COST: Costco (1)

History

Although Costco was founded in 1983, the organization that we know today was actually the result of a merger between Costco and its predecessor company Price Club, which was the result of Sol Price’s previous company FedMart, which itself really came out of Fedco in the 1940s.

In some way these are all stacked learnings from Sol Price and his various business offsprings over the years to create the Costco today.

Sol Price was born in 1916 in New York City. His parents were Jeweish immigrants from Belarus, they arrived to America just a few years ago as teenagers with no money and spoke no English. As a young child, Sol develops an eye defect that caused his left eye to droop. He was really self conscious about this but channelled this insecurity into being a overachiever in school. He skips two grades in school, then in the middle of his high school, the family moved from New York to San Diego, California.

During then, San Diego was a small town of 150,000 people and the US Navy with the defense industry was starting there. Then World War 2 came, Pearl Harbour was attacked and San Diego became the principal part of the Navy. There was a boom in the metal industry and shipbuilding.

After the war, San Diego went on the path of becoming the 8th largest city in America and became a fertile market for a new retail enterprise in postwar America. Sol got his law degree and started practicing as a lawyer right before this boom.

Sol starts counselling entrpreneurs with these new retail concept startups that were emerging. One of these was called Seven Seas Locker Club, which is literally a club with lockers where Navy sailors can store their uniforms when they were on leave and wearing their civilian clothes. When they go out to sea, they can store their personal belongings while away. Adjacently the club sold all kinds of goods and services like laundry, jewelry, food, haircuts etc. This concept would later become what retail calls “loss leader strategy”, where the retailer prices a product lower than it production cost to attract customers into the shop to sell more expensive products.

Another client was a jewelry store called Four Star Jewelers. In addition to operating their own jewelry store, they also sold wholesale to other retailers. There was one retailer in particular that accounted for the majority of their wholesale volume, it was an odd retail concept operating out of Los Angeles called Fedco.

Fedco turned out to be a non profit membership club, it was called Fedco because it was only open to federal employees, primarily postal workers. After the war, about 800 postal workers in LA decided they wanted to pool their buying power together and started this club to get better prices on goods that they can all participate together.

They charged a membership fee, but unlike Costco today, Fedco did not make any money on the memberships because it was just $5 for a lifetime. Fedco became very popular amongst government employees all over southern California, including San Diego, people would drive a large distance just to do bulk shopping at Fedco.

Sol Price saw this and wanted to recreate Fedco in San Diego, his wife had an empty warehouse building, so he called up Fedco and asked for a joint venture. But Fedco was non-profit so they were not interested in expansion and they rejected him. Sol then decided to do it himself, in November 1954, he opened the store and called it FedMart with one important difference that his store is for-profit.

FedMart was a membership club but customers didn’t have to be federal employees, and they undercut the membership fees of Fedco. During that time there were laws that said manufacturers of goods could not sell products below a minimum price to the general public. However if you were in a membership club, you were not defined as “general public” and thus could skirt these laws.

When Sol opened the first FedMart in 1954 it was a huge and immediate success. They expected to do $1mil sales in the first year, but they did $3mil instead. He stopped practicing law and went full time with FedMart, he hired a young college student named Jim Sinegal, as a part timer. Jim would end up working for the next 22 years at FedMart and become the CEO of Costco.

Sol codified 4 principles for the FedMart playbook:

1. Provide the best possible value to customers

2. Pay good wages to employees and provide good benefits, including health insurance

3. Maintain honest business practices

4. Make money for investors

These are very similar to Costco’s priority order values today:

1. Obey the law

2. Taking care of members

3. Taking care of employees

4. Respecting the suppliers

Particular note on point 2: paying good wages and health insurance. This is a very progressive idea in the 1950s prevailing until today. Costco’s average hourly wage is $26 and Walmart is $19.5. Employees of Costco are eligible for 401(k) matching and good healthcare even for hourly workers. As a result employee turnover is very low, after the first year Costco today has only 7% attrition rate, while typical retail is 20%. Moreover, well paid employees reduces theft, the shrinkage (unaccounted for merchandise) at Costco today is very low at 0.15% of sales.

At start of 1970s, a new retail concept in Europe emerged, pioneered by the French company Carrefour, it was the hypermarket. It is what we understand today, hypermarkets are full scale grocery stores supermarkets. Sol and his son, Robert, was looking for partners to take FedMart across Europe and they met with a German retailer named Hugo Mann. The idea was Mann was going to help FedMart take this hypermarket concept and spread it across America, which was what Walmart did with great success 15 years later.

Hugo Mann realized that FedMart was sitting on a goldmine of real estate and just wanted the portfolio, he had no interest in pioneering hypermarkets in America. He bought two-thirds of FedMart, got into a big fight in the first board meeting, and removed Sol and Robert in a corporate buyout. By the way, FedMart went bust after 5 years of the takeover, but Hugo Mann became quite rich from the real estate.

Sol Price, now 60 years old, was a man on a mission after being kicked out of his own company. Literally the next day after Sol and Robert were removed, they got a lease at an office and started to strategize on a new business plan. They felt that the centralized warehousing operations that Jim Sinegal ran at FedMart was under-appreciated.

Sol and Robert decided to run a warehouse operations where their customers were small business owners. The logistics were simple: they take pallets of stuff, move it to a location in the warehouse, then the customer comes and take a huge amount off the inventory. Initially they thought only business owners were willing to shop and buy in this way, but now we know individuals and families are willing to buy in bulk too.

They kept the original membership fee because they are providing real value to their customers in terms of logistics and price. Sol and Robert poached a few people from FedMart and went running with this new business plan, calling the new company Price Club.

In order to keep operations tight and realize maximum benefit, Price Club only stocks about 3000 of the highest volume items. Compared to Walmart which had about 50,000 SKUs (stock keeping units), FedMart also had close to that number. Going down to a small number of SKUs is a non consensus move.

Today Costco keeps SKUs very low at about 3800, in constrast Walmart has 100,000 to 250,000. As a result Costco can negotiate with suppliers for lower prices in order to transfer this savings to customers. Because lower SKUs means easier tracking and lower supplier count means more detailed supply management and better supplier relationships.

Price Club eventually expanded but compared to FedMart before, the competition and capital dynamics were different. Because of this low SKU and warehouse logistics model, Price Club generated huge cashflows. We can follow the cash flow cycle:

1. Supplier delivers to warehouse, drops off the pallet and invoice Price Club.

2. Invoices tend to be 30 days payable, but the minute the pallet is dropped off it is good for sale.

Today Costco turns their inventory 12.4 times per year, compared to Walmart 8 times, Home Depot 5 times. Therefore Costco sells through its inventory faster and more often every 30 days, with a typical payment terms being 30 days, Costco can turn inventories a few times before they have to pay suppliers on average. This is called a negative cash conversion cycle where suppliers effectively finance Costco’s inventory.

There are companies that can achieve a negative cash conversion cycle but usually using predatory terms where they stretch the payment period.

Following the success of Price Club, Sol received another call from a Seattle retailer named Bernie Brotman. He wanted to open a franchise in Seattle just like the Fedco and FedMart days. It would be Bernie’s son, Jeff, who called Jim Sinegal and convince him to come up to Seattle and run the business plan to clone Price Club. Jim called this clone Costco.

In the 1980s, Costco made $1bil revenue in less than 3 years of operation and $3bil in less than 6 years. They go public in 1985. In June 1993, Costco and Price Club merged together to form Price Costco. 52% of the equity in the combined company went to Costco shareholders, 48% to Price Club shareholders. It was a respectful transaction treating Price Club as equal, paying a premium for it’s shares, although Costco was growing much faster.

In 1999, Price Costco renamed itself to the Costco (COST) that we know of today.

Sol Price lived to be 93 years old and died in 2009. After the merger, he dedicated the rest of his life (15+ years) to philanthropy and politics.

Competitive Advantages

Selection for Wealthy Customers

Bulk purchases are cheaper per unit but consumers have to pay more upfront, including membership fees. This means COST selects for members who are not sensitive to cash flow. The average COST consumer makes about $125,000 a year while Walmart has a median income of $80,000 (median US income is $71,000).

Psychology of Prepaid Membership

The $60 membership makes consumers assume that they are getting some good deal so it makes consumers want to maximize the margin dollars on discounts. This can lead to buying more than what the consumer actually needs.

Profit Margins

Unlike the regular retailer, COST does not markup anything more than 14% above suppliers’ price. Some goods have less than 14% gross margin (eg. electronics around 7%). The only exception is their own brand Kirkland Signature, where they make 15% margin, just 1% more. Typical retail store markup is easily 100%, for example Walmart discounted items has gross margin of about 25%. Over decades of delivering this promise of “lowest price”, members trust that COST will always give the best value proposition. More importantly, suppliers trust that any savings in negotiation will flow down to the customers, and COST will not undercut suppliers for their own profit. This intangible value of trust between suppliers, consumers and COST cannot be seen in traditional accounting. If we look at the P&L, the gross margin fluctuates around 12% to 13.5%, compared to Walmart average 25%.

The split of operating income between membership fees and retail is about 70:30. The proportion for retail is significant enough that COST has the incentive to grow retail instead of just caring about membership retention.

Valuation

Despite having the lowest gross margins within the retail & consumer staples industry, COST is the most efficient large cap retailer in terms of return on invested capital (ROIC).

On average, the consumer staples industry earns a ROIC of 5%. Over the last 10 years, ROIC ranges for Walmart and Target was between 10 – 15% and 10 – 20% respectively. COST returned 15 – 20% consistently over the same period.

Although COST possesses highly defensible economics, the current market cap is $297b at over 40x earnings. We think it is too expensive.

Current news

There is a new CEO, Ron Vachris, who will replace Craig Jelinek starting January 2024. Ron has been with COST for nearly 40 years, he worked as a forklift operator at Price Club even before the merger.