ISSAQUAH, Wash. -- Costco Wholesale Corp. here is going urban.
In an attempt to find a niche for its warehouse clubs in densely populated areas with limited real estate, Costco is about to start testing a new "city-store" format that will carry only food and sundry items and operate in less than half the space of Costco's sprawling prototype.
The first experimental city stores will open in Manhattan in New York City sometime in 2002, Jeff Brotman, Costco chairman, told SN in an interview.
If the experiment is successful, the New York City stores could pave the way for Costco to move into dense population centers in Chicago, Los Angeles and other major cities, according to Brotman.
"There are lots of places all over the U.S. where we could do something like this," he said, "and there are also suburban applications."
However, Costco is uncertain at this point what to expect from its urban experiment.
The city stores will carry the same banner -- Costco Wholesale -- as all the company's warehouses; however, they will encompass the food and sundry assortments of the traditional 148,000-square-foot Costco without any of the clothing, appliances and other general-merchandise assortments the company usually offers.
Brotman said all food assortments will be institutional and otherwise large-sized offerings familiar to Costco shoppers, not the smaller sizes found in supermarkets.
"It's a complete experiment, so we have no idea whether it will work," Brotman told SN. "And you never bullseye everything from the beginning, so we expect a lot of fine-tuning once it opens. It could take us a year or two of operation before we determine if it's successful and whether we want to open more."
Besides the city-store experiment, Costco's outlook for the next few years includes the following:
An aggressive expansion program in the United States and overseas, including 25 new warehouses this year, 30 next year and possibly 35 in 2002.
Further development of its Web site, with plans for self-delivery within a couple of years.
Ongoing efforts to fine-tune its existing warehouse format.
Costco operates 302 warehouses in 27 states and six foreign countries, including Mexico, Canada, the United Kingdom, South Korea, Taiwan and Japan. Sales in 1999 were $27 billion, and the company projects an 11% sales increase this year to $30 billion, according to Jim Sinegal, president and chief executive officer.
He told SN Costco is generating the industry's highest sales per unit -- $94 million worldwide and $101 million at its U.S. stores alone -- compared with a $54 million average at Sam's Club and a $40 million average at BJ's Wholesale Club. For food alone, Costco sales average $50 million per unit, Sinegal pointed out.
Costco has 13.7 million members worldwide, with annual membership fees of $35 a year for business customers and $40 for individual shoppers.
Business customers account for 30% of the membership and 60% of sales, Sinegal said, "though the percentage of business members is down from a couple of years ago because, as we've added more locations, we probably have tended to build more consumer business. But we're mindful of the mix, and we like to keep a larger proportion of business members because those people are fantastic customers who buy merchandise for resale, to use in their own businesses or for personal consumption."
Chuck Cerankosky, a securities analyst with McDonald & Co., Cleveland, told SN he views the city-store experiment as a way for Costco to get back to its food-service roots, "which is what the company started out to be, although over the years the mix of products has expanded to accommodate more household customers."
According to Brotman, the first city store will be located in Manhattan's Chelsea area and may attract a higher proportion of business customers than the company's more traditional warehouse outlets.
"Businesses proliferate in that area," he said, "not only the store fronts that dot the lower floors of most high-rises but also businesses with offices in the buildings above. The density of businesses in that area is extraordinary."
But Costco also hopes to convince residents in the immediate area to alter their shopping habits and join Costco, Brotman added.
"There are a lot of people who live within two to three blocks of that first city store who clearly would benefit financially and qualitatively from shopping with us, and we hope to convince them to become Costco members."
The Chelsea store will be housed in a two-story location with a total of about 60,000 square feet of selling in a former armory building that is being developed for retail and residential use. The unit will rely on walk-in trade, with no accommodation for parking, Brotman pointed out.
He said Costco also contemplates opening a 70,000-square-foot city store farther uptown, on the Upper West Side, and a full-sized 135,000-square-foot unit near Columbia University, which would be part of a multi-story vertical mall (that is to include a Home Depot and Expo) with ample parking. All three locations are likely to open at about the same time, he noted.
Brotman said he isn't sure what kind of synergies might be possible among the three Manhattan locations and between those stores and Costco warehouses in the surrounding area. "But obviously people could use their memberships at all locations, with those who want to shop just for food able to go to the city stores while those looking for food and nonfood items could go to the Columbia University location."
The city store is a more open manifestation of the kind of low-key experimentation Costco traditionally does to remain innovative.
"You don't see us making major changes," Brotman said. "We change in very minor ways over long periods of time, and it isn't until you add everything up that you see a different look emerging.
"We will continue to try to innovate within the context of what we're now doing."
However, neither he nor Sinegal was willing to be specific.
According to Sinegal, "We've always been considered an innovator in our business, and we must be at least that creative over the next 15 years or so because competition will be tougher as supermarkets expand the size of their stores and as they get more into nonfood merchandising; as Wal-Mart, Kmart and Target continue to open supercenters, and as other formats like Builders Emporium continue to expand."
He said creative merchandising decisions by Costco in the recent past include moving in to fresh meat and bakery; adding one-hour photo-processing, pharmacies and optical shops; expanding the apparel sections; installing food courts; adding fuel centers, and moving tires outside the main store to an adjacent location.
Jonathan Ziegler, managing director of Deutsche Banc Alex. Brown, San Francisco, said Costco's history of innovations is key to what has made the company successful. "They test a lot of things and make them work," he told SN. "But the real focus is working with vendors to take costs out of products and packaging so Costco can continue to drop prices at the same time it keeps raising quality.
"And they keep the stores exciting. If it were just serving the needs of the business customer for resale, going to Costco would be boring. But they develop new products on a regular basis, which makes trips to Costco like going on a treasure hunt and always finding something new.
"That excitement generates return visits and impulse sales."
Cerankosky expressed similar thoughts: "Costco is constantly looking at merchandising categories and ancillary departments that will allow it to provide value, and members enjoy seeing different merchandise flowing through the stores and occasionally some new category. That kind of innovation increases the frequency of visits by members who signed up to make stock-up trips and find they want to come more often to see what new items are available."
It's that quality that makes Costco Internet-proof, Cerankosky added. "There's a consistent assortment of top-value staples on the food side, but on the nonfood sides, while there will always be sporting-goods items, you never know in advance what will be there or what great values you'll find, and that's what makes shopping at Costco so exciting."
Crossover merchandising is the key to the Costco philosophy, Sinegal said. "That's the whole concept -- we're a total shopping experience. So if a customer comes in to buy a fax machine for his office, we're hoping he'll pick up salmon for dinner and a dozen roses for his wife.
"In fact, one of the most common things we hear from customers is that they always spend more than they intended. That's what every retail operator tries to do, and that's what we try to do."
The difference is that Costco succeeds better than most, with comparable-store sales rising 10% last year, including a 13% jump in the fourth quarter.
Despite its success, however, Sinegal acknowledged that Costco can never be all things to all people.
"We know we can't sell every item, and we don't even try," he told SN.
"One reason for our success is that we follow a discipline that accepts an intelligent loss of sales, which runs counter to most merchants' thinking. But we'd rather do what we do well and give up some business than try to be all things to all people."
Accordingly, Costco limits its overall assortment to about 4,200 stockkeeping units, with food items accounting for about one-third of the total, or about 1,400 SKUs.
"We understand our business," Sinegal said. "We're not a Fred Meyer with 140,000 SKUs. And when a customer walks in, we accept the fact he's going to see only 12 TV sets for sale, compared with 100 at Circuit City, or 12 boxes of cereal, compared with 300 at QFC, or 200 office supplies, compared with 4,000 at Office Depot.
"Yet we envelop the customer in merchandise, and I defy anyone to be able to tell we have only 4,200 SKUs, because it looks like we have 100,000. The key is being very selective in each category."
Its success has prompted Costco to accelerate its unit growth year by year, with 14 new warehouses opened last year, 25 more scheduled to open this year -- 16 in the United States and nine overseas -- and 30 or more a year over the next two years.
Domestically, the company plans to open its first units this year in Dallas and Austin, Texas; Pittsburgh; and St. Louis, as well as its second location in Cincinnati and additional locations in other established markets.
Costco still has considerable room for domestic growth, Sinegal said. "We're not yet in Minneapolis, Houston, San Antonio or New Orleans. But we will look at any market that's attractive and evaluate it on the basis of sites available and competition."
Costco is also involved extensively overseas, with 31 stores outside the United States accounting for approximately 30% of its total sales.
Domestically, the company into e-commerce through the Web site it launched in 1998.
The site offers "more exotic merchandise" than Costco regularly carries in store, Sinegal said, including an expanded selection of some higher-end nonfood items. Non-members can buy off the site by paying 5% over the price charged to members.
Sinegal said the site "is doing better than expected, although we started off doing less than we expected. But we did as well in January and February as we did at Christmas, and perhaps a little better, and we're pretty pleased so far."
While it's hard to say if Web sales are coming at the expense of warehouse sales, Sinegal said, he believes most Web sales are incremental.
Web items are shipped to buyers via a third-part delivery service. "But we really need to do our own distribution, as soon as volume grows to a size that demands it," Sinegal said. He said he expects Costco to get into self-delivery "in probably a year or a year and a half."
Except for a couple of gift-pack food items, the site does not offer any food, and Sinegal said he doubts any will be added.
At warehouse level food is positioned at the rear of the store.
Food accounts for 35% of floor space and close to 50% of sales, Sinegal said. That 50% includes institutional sizes of paper goods, cleaning supplies and candy and a lot of tobacco products, he noted; excluding those items, "food as defined by what a supermarket sells is probably closer to 30% of sales," he said.
Food sales have shrunk about 2% over the past two years, Sinegal pointed out, as general-merchandise sales have escalated, particularly as computer-related equipment has become a hotter seller.
Of the company's food assortment, 70% is dry grocery, 8% is fresh, 7% is refrigerated, 7% is tobacco products and 6% is frozen foods, Sinegal said.
Costco's warehouses carry a limited selection of fresh items -- only those that fit into the warehouse concept, Sinegal said, including a handful of steaks and seafood items in value-packs; bagged produce, and baked goods in institutional sizes and multipacks.
"Supermarkets are not our business," he said. "A customer that shops with us must still go to a supermarket because we don't have everything they need, and we don't pretend to."