How Kirkland Signature powers Costco's success

New York(CNN Business) Costco's house brand, Kirkland Signature, is even bigger than you might think.

Last year, it raked in nearly $40 billion, an 11% increase from 2017. That's more than JCPenney and Macy's combined. Kirkland's sales also beat out Campbell Soup, Kellogg, and Hershey put together.

Kirkland, which Costco sells for at least 20% cheaper than national brands at its warehouses, helps the club keep prices low even on the products it doesn't make.

"Kirkland acts as a universal club marshal," said Timothy Campbell, analyst at Kantar Retail. "It keeps suppliers honest."

Costco is one of America's biggest retailers, but it only sells around 3,800 different products at warehouses. Big brands don't want to risk being left off Costco's shelves, so they'll usually drop their prices.

Last year, for example, Costco lowered the price of 40-packs of Kirkland half-liter water bottles to $2.99. That move forced national brands like Poland Springs to follow suit.

Costco also introduced Kirkland triple-blade razors last year after years of selling Gillette blades at higher prices. It recently launched a 35 oz. Nutella-like hazelnut spread that could put pressure on Fererro. And it has added its own coconut water and nut bars at discounts to Vita Coco and Kind Bar.

"When a traditional brand is losing shelf space or market share, what do they do? They create a better value," Costco Chief Financial Officer Richard Galanti said in an interview.

That's a win for Costco. Yet for brands, Kirkland products can threaten their sales and undermine pricing power.

Brands are loath to stop selling their products at Costco since they rely so heavily on its customers. But it's a "huge deal to them" when a Kirkland product starts appearing at warehouses, Campbell said.

Kirkland boom

Costco has staked its name on Kirkland. As Kirkland goes, so goes Costco.

The 24-year-old brand is a valuable asset for Costco that draws club members into its warehouses and spurs them to renew their $60 and $120 annual subscriptions.

"Kirkland is a brand in its own right," said Karen Short, retail analyst at Barclays. "It is one of the reasons people go to Costco. That's not necessarily something you can say about many private labels."

In 1995, Costco (COST) brought all of its private-label lines under Kirkland, which is named after the city that hosts Costco's corporate headquarters: Kirkland, Washington.

"I don't think at the beginning of this process in the early 1990s we thought nearly a third of our business would be under this brand," Galanti said.

Although Kirkland has been more successful than its competitors' own brands, Costco's strategy carries risks.

Since Costco offers a limited selection of items, it has less room to make errors with the brand or sales will suffer.

"We have to be careful," Galanti said. "We're not just putting it on things. Just like any branded item, any private label lives and dies based on how it performs."

In its annual securities filing, Costco warns investors that sales and profit margin would suffer if Kirkland "experiences a loss of member acceptance or confidence. Rivals do not have similar warnings for a single brand, a sign of Costco's reliance on the brand.

Kirkland had its share of misses in the past.

Costco pulled its Kirkland light beer this year after a tepid response. Galanti also said Costco discontinued its Kirkland soda after realizing that "no one was looking for a third major cola out there."

But mostly, Kirkland helps bolster Costco's reputation for high-quality merchandise, Barclays' Short explained. Shoppers are attracted to mundane Kirkland products, like toilet paper, cheap bottled water, and nuts, as well as stuff like golf balls and wine.

In addition, Kirkland helps Costco control supply chain costs. For example, when Costco changed Kirkland cashew jars from round to square in 2014, it was able to load more of them into trucks and on warehouse racks, according to Costco Connection.

Kirkland Kombucha

Rivals have taken note of Kirkland's success, and Costco faces new competition from store brands.

Discount grocer Aldi is growing in the United States, and it relies heavily on its own brands. Trader Joe's also has a similar strategy to Costco. Both of those companies share customers with Costco, Campbell said.

Amazon (AMZN) has aggressively built out its assortment to widen its selection and gain leverage over big brands.

Costco (COST) is facing renewed pressure from from Walmart (WMT), which has invested in improving its brands and Member's Mark from its Sam's Club arm.

Walmart has recently added clothing lines like Terra & Sky and Time and Tru women's clothing. It also launched an in-house kitchen to test new flavors for house food brands.

Walmart's biggest brand winner has come from Sam's.

Three years ago, Sam's pulled a page from Costco and consolidated all its private labels under the Member's Mark banner. The brand now makes up 27% of Sam's sales.

"We really dialed up our focus on the Member's Mark brand," Sam's CEO John Furner said in October. "The power of having one brand has been really strong."

One of Member's Mark's most successful innovations: Donut shop coffee, which Sam's spent a year testing.

Galanti said Costco must continue to innovate Kirkland to fight off Member's Mark.

Costco has high hopes for new items like the razors, Kombucha, and sparkling water to rival LaCroix.