The Surprising Business That's Boosting Costco's Growth

Investors are very forgiving when it comes to the stock of Costco Wholesale (NASDAQ: COST). Although it dipped last week after reporting a mere 1% year-over-year increase in revenue, it's still up 34% year to date, strongly outpacing the S&P 500.

Costco has built up its reputation over many decades to become so deserving of that ironclad investor confidence. It's reliable for steady growth, and the market isn't willing to send it down too much based on one quarter. Investors see the long opportunity ahead and expect sales to pick up. And much of that is already coming from a surprising source.

Happy members are going digital

Costco members love shopping through the company's huge warehouses. But in today's day and age, every large retailer has some sort of digital presence, Costco included.

It doesn't sell everything on its website that it sells in its warehouses, like fresh produce, but it has a healthy assortment of products and more large items like appliances than it sells in its stores.

Total revenue increased only 1% in the fiscal fourth quarter (ended Sept. 1) and came in below analyst expectations. But sales in the e-commerce segment increased a surprising 18.9%. And that wasn't a fluke. E-commerce has been growing at double-digit rates for three straight quarters after dipping into negative territory last year.

Data source: Costco quarterly reports.

E-commerce traffic, conversion rates, and average order value were all up year over year, and management said that the segment was driven by "sales growth, item mix, and fulfillment productivity."

Delivering the Costco way

Interestingly, Costco reported similar trends in average ticket and volume that it has over the past few quarters: a 0.9% decline for average ticket size and positive 6.4% volume growth. That means people are buying more frequently but spending less per trip. Up until now, that has implied more groceries and fewer big-ticket items. But that's not how it played out in the fourth quarter.

Higher-ticket items were underperforming with high inflation, but in the fiscal fourth quarter (ended Sept. 1), they made a nice rebound. It was the grocery items that took a step back after surging last year. Appliances, furniture, and jewelry were all up by double digits in the fourth quarter. That's where e-commerce comes in.

Costco has its own logistics business to handle its vast amount of deliveries -- more than 4.5 million products over the past year, a 29% year-over-year increase.

More members are finding value in buying pricier items online, which was a problem when customers were holding back but is turning out to be a strong e-commerce growth driver. They also enjoy the company's treasure-hunt deals that change all the time on the site. And management is figuring out how to make the segment more profitable.

Since Costco is responsible for logistics costs on e-commerce sales that aren't an additional expense for sales at its physical warehouses, and it can't pass all the expenses along to customers and still offer the same prices, the e-commerce business is more expensive to run, particularly with bulkier items like furniture and appliances. Management mentioned assembling orders and packaging them, which requires employees, usually the highest expense for any business.

It's a similar story with buy online, pickup in store (BOPIS). This isn't cost-efficient for lower-priced goods, but it is for certain larger items, which would otherwise require freight and delivery expenses. Management said that it started offering TVs through its BOPIS program, with a positive response. It's still rolling out more e-commerce features and services, figuring how to generate sales at a profitable level in this new omnichannel world.

Is there more coming?

Although Costco has offered some e-commerce for years, management feels like it's just getting into tech. There's a lot to explore here, and the company could enter e-commerce and perhaps offer other tech services in a Costco kind of way.

In the meantime, expect online sales to play a larger role in overall revenue for the foreseeable future. As interest rates go down and members begin to spend more on higher-end items, they're more likely to take advantage of Costco's impressive logistics services and lower prices.

The company should also benefit from a surge in the real estate industry. As people buy homes and get back to home improvement, they're going to find value in Costco's appliances and furniture, and they're making these purchases online.

Investors shouldn't worry about Costco's revenue miss in the fourth quarter, and they should gear up for better days ahead, boosted by a robust e-commerce platform.

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Jennifer Saibil has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.