Costco (COST)

Introduction

Everybody that I know loves Costco. The only thing they don’t like is the crowds! (A great problem to have)

Why I Chose Costco

Costco has a history of doing things differently than most other businesses. Where most companies focus on short-term profits, Costco focuses on long-term effectiveness which leads to maximum growth and profits. There’s a huge difference there. This is called “scale economies shared” popularized by Nick Sleep.
Costco makes almost no money on their products, only on memberships.
It’s antifragile, as we saw during the pandemic.
Leadership is interesting and one in a thousand.

Terms You Need to Know

It’s important to understand SES and why it’s so important. From Nick Sleep in his letters to investors:

“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’ incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”

“In the office we have a white board on which we have listed the (very few) investment models that work & we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them.”

“Early in a firm’s development it makes sense to reward customers disproportionately as customer referrals and repeat business are so essential to the development of a valuable franchise. With maturity this bias can be reduced and shareholders can reasonably take a greater slice of the pie. Too much, however, and the moat is drained with negative consequences for longevity. The temptations are enormous because capital markets will reward profiteering. There are many examples of companies which ‘harvest’ excessively, when perhaps they should focus on longevity. This may have been what happened at Coca Cola which has leant excessively on bottlers, or Gillette where advertising has been cut, or even at Home Depot which has boosted gross margin in recent years. Shareholders often suffer a double whammy as highly rated companies enter ‘growth purgatory’, because growth slows just at the time when shareholders spot the mis-analysis of reported profitability.”

Historical Performance

Costco had a great last 5 years, which is why it’s so popular right now.

Here’s how it compares to the S&P500:

In the rest of this report I’ll look at what makes Costco special, and if it’s a good investment today.

Selected Financial Data

Here is where Costco sits.

The Basics of the Business

Costco sells goods and services to customers across the world through their warehouses. They are widely popular for their discounts across all they offer from food, clothes, appliances, technology, travel packages, and fuel.

How Costco Saves You Money

Costco leans heavily into Scale Economies Shared (SES). It’s a simple concept, but difficult to implement over any long period of time. Whereas most companies prioritize short term profits, Costco shares discounts and pricing with customers.

Company A:
- Buys nuts for $10
- Marks up nuts 50%
- Sells nuts to customers for $15
Costco:
- Buys nuts for $8
- Marks up nuts 15%
- Sells nuts to customers for $9.20
- Works with vendor to decrease shipping costs, putting nuts in square containers instead of round containers, thus lessening number of shipments needed. New cost for nuts: $5
- Marks up NEW price 15%
- Sells nuts to customers for $5.75

Example: Proctor & Gamble was going to raise its price on Bounty paper towels 6% so Jim Senegal and Costco bought hundreds of truckloads before the price hike, thus saving his customers pennies per roll. “If that stuff doesn’t really turn you on, then you’re in the wrong business.” Jim Senegal, founder and former CEO.

How Costco Makes Money

Memberships!

Customers get products at-cost, meaning Costco only makes a profit from membership sales. It’s a very simple concept, but hard to implement over the long term. Why? Greed. Both private and public companies have a lot of pressure to maximize profit.

The thing is, Jim Senegal had the vision to prioritize people over profits, which eventually would lead to enormous profits.

Here’s the rate of growth since 1985:

17.3% stock price annual growth since 1985 is amazing. As it turns out, saving people money is extremely beneficial for everyone involved.

Customer Perspective

One of the things I like most about Costco is how close they are to their customers. They have a very tight feedback loop and a proven model: “We only have one bullet in our gun: the right product at the right price.” Does it work? I think so:

There’s stories of these everywhere as Costco is dominating the value proposition for customers. Long lines, a ~90% membership renewal rate, and increasing store numbers across the globe.

“The one constant is value. Value is appreciated no matter where you go.” Jim Sinegal

If Costco Closed Today

Another test: what if Costco closed its doors today? There would be complete chaos. People aren’t only preferring Costco to most other large retailers, they are die-hard fans.

If you are middle-class or lower, then the importance of a Costco membership becomes every-more important.

Put another way: Costco is important to 95% of customers and potential customers.

Employees First

One of the things I always look for is employee satisfaction.

“When employees are happy, they are your very best ambassadors.”

If you know people who work for Costco for any length of time, you know how well they take care of their people.

The business norm is to charge as much as possible, and to pay as little as possible.

Costco is going the other way, taking very good care of its employees:

For comparison, here’s how the average retail employee across the nation gets treated:

Average $10 per hour
Rarely get full benefits
Turnover as high as 65%
Costco pays its employees almost 2x what Walmart pays.

Strength and Weaknesses

✅ Discipline of Leadership

Out of all the companies that I have seen, nobody has executed on a vision like Costco. The discipline of their leadership is unparalleled. Most companies are rife with overpaid executives and directors, reckless spending, and shoddy accounting practices. Not Costco.

This discipline is by far Costco’s greatest strength.

✅ Culture

Regarding culture, businesses have 2 things: their culture, and their stated culture. Those are usually two different things. The more the stated culture and actual culture overlap, the stronger the business. After all, “culture eats strategy for breakfast” (Peter Drucker)

“From the bottom up, Costco is built on a culture that values passion, pride, integrity, and treating your employees right — one its co-founder spent decades carefully crafting. The payoff was huge.”

Then again later:

“Culture isn’t the most important thing — it’s the only thing.”

“For Sinegal, that culture of promoting passion, integrity, ownership, and motivation in his employees and ensuring that the customer can trust that they are always getting the best deal by shopping with Costco is the core of the company and the key to its success.”

It’s a small detail, but the synonyms above signal increased overlap with Costco’s stated and actual culture. “Passion, pride, integrity, and treating your employees right” vs “passion, integrity, ownership, and motivation in his employees and ensuring customers . . .” Pride and ownership. Those things are definitely baked in to Costco’s culture.

✅ Antifragility

From the pandemic we have seen Costco do even better as people became more price-conscious. This is Costco’s greatest strength. When looking for investments I value downside protection, and Costco’s antifragility boosts that protection very well.

“In another year of uncertainty, Costco was steadfast in providing goods and services, remaining nimble, and adapting our business as needed to best serve our members and protect our employees”

(Note: this does not mean Costco is a good investment at any price. More below in the stock section of this report).

⛔ Complacency

When I look for weaknesses with Costco I’m confronted with complaints about their business model, not weaknesses.

They don’t have everything
Costco stores aren’t in smaller towns
You have to have a membership to get in

All of these things are what make Costco Costco.

The major thing that I can see hurting Costco is complacency. Right now Costco has everything going for it because they have attention to detail running through the company from top to bottom. Very good!.

If management should change for the worse, or if Costco started to change its values to “creating stockholder value” then things could begin to unravel. However, this is highly unlikely given Costco’s history.

⛔ Managing the Behemoth

Costco’s distribution and logistics arm is crucial to its operations of creating value for customers. The larger the Costco ecosystem gets the, the more difficult it is to manage. This can bring about unforeseen difficulties in growth, especially internationally.

I see this as another big risk for Costco, but not one they aren’t equipped to handle. Their vice presidents of regions are experienced and tenacious.

Operational and Financial Health

Operations

Costco is expanding healthily. Here’s a list of new warehouses in fiscal year 2021:

12 in the US
4 in Canada
3 in Japan
1 in Taiwan

Total warehouses in the last few years:

815 in 2021
795 in 2020
782 in 2019

Costco isn’t only adding more warehouses, but expanding current warehouses. A good example of this is Salem Oregon, where the Costco warehouse was located on a very busy street with limited parking. They were losing a lot of business simply because the parking lot was full most of the time.

So they moved to near the edge of town for more space, more parking, and more business.

All of this expansion comes from an increase in memberships:

A lot of companies struggle with keeping the main thing the main thing. Costco doesn’t have that problem. As long as Costco keeps doing what they are doing they will continue to grow memberships and warehouses.

Revenue

Costco has increased revenue every year for the past ten years, even during the pandemic. (Antifragility at its finest)

This is not surprising, as Costco keeps adding memberships and warehouses.

Liquidity

Here is Costco’s liquidity ratio of the past few years:

It’s not as high as I’d like, but Costco is pretty capital intensive with a large inventory. I don’t view this as a negative since the demand is so high and steady. They also manage their debt very well. I consider Costco a master of debt management.

Solvency

Costco hovers between 0.4 to 0.6 debt-to-equity. Very reasonable. I’m pretty conservative so I like to see a ration of 0.4 or lower, but again Costco has been very consistent with strategy that they get a pass here. ✅

Operating Efficiency and Profitability

Keep in mind here that Costco’s strategy employs LOW margins. Let’s check it out:

Most companies are clamoring for higher margins, squeezing the customer for more and more money. It’s amazing to see Costco go the other way and do so well.

Distribution of Earnings (Cash Flow)

Here’s a breakdown of cash from operations, capital expenditures, and free cash flow:

I see consistent and healthy Free Cash Flow (FCF) year over year. Here’s where those FCFs are going, in the form of Return on Invested Capital:

The thing is, Costco is an ROIC machine of the highest order. All those warehouses, and all that discipline of leadership leads to a compounding that most large cap businesses would dream of.

Management

W. Craig Jelinek is the CEO of Costco, taking over after legendary Jim Sinegal. Both have extensive experience with membership-based retail, and both having worked from the bottom up. They are not career executives, but Owner Operators (OO).

There are three types of leaders: Owner Operators (OO), Long-Tenured managers (LT), and Hired Hands (HH). There are pros and cons to each, but my favorite is the OO, who has been with the company for quite some time, and knows the business from the ground up.

The best thing about OO leaders are their ability to see through fog of large organizations.

Future Growth Opportunities

One of the main concerns with Costco is “They’re so big, do they have room to grow?”

Let’s look at how many Costco warehouses are in the United States vs the rest of the world.

California has 131 locations alone.

Now let’s look at the rest of the world:

China has only 2 Costco warehouses with a population in the billions.

France, Spain, and many other countries have significant room to grow.

We also can’t forget that total memberships are only up to 61.7 million.

Lots of room.

The Stock

Costco is loved my many, and even more so by investors. Costco is expensive, ending 2021 with a P/E ratio of 40.2.

As of 4/7/22 the P/E ratio is 46.4.

This doesn’t mean that Costco will not grow into these prices, but I am looking for the right company at the right price. Costco is definitely a great company, but it’s not the right price for me right now.

For those of you concerned more with Price-to-Free-Cash-Flow (P/FCF) here you go:

No matter how you slice it, Costco is expensive.

But the quality is outstanding as you can see in the increasing Return On Invested Capital (ROIC):

Conclusion

Disciplined and experienced leadership behind Costco is the main reason they are so popular. They will always be pressured to take profits, but I’m convinced that Costco operates by their own code, and it’s working very well.

It will also be interesting to see how they grow, and what hiccups they have along the way.

Personally, I hope they fall out of favor with the market so that their stock becomes more affordable. This will not likely happen though.

I see a lot of smart investors balk at Costco because it’s too easy, and there’s no effort required in understanding it. That’s fine. It doesn’t take supreme intelligence to do this. It just takes a strong stomach to hold on the investment over years and year.