Can Costco keep prices low?

By BusinessWeek

In the fickle world of retailing, where hot concepts can be as fleeting as pop stardom, Costco Wholesale (COST, news, msgs) has been a fortress of stability over the years.

The discount warehouse chain has built an empire of 544 stores in 40 states on one proposition to which it is fanatically devoted: keeping the prices of its quirky assortment of wares -- everything from bulk antacids to flat-screen televisions -- as low as possible.

The beauty of Costco's deep-discount, high-volume model is that it works even when the economy is at its worst: The company has held up well during past economic downturns.

But one thing the model doesn't account for is the toxic brew of recession and surging prices. And that dreaded scenario, last seen in the 1970s, is turning 2008 into one of the most challenging stretches in Costco's 25-year history.

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Despite slowing economic growth, soaring commodities prices this year have forced manufacturers around the world to increase the prices they charge retailers, which in turn have raised their prices on consumers.

Yet Costco can't raise prices as easily as its rivals can. It gets about three-quarters of its operating profits from membership fees, which range from $50 to $100 a year. If Costco were to hike prices too high, some of the 29 million households that carry memberships would simply let them expire. Profits could suffer.

Costco Chief Executive James Sinegal isn't panicking and throwing out the playbook, however. Instead, he's sticking with what he does best. Sinegal, 72, is cranking up Costco's already aggressive cost-cutting machine to new levels, challenging managers to find ways to pare.

After Procter & Gamble (PG, news, msgs) announced a 6% price increase on Bounty paper towels and Charmin toilet paper, for example, Costco bought hundreds of truckloads at the old price and stuffed them into storage depots, saving customers precious pennies per roll.

It has even looked into growing its own pumpkins to help preserve the $5.99 price tag on its store-baked pies. "If that stuff doesn't really turn you on," says Sinegal, "then you're in the wrong business."

So far, the results have been mixed. Membership growth is up 7.3% from last year, and sales at stores open at least a year grew by 7% in September. But higher costs are pinching profits.

The company warned Wall Street in July that its fourth-quarter profit would be "well below" expectations. On Oct. 8, the company reported earnings-per-share growth that fell short of those lowered expectations.

One thing working in Costco's favor is its buzz factor. The chain is known for its constantly changing roster of high-quality goods, which entices shoppers to make impulse buys. Anyone can walk into Wal-Mart Stores (WMT, news, msgs) for cheap underwear, but getting a discount Cartier watch is something else entirely -- especially when customers know it may not be there when they come back.

Such deals, more prevalent in a weak economy, have made Costco a place where even the highly affluent like to brag about shopping. (The average member household makes upward of $75,000 a year.)

David Novak, CEO of Yum! Brands (YUM, news, msgs), says he buys wine and cleaning equipment at Costco. As QVC CEO Michael George, a longtime member, puts it: "You don't just go there for bargains. You go there for the treasure hunt."

Continued: The buzzer goes off

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