Is Costco's Low-Margin Strategy Failing?

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It's no secret that Wal-Mart Stores is the largest retailer in the world. Currently, the company has a market capitalization of $258.9 billion and in 2013 it brought in revenue of $469.2 billion. However in recent years the most interesting retailer has been none other than Costco Wholesale Corporation . Over the past 10 years, Costco has grown its revenue by 118.6% while Wal-Mart has experienced barely half that growth. This should serve as a testament to both its size and management's ability to make intelligent decisions, but there is one downside to its pace of growth; small margins.

Growth comes at a big cost

In the table above, we can see the net profit margins of Costco, Wal-Mart, and Target . Though none of the retailers above have what would normally be called wonderful margins, there's a clear difference between Costco and the rest of the pack. What this likely means is that, for several years, Costco has been willing to take a much smaller profit on its sales in an attempt to boost growth, a strategy known as cost leadership. By doing so, a company hopes to achieve long-term growth and market share by foregoing short-term profit today.

On top of impacting the company's bottom line, this strategy also impairs its return on equity, the measure of how much of a return shareholders receive each year for every dollar invested into an enterprise.

In the graph above, we can see the impact that the company's low margin has had on its return on equity. In every year (except for 2013), Costco lagged both Wal-Mart and Target using this measure. However, we can also see that the company is gradually improving, rising from a return on equity of 10.9% in 2009 to 18.8% in 2013.

But wait! There's more!
This is an interesting illustration of the company's improving returns even in spite of its cost leadership approach to business. However, not even this paints the entire story. Return on equity is driven by net income and book value of equity. For this reason, it is possible that debt can inflate a company's return on equity by decreasing a company's total common shareholder's equity, or that it can deflate it by decreasing said company's net income.

To account for these differences, I factored out both the long-term debt and tax-adjusted interest expenses of Wal-Mart, Costco and Target in the graph below:

This graph shows a slightly different story than the first. While in the first graph, we see that Costco came in third place in terms of return on equity, it's actually in second place when you factor out debt and after-tax interest expense. What this means is that when you crunch the numbers, all three companies saw their return on equity inflated by debt, but far less so for Costco.

Target's return was significantly affected by debt. Wal-Mart's return was inflated as well, but not anywhere near that of Target. Meanwhile, Costco saw hardly any change in its return on equity due to debt assumption, with the exception of 2013 when the company increased its debt load from $1.38 billion to $5 billion.

Foolish takeaway
Using the data compiled above, we can more effectively evaluate the value given to investors who buy up a piece of these companies. It is true that Costco experienced a lower return on equity than its peers over the previous five years, but the Foolish investor should keep in mind that the returns gained by both Target and Wal-Mart carried greater risk should business falter. When you consider that Costco is seeing its return on equity rise every year, irrespective of its debt load, then the company's position looks quite clear.

To make things even better, Costco has the lowest long-term debt/equity ratio of the three at 0.46 (compared to 0.54 and 0.89 for Wal-Mart and Target, respectively), which means that it has the capacity to pump up its future returns with the assumption of greater debt should it choose. So, what's the verdict after all this? While the future isn't always certain, it appears as though Costco's decision to forego higher margins now is paying off. It cannot be guaranteed that this will continue into perpetuity, but I think it would be wrong to say that the company's situation is pointing to a downturn anytime soon.

The article Is Costco's Low-Margin Strategy Failing? originally appeared on

Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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