Latest / Business Strategy Talks with Fexingo: Competitive Advantage, Market Positioning, and Growth Planning / How Costco Built a Moat on Membership Fees and Capped Margins
Transcript
- Lucas: Luna, I want to talk about a business model that seems almost deliberately designed to leave money on the table, and yet it's one of the most resilient retailers in the world. Luna: You're talking about Costco, I assume. The place where I always walk out with a rotisserie chicken and a kayak I didn't plan on buying. Lucas: Exactly. Costco's moat isn't about having the best technology or the slickest app. It's about a structural profit model that competitors can't replicate without breaking their own business. Luna: Walk me through the numbers. I know the membership fees are huge, but how does that work? Lucas: So Costco makes most of its operating profit from membership fees, not from selling goods. In fiscal 2025, membership fee revenue was roughly $5.2 billion, while net income was about $7.3 billion. That means membership fees cover the vast majority of profit. The actual merchandise is sold at a near break-even margin. Luna: Right. They cap gross margins at 14 percent. That's the famous rule. Lucas: Yes. Jim Sinegal, the co-founder, set that policy decades ago. The idea is that if you find a great deal on a product, Costco could have charged you more. But they choose not to. That builds tremendous trust. Luna: And that trust translates into a 93 percent renewal rate in North America. Which is insane for a subscription. Lucas: It is. And that renewal rate is the moat. Because once you have 130 million cardholders paying an average of about $120 a year, you have a predictable, growing revenue stream that doesn't depend on same-store sales fluctuations. Luna: Compare that to a traditional retailer like Walmart. Walmart makes money on the spread between what they pay and what they sell for. If they tried to cap margins at 14 percent, their entire profit structure collapses. Lucas: Exactly. Costco's model flips the script. The customer isn't the person buying the toothpaste. The customer is the person paying the membership fee. The toothpaste is just a reason to keep paying. Luna: That's a subtle but profound shift. And it creates a different set of incentives. Costco isn't trying to squeeze every dollar out of each transaction. They want you to feel like you're winning. Lucas: And they reinforce that feeling constantly. The $1.50 hot dog and soda combo has been that price since 1985. When inflation hit, some analysts said they'd have to raise it. Costco's CFO said publicly, 'Not on my watch.' Luna: That's a marketing cost, essentially. That hot dog loss leader drives traffic and it's a symbol of the brand's commitment to value. Lucas: Right. And Costco uses that traffic to move massive volumes. They only carry about 4,000 SKUs in a typical warehouse, compared to 30,000 or more at a grocery store. That means they buy in enormous quantities and negotiate rock-bottom prices. Luna: So the limited selection is actually a feature, not a bug. It simplifies the shopping trip and reduces their inventory risk. Lucas: And because they turn inventory so fast—about 12 times a year, compared to 6 or 7 for most retailers—they need less working capital. That gives them a cost advantage even before the membership fee kicks in. Luna: Then there's the treasure hunt element. You go in for paper towels, but you leave with a $5,000 diamond ring because it's there at a price you can't resist. Lucas: That's deliberate. Costco rotates about a quarter of its merchandise every month. They bring in high-end wine, electronics, even cars through their auto program. It creates urgency. You don't know if that deal will be there next week. Luna: That's a moat that's hard to copy because it's a behavior. Sam's Club has tried to replicate it, but they've always been more of a me-too. They don't have the same brand trust. Lucas: Sam's Club actually had higher sales per square foot for a while in the early 2000s, but Costco pulled ahead. The difference is Costco's focus on the affluent customer. Their average household income is about $100,000. That's not a bargain shopper. That's someone who appreciates quality but wants a deal. Luna: So Costco actually targets higher-income customers. That gives them pricing power on premium items like organic food and electronics, while still maintaining the value perception. Lucas: Exactly. And that customer base is more loyal and less price-sensitive to occasional increases in membership fees. Costco has raised fees every five years or so, and renewal rates barely budge. Luna: What about e-commerce? That's been the Achilles' heel for many warehouse clubs. People don't want to buy a 48-pack of toilet paper online. Lucas: Costco's e-commerce is about 7 percent of total sales, compared to Walmart's 13 percent. But they're not trying to compete with Amazon on convenience. Their online business focuses on bulky, high-value items—furniture, electronics, jewelry—where shipping costs are manageable and the member already trusts the price. Luna: And they've used their warehouses as fulfillment centers. That's a capital advantage. But the real moat isn't digital. It's the physical treasure hunt experience. Lucas: I think that's right. And that experience is hard to digitize. There's a reason Costco doesn't have a loyalty program beyond the membership itself. The membership is the loyalty program. Luna: It's also worth noting that Costco treats its employees well. They pay above industry average and have high retention. That reduces turnover costs and builds institutional knowledge. Lucas: Yes. The average hourly wage at Costco is over $25, and 90 percent of employees have health insurance. That's expensive, but it means their staff is knowledgeable and motivated. That feeds back into the treasure hunt—employees can actually answer questions about the diamond ring or the wine. Luna: There's a consistency to the model. Every decision reinforces the moat. Capped margins, membership fees, limited SKUs, high wages, treasure hunt merchandising. It's a system. Lucas: And that system has produced remarkable financial results. Costco's stock has outperformed the S&P 500 by a wide margin over the last two decades. The compound annual growth rate is roughly 15 percent, including dividends. Luna: Before we go further, I want to mention something. If these conversations have moved your work forward in some small way, listener support is what keeps this show ad-free and independent. Lucas: Yeah, it's a couple of dollars a month that genuinely makes a difference. Buy me a coffee dot com slash fexingo. That's all lowercase. Luna: And even just one coffee helps cover the hosting and editing. It's a small thing that adds up. Lucas: Anyway, back to Costco. I think the biggest threat to their moat isn't Amazon or Walmart. It's the changing nature of how people shop. Luna: What do you mean? Lucas: The treasure hunt model works best when people have time to browse. But convenience culture is eroding that. More households are using delivery apps or click and collect. If shopping becomes purely transactional, Costco loses its edge. Luna: They've actually invested in two-day delivery and same-day through Instacart. But the margins on those are lower. And the in-store impulse purchase opportunity disappears. Lucas: That's why they've been cautious. They'd rather forgo some e-commerce growth than undermine the core experience. That's a strategic choice that most public companies would struggle to make. Luna: It's a moat built on discipline. And few retailers have that kind of discipline. Lucas: So the question is: can the model survive another decade? I think yes, as long as they maintain the membership value proposition. If they ever break the trust—raise margins, cut quality, or let the treasure hunt decay—the moat evaporates. Luna: But so far, they've shown remarkable consistency. And that consistency is rare. Lucas: It really is. Costco is a case study in how to build a moat by not maximizing short-term profit. Which, ironically, is the most profitable long-term strategy.