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April 27, 1999
Costco Companies for Mom
by Dale Wettlaufer
([email protected])
Trading at $89 as of April 26, 1999
Dear Mom,
You have done very well with your investment selections over the last couple years. I'm very proud that you take a businesslike approach to investing and apply your business experience so well to that process. So I know you don't need any suggestions from me, but I also know that you're always in the market for some good ideas. I believe I have one for you -- it's Costco Companies <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COST)") else Response.Write("(Nasdaq: COST)") end if %>.
First, there's no question that Costco is a great retailer and a very well run company. By delivering name brand and very high quality private label products to the customer at the lowest possible prices, Costco creates a ton of value for customers and, as a consequence, shareholders.
Price and Quality Products
Costco is a warehouse retailer that sells dry goods and hard goods such as detergents, health and beauty aids, automotive products including tires, flatware, and cookware; gourmet foods such good cheeses and meats, fresh lobster, and a great selection of wines; services such as deeply discounted merchant transaction processing; and grocery items such as milk, juices, cereals, candies, and produce.
The philosophy at Costco descends straight from retailer innovator Sol Price, who started Fed-Mart and later Price Club. In his autobiography, Sam Walton, Made in America (a book almost any investor hoping to understand retailing would be insane not to own at the $7 cover price), Wal-Mart's founding genius talks about Price often: "I guess I've stolen -- I actually prefer the word 'borrowed' -- as many ideas from Sol Price as from anybody else in the business." (p. 102) That philosophy is simple: If Costco can't save you money on an item, it won't sell it.
Costco board member and Wesco Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: WSC)") else Response.Write("(AMEX: WSC)") end if %> Chairman Charlie Munger positively gushes about Costco, and in that, he's not much different from 90% of the many Costco customers to whom I've spoken. From a 1997 Forbes cover story: "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." "Including Sam Walton," the magazine asked. "Munger nods."
Merchandising
When people think of warehouse clubs, they think of huge package sizes, cheap products, and low-income clientele. What you see when you go to Costco is different. You see a wide variety of customers that cuts across demographics -- the common denominator being that people are looking for value. Saving people money -- big money over the course of a year -- isn't the entire part of a value equation. Value is the intersection between product satisfaction (which includes the service components at Costco), product utility, and price. You can sell junk to someone at a rock-bottom price or you can sell exclusivity at a needless markup. The value proposition, not just the price proposition, is what Costco considers in its merchandising.
According to BT Alex. Brown retail analyst Barbara Miller, Costco's average store has about 3,500 stock keeping units (SKUs) in a 120,000 square foot store, "...minuscule relative to, for example, a supercenter in the same size box [store].... COST's merchandising is a key thing responsible for its success," Miller said. "Clubs are item merchants, hence each selection is important."
Forbes focused on this idea as well: "By stocking only a few branded goods in each product category, Costco is in essence doing the customer's comparison shopping and demanding the best terms from the vendor." In other words, when you walk into a Costco, you're not faced with random piles of stuff you don't need or cheap knockoffs of stuff you do need. For those shoppers who are not looking for an adventure in cheap, unknown substitute brands, they can feel comfortable walking into a Costco.
When it comes to the company's private mark, Kirkland Signature, the company is very serious about the brand equity it is building. Barbara Miller agrees, "Even its private label products, Kirkland Signature, compare themselves to the best (e.g. the luggage is compared feature by feature with Tumi) -- the chicken breasts are co-branded with Tyson." Forbes relays an interesting story on this point: "[Costco CEO Jim] Sinegal is careful not to abuse his customers' trust by using the signature label on something second-rate. Because Procter & Gamble came up with a superior paper towel, Costco won't sell its towel line as Kirkland, choosing instead a lesser private label. No easy hits on the customer -- that's the rule."
Depending on the product, the savings at Costco can be substantial or it can be minimal. If you're buying Gillette Mach 3 cartridges, for example, you're going to get somewhere around Wal-Mart's and Sam's Club prices. Both have huge purchasing power and pass along the savings to customers on these types of items in order to pull customers into the store. On something like Costco's Kirkland brand shampoos and conditioners, you get a salon quality product with very high quality ingredients for $2.50 (the 34 oz. size) that would sell for at least $15 elsewhere. It's not that hard to imagine a company like Paul Mitchell or another higher end shampoo marketer making this product for Costco, either. Duracell manufactures Kirkland Signature batteries and Agfa manufactures Kirkland Signature film.
A Buyers' Cooperative
One way to look at Costco is as sophisticated buyers' cooperative. It can deliver good discounts on a select number of brand name items such as Coach leather items and quite appreciable discounts on everyday items such as milk, and offer giant discounts on high-quality, private label merchandise. It also uses its bulk purchasing power to offer highly discounted services such as photo processing and pharmacy services. Executive Membership customers, who pay a higher up-front membership fee ($100 versus $40 for a regular membership), can take advantage of large discounts on health, auto, and home insurance; check printing; credit card processing; and discounted mortgage and real estate brokerage service. No doubt the company will add other services to that menu, as well. Costco also operates gasoline stations at certain locations, which is a good draw and isn't a loss-leader sort of investment, either. It supports itself and shows the same returns that the main part of the business produces and is a great service for the customer.
Business Model
The key to the growth of this business and its economic competitiveness is that it's making itself as slim an intermediary as possible, passing on part of the return to customers and part to shareholders. That economic attribute is the hallmark of some extraordinarily successful companies, including GEICO, the direct auto insurance unit of Berkshire Hathaway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BRK.A)") else Response.Write("(NYSE: BRK.A)") end if %>; direct PC companies Gateway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GTW)") else Response.Write("(NYSE: GTW)") end if %> and Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>; Internet retailer Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %>, uber-retailer Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>; and discount brokerages Charles Schwab <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SCH)") else Response.Write("(NYSE: SCH)") end if %> and E*Trade Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EGRP)") else Response.Write("(Nasdaq: EGRP)") end if %>.
The idea is to price products as low as possible -- low margins are a sign of success, not of failure. If you're a retailer in this line of business, you're not succeeding if you have high gross margins -- you are most likely becoming uncompetitive because you are not delivering the most value to the customer. Put together with the ability to manage working capital and fixed assets very well, a high asset turns, low-margin business can create generous returns on capital (click here for capital management and business model data, as of the third quarter of fiscal 1998).
As a sidenote, I would see increasing gross margins at Amazon.com as a bad thing. I would want to see them keep pushing down prices while still generating good returns on capital. Extreme price competition in many industries, including retailing, is a fact of life that will kill many a company, or at least severely stunt their growth, if that extreme price competition is not embraced and built into the business model.
Consider the company's gross margin last year -- 11.91%. That's less than half a supermarket company's margin. Obviously, if a company is targeting 20% gross margin and only reaches 11%, then something's wrong. But this company is on-plan with its margins. It's the asset activity that determines how well shareholders will do. Consider Safeway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SWY)") else Response.Write("(NYSE: SWY)") end if %>, which is not a comparable at all, but just for the purposes of looking at different financial models:
Gross Margin Op. Margin Cap. Turnover Cash Conversion Cycle
Costco 11.91% 3.24% 6.23x 7.5 days
Safeway 29.1% 6.5% 3.25x 7.9 days
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