Costco (COST) recently signed a deal with Green Mountain Coffee (GMCR), under which the latter will manufacture store brand coffee packs for Costco. Costco's focus on its private label brands is evident from its successful Kirkland signature and this deal will add another product to its shelves.

Private label brands have been quite successful in the U.S. and Europe and form a significant proportion of the total retail sales. Given the current economic growth in the U.S. and tough economic environment in Europe, we expect this trend to continue. Private label brands tend to be cheaper and have higher gross margins, thus their appeal to both consumers and retailers. Although this might seem to be a small step for such a big retailer, it is an important one in context of the aforementioned trends.

Importance of private label brands

Private label brands are generally cheaper than the national brands and have higher gross margins. Costco also reports that the quality of these brands is comparable to the national brands so they not only attract customers due to lower prices but are also more profitable for the company.

The private label brands are also cheaper because of the retailer's enhanced control over their sourcing costs, quality and quantity. Moreover, they are specific to retailers and do not have promotional expenses associated with them, which further reduces their costs.

The retail industry has witnessed the increasing penetration of private label brands over the past few years. In the last 10 years, according to Food Product Design, the sales of private label brands have increased by about 40% in the United States. The U.S. consumers have shifted to private label brands as a result of tough economic conditions and due to their lower cost and comparable quality.

Last year, according to the same industry information source, the revenue and unit share of private label brands in the U.S. was around 17.4% and 21.8%, respectively. In Europe, according to TalkingRetail, the value share was around 31% with private label brands being about 30% cheaper than national brands.

With the prevailing tough economic environment, shoppers are likely to remain price conscious. We therefore believe that private label brands will continue to be successful in the future as well. For Costco, given its thin gross margins, this can deliver substantial value as there is hardly any room to absorb the effects of food price inflation and other price shocks. Increasing the penetration of private label brand in its retail space might help Costco sustain its competitive pricing amid increasing material costs.

Our price estimate for Costco stands at $111, implying a premium of about 15% to the market price.