Costco Bull's Pen
by Yi-Hsin Chang ([email protected])

(With apologies to Elizabeth Barrett Browning)

O Costco, how do I love thee? Let me count the ways.
I love thee to the depth of thy discounts -- thy low prices
Are sure to throw rival warehouse clubs into crisis.
I love thee to the height and breadth of thy stores, services and offerings,
From chips and beer, to salmon, champagne and other delectable things.
Plus name-brand clothes, office supplies, major appliances,
CDs, electronics, furniture, small household appliances.
I love thee for thy unwavering sense of commitment to quality;
Even thy private Kirkland label is good enough for nobility.
I love thee for thy constant heroic cost-cutting measures;
Shopping at Costco is really one of life's simple pleasures.
I love thee to the level of thy skyrocketing sales;
On a per-unit basis, Wal-Mart's Sam's Club simply pales.
I love thee for thy high sales volumes and rapid inventory turnover.
Thy steady stock performance shall make me enough to buy that Range Rover.

I'm proud to admit it: I'm a lover of Costco <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COST)") else Response.Write("(Nasdaq: COST)") end if %>. Once you become a card-carrying member, as I and several fellow Fools have, you just can't help but wax poetic about it. That's actually how Costco generates most of its new memberships -- through word of mouth. The company's policy is to "limit advertising and promotional expenses to new warehouse openings and occasional direct-mail advertisements." Still, according to an independent customer survey, Costco has earned a loyalty factor that only Nordstrom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NOBE)") else Response.Write("(Nasdaq: NOBE)") end if %> can approach -- a nearly 97% renewal rate among active businesses. It's a level of commitment more sacred than many marriages and most relationships between patients and their doctors.

As my fellow hack Dale Wettlaufer pointed out in a recent Industry Snapshot and several Fool on the Hill columns (9/8/98, 9/11/98, 8/20/98), Costco's North American outlets raked in around $87 million per unit last year. In comparison, arch rival Sam's Club, a division of mighty Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>, with substantially more stores and members, took in a mere $45 million on a per-store basis, while BJ's Wholesale Club <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BJ)") else Response.Write("(NYSE: BJ)") end if %> averaged about $40 million. In terms of total sales, Costco again topped its competitors with $21.87 billion versus $19.78 billion at Sam's Club and $3.23 billion at BJ's.

The numbers aren't surprising. Costco is simply a more efficiently run business than its rivals. Except for Discover and now its own branded credit card, the warehouse club only accepts cash and checks. This allows the company to take advantage of early payment terms to obtain discounts from its merchandise vendors. Combined with the stores' high sales volume and rapid inventory turnover, this means that cash-rich Costco can operate using a fraction of the working capital needed to run, say, a Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %>, which generates roughly the same amount of revenue, according to a telling cover story in Forbes magazine. Plus, Costco buys almost all of its merchandise directly from manufacturers, eliminating many of the costs of multiple-step distribution channels.

Through strict monitoring of entrances and exits -- you can't enter without a membership card, and you can't leave without having your receipt and purchases (and large bags) checked. The company has been able to limit inventory losses to less than one-half of 1% of net sales -- unheard of among other discount retailers. It also doesn't have many problems with bounced checks because it sets ceilings on business check purchases and limits individual memberships to certain qualifying groups. Members who have issued returned checks automatically lose their membership rights.

A typical Costco warehouse has a no-nonsense, no-frills floor plan designed to maximize the use of space. It looks and feels like a warehouse, though it's certainly clean and well-lit. Merchandise is usually stored on racks stacked directly on top of one another above the sales floor, making it easy to restock display merchandise using a forklift. Even with photo processing, finished photos are organized alphabetically on several racks on the sales floor, leaving individual customers the task of serving themselves by sorting through the marked envelopes, further reducing labor costs. Costco carries on average roughly 3,600 to 4,000 active stock keeping units (SKUs), or unique items, per warehouse compared with 40,000 to 60,000 found at most discount retailers and supermarkets.

At the checkout stand, members don't mind that the store offers no shopping bags and that they generally must load their own carts (or sometimes cardboard boxes the store would otherwise discard) -- again, self-service at work. Costco's warehouses are typically open every day but only for a total of about 68 hours per week, closing earlier on weekends. Because these operating hours are shorter than those of other discount grocers and supermarkets, Costco further saves on labor expenses.

Ultimately, what makes Costco do such good business is that it runs a good business. It's a warehouse club "dedicated to bringing [its] members the lowest possible prices on quality brand-name merchandise" by leveraging its tremendous buying power and constantly cutting costs. In fact, it carries only products on which it can provide significant cost savings. The company's operating philosophy: "Keep costs down and pass the savings on to our members."

Costco's margins are incredibly low. Gross margin before membership fees last fiscal year was 10.1%, up from 9.7% the year before but compared with 20% or more at most supermarkets. The formula for making money here is simple:

value + low prices + low costs = happy customers = high volumes = profits.

The nominal annual membership fee -- what's $40 when purchases average close to $100 per visit? -- helps to defray much of the operating cost and allows the company to sell its merchandise close to cost and yet still make money.

As the aforementioned Forbes story points out, Berkshire Hathaway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BRK.A and BRK.B)") else Response.Write("(NYSE: BRK.A and BRK.B)") end if %> Vice Chairman Charlie Munger broke his own rule of not sitting on outside boards by joining Costco's board of directors last year. But like the rest of us, he discovered Costco as a shopper, not as an investor. Incidentally, Warren Buffett's Berkshire also owns 550,000 Costco shares as of the latest filing.

"It's hard to think of people who've done more in my lifetime to change the world of retailing for good, for added human happiness for the customer," raves the 70-something Munger -- and that includes Sam Walton.

Actually, Sam Walton "borrowed" the idea for Sam's Club from industry pioneer Sol Price, who founded Price Club seven years earlier as well as Fed-Mart (in the 1950s), the model for Walton's now juggernaut of a retailer, Wal-Mart. In October 1993, Price Club merged with Costco, which had been co-founded by veteran Price Club executive and Sol Price protege Jim Sinegal.

Not only does Costco/Price Club have a storied past, its future also looks bright -- half of the country, by state and population, remains Costco-less, not to mention the endless opportunities abroad. As Berkshire's Munger points out, "This is an absolute revolution and in my opinion a revolution that has a long way to go." Now that's what I call waxing poetic.

Next: The Bear Argument