In the past few blog posts I have explained what creates a “moat” (i.e., a sustainable barrier to entry against competitors). Costco is an interesting case in that instead of a dominant reason for the moat’s existence (for example, self-reinforcing demand side economies of scale/network effects in the case of Google) there are lot of little things which create the Costco moat. As is the case with Starbucks, the moat is made up of a lollapalooza of factors like brand, company culture, systems and supply-side economies of scale. In 2001, the year the Internet bubble popped, Jim Sinegal met Jeff Bezos in a Starbucks in Bellevue, Washington and told the Amazon CEO about the Costco business model. In the book “The Everything Store” the author writes about that meeting:
“Sinegal explained the Costco model to Bezos: it was all about customer loyalty. There are some four thousand products in the average Costco warehouse, including limited-quantity seasonal or trendy products called treasure-hunt items that are spread out around the building. Though the selection of products in individual categories is limited, there are copious quantities of everything there—and it is all dirt cheap. Costco buys in bulk and marks up everything at a standard, across-the-board 14 percent, even when it could charge more. It doesn’t advertise at all, and earns most of its gross profit from the annual membership fees. ‘The membership fee is a onetime pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else,’ Sinegal said. ‘It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco.’”
As I said in my post about Jeff Bezos, the existence of “pricing power” and attractive returns on invested capital are the right test of whether a moat exists. Morningstar writes:
“Because much of Costco’s membership revenue is booked in advance, cash flow volatility is below average. Membership renewal rates stand at about 90% in the U.S. and Canada, and they did not materially differ from this level during the Great Recession. On a global basis, renewal rates stand at about 86%… With an average of 3,800 active stock-keeping units per club versus more than 60,000 at most mass-merchant superstores, Costco wields almost as much bargaining power as Wal-Mart and Kroger. The firm reduces handling costs by purchasing merchandise directly from manufacturers and storing merchandise on sales floors rather than in central warehouses. Self-service store formats and modest marketing requirements help to minimize operating costs, allowing Costco to deploy much of its assortment as a loss leader. …Costco derives roughly 75% of its operating profits from membership fees. Member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. However, Costco offsets thin margins with massive sales volume and rapid inventory turnover, leading to exceptional unit productivity levels. In fiscal 2013, Costco generated about $162 million per club, compared with $80 million per unit at Sam’s Club in its most recent fiscal year. On a square footage basis, this translates into more than $1,100 net sales per square foot, a range normally reserved for high-end jewelers and fashion apparel retailers. Exceptional productivity also leads to strong returns on invested capital, which have consistently been in the low to mid-teens over the past five years, comfortably ahead of our 8.6% cost of capital assumption.” – Costco’s Bulking Up Its Moat
2. “Anybody can sell merchandise for low prices. The trick is to be able to do it well and to make money while you’re doing it.” As Charlie Munger said at the 2014 Berkshire meeting: “Costco is unbelievable. It is against the human nature of many entrepreneurial people to get price down and service up…” As I also noted in my post on Jeff Bezos, if you lower prices, sales volume goes up and that drives absolute dollar free cash flow and the interest free loan from suppliers – known as float. That higher sales volume gives Costco huge leverage with the one vendor that it decides to carry (Safeway negotiates with many suppliers of peanut butter while Costco has one). Costco also focuses on a specific set of customers, argues Megan McCardle:
“Costco really is a store where affluent, high-socioeconomic status households occasionally buy huge quantities of goods on the cheap: That’s Costco’s business strategy (which is why its stores are pretty much found in affluent near-in suburbs).” – Bloomberg
3. “We’re not kamikaze pilots. We want to do things in a sensible fashion. If we can speed up our growth, without outdistancing our management team, and provide a quality product, then we will do so.” The easiest and best way to be smart is to not be stupid. That Charlie Munger is on the Costco board of directors of a company which takes pride in being sensible should not be a surprise. Costco opens new stores at a reasonable pace each year. Lots of the expansion is outside the US. Not getting too far out in front of your skis on store openings is wise. For this reason, Costco opens 25-30 new warehouses each year.
4. “Paying good wages is not in opposition to good productivity.” “You’ll get good people” If you have stores with fewer SKUs and products that sit on pallets they came in, productivity goes up. Someone is paying for all those people who haunt the grocery store aisles stocking goods and straightening boxes and that gets reflected in grocery store prices. Megan McArdle writes: “Costco has a tiny number of SKUs in a huge store — and consequently, has half as many employees per square foot of store. Their model is less labor intensive, which is to say, it has higher labor productivity.” CBS News reported this week that according to data complied by Glassdoor: “Costco ranks as the second-best company for pay and benefits, trailing slightly behind Google. The average annual salary for a Google product manager is $146,215, according to Glassdoor data. The average hourly pay for a front-end cashier at Costco, by comparison, is $16.07 an hour. ”
5. “If you’re a big-picture guy, you’re not in the picture. Retail is detail.” A number of very prominent hedge fund investors have been brutally punished by venturing into retail, via companies like JC Penney and Sears. Retail is hard. At the 2014 Berkshire meeting, “Buffett noted that most of his investment misses — at least those related to straying outside his circle of competence — have been in retail. Without explicitly saying, he more or less chalked this up to not knowing the businesses.”
6. “This is almost like show business. I mean, every day you’re opening up and it is show time.” The “treasure hunt” aspect of shopping at Costco is intentional. Some people get a dopamine rush when they find the unexpected treasure as the wander the aisles at Costco. The feeling of walking out of Costco having spent more than you imagined going into the warehouse is common. Charlie Munger puts it this way: “If you get hooked on going to Costco with your family, you’ll go for the rest of your life.”
7. “I think the biggest single thing that causes difficulty in the business world is the short-term view. We become obsessed with it. But it forces bad decisions.” “One of the follies of American business is that we are all so tied into these quarterly results and having to perform that it’s damaged a lot of businesses.” “You have to worry about where the business is headed long-term.” My post on Jeff Bezos explains how this creates competitive advantage over other companies who only think about the short term, and drive the business based on short term changes in ratios.
8. “Wall Street is in the business of making money between now and next Tuesday. We’re in the business of building an organization, an institution that we hope will be here 50 years from now.” “Driving stock up from one day to the next is not what we are about. We are about building a good company and performing for the long term. I know everyone says that, that sounds trite when I repeat it that way, but that is and has always been our attitude about our business. If we do the right things, the stock price will take care of itself, and our shareholders will be rewarded.” It’s that simple.
9. “You haven’t got enough space in your paper to print all the errors we’ve made. But what we like to say is that we’re not going to make that same mistake five times.” Try to make new mistakes, but recognize that making mistakes is a part of finding success. It is wise to fail regularly at new things, trying to learn “via negativa”, but fail quickly when you do fail.
“Jeff Brotman, Costco’s co-founder and chairman, says Bezos “doesn’t have to make a profit or break even on” services like Amazon Prime and AmazonFresh. “He’s building great loyalty with that, as we have with our executive membership,” which costs $110 a year and entitles members to additional benefits. Like other Costco executives, Brotman was skeptical that home grocery delivery could be profitable, but he notes that Amazon doesn’t really have to make it work perfectly in the short term: ‘He can spend a billion dollars experimenting and putting televisions on a truck and delivering them the same day with apples and oranges. That’s a research and development experiment that competitors and normal online businesses can’t do.’” – Businessweek
10. “We want to turn our inventory faster than our people.” Employee turnover is costly. New employees need to be trained and mistakes can be made in hiring. The only complaint I have heard from a Costco employee is that you advance at Costco one retirement at a time. Charlie Munger has a different view and calls Costco: “a total meritocracy.”
11. “We would rather have our employees running our business.” As is the case at Nordstrom, Costco employees start at the bottom and for that reason understand the business from the ground up. Letting ‘the employee who sweeps the floor, select the broom’ means jobs get done better and employees both feel better about themselves and are happier. As I wrote in my post on Howard Schultz, Starbucks similarly thinks store managers making decisions about that store is wise. In his book “The Outsiders” William Thorndike writes: “There is a fundamental humility to decentralization, an admission that headquarters does not have all the answers and that much of the real value is created by local managers in the field.”
12. “Competition makes us better. Some of our best stores have a Sam’s Club next door.” Sam’s is a competitor, but Amazon is a bigger threat. Jim Sinegal perhaps regrets that he taught Jeff Bezos so much about Costco’s business model, but great CEOs are often natural teachers. And that’s a good thing.
Finally, Morgan Housel writes:
“Asked about his favorite company outside of Berkshire, Munger literally interrupted the questioner and answered, “That’s easy. It’s Costco. “It’s one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet,” he gushed. “I just can’t say enough about my admiration for Costco. More of you should look at Costco. In fact, every time Donald Trump says something and you get discouraged, you should think about Costco.” He wasn’t done. “It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It’s almost a religious duty. He’s sacrificing short-term profits for long-term success.” This wasn’t the first time Munger let his admiration run wild. Last year he said, “Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation.”