do if inflation moderates. During the recent earnings call, Galanti was vague about the company’s plans, adding only that the decision for when to raise fees doesn’t involve “some big analytical formula.”

In the meantime, other retailers have introduced optional membership programs to encourage shoppers to spend more money with them. In 2020, Walmart launched Walmart+, a plan that costs US$98 a year and includes free shipping and delivery, fuel savings, and access to the Paramount+ streaming-TV service. In April, Target introduced a similar program called Target Circle 360; for US$99 a year, users save on speedy shipping and are given an extra 30 days to make returns. There’s also Amazon Prime, a US$139-a-year subscription with shipping and digital-entertainment perks. For shoppers looking to buy in bulk, one of Costco’s closest rivals is BJ’s Wholesale Club, which similarly requires customers to become members and pay either US$55 or US$110 a year.

Despite the myriad in-store and online shopping competitors, Costco members remain especially loyal. About 93% in the US and Canada, and 90.5% worldwide, renewed as of the latest quarter, with both rates essentially unchanged from a year ago.

Loyal Shoppers

As Costco’s membership base has grown, the proportion renewing their plans has remained consistent

Source: Company filings

Over time, international renewal rates should also build to near North America’s levels. That’s because many of its locations abroad are still new. In China alone, the company has opened six stores since 2019 to much initial fanfare (the grand opening of the first location drew such large crowds that it had to close early for the day). New stores initially attract consumers who are curious about Costco but don’t necessarily live nearby or plan to remain members. Therefore, it can take time for the customer base to stabilize.

While Costco remains a high-quality company, the stock’s rally this year—partly due to high expectations for its expansion in China—has caused the valuation to become stretched relative to its growth prospects. The business is a steady grower, with revenue set to climb by mid-to-high single digits over the long term, yet as it grows it passes on savings to customers, which means margins shouldn’t change much. As competition increases and the company prepares to raise membership fees, investors will watch closely for any change to its membership growth.

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A Ground’s Eye View on Inflation and Its Persistence

The pandemic sowed the seeds of today’s inflation. That much is clear. Last year, fear and government-mandated lockdowns sparked a global recession. Businesses rushed to cut production ahead of an anticipated slowdown in consumption, or were hobbled by forced plant closings, anxious workers, or snarled logistics. But the sheer sweep of the income support in many developed countries meant that household incomes didn’t fall nearly as far as had been expected based on the rise in unemployment. Unable to spend on services like eating out and travel, consumers flush with cash turned to buying, or attempting to buy, big-ticket goods and better houses.

The outsized demand for durable goods has run headlong into the diminished supply. While the springboard for price increases may have been reduced supply, the strength and persistence of those increases, which are now feeding through to labor markets, are raising the specter that aggregate demand is outpacing even normalized aggregate supply. There is precious little that monetary policy can do to counter supply-led inflation, but—Omicron willing—it is likely to be temporary. But if inflation comes to be led by stubborn excess demand, then tight monetary policy is the orthodox response, and we can expect central banks to hit the economy over the head with a brick to prevent a sustained wage-price spiral. Demand-led inflation would have significant implications for asset prices.

Inflation is notoriously difficult to forecast; even some at the US Federal Reserve (Fed) concede that it has no working model for inflation.1 We could do no better and accordingly make no effort to forecast future inflation. What we can do is talk to the companies we own or follow and tease out the impact on their earnings from the rising input costs they’re experiencing; their changing bargaining power vis à vis their suppliers; whether they are able to pass on higher costs to their customers before stifling demand; and how all that is coloring their business outlook. The following represents what our research analysts have been able to glean from those conversations.

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What P&G’s Pricing Decisions Tell Us About Inflation

Inflation has been the relentless economic theme of the last two years. Even with interest rates higher than before the pandemic, global supply chains no longer paralyzed by virus-related bottlenecks, and the World Health Organization declaring an end to the COVID-19 emergency, prices for goods and services in many parts of the world continue to climb.

As the world’s largest consumer-goods company, Procter & Gamble provides insight into what’s driving the pricing decisions at big brands.

Competitive Advantage and Pricing Power

Portfolio manager Jingyi Li discusses how several Global Equities portfolio companies are using their pricing power to navigate through this period of higher interest rates and higher inflation.

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