Costco: A Lesson in Owner-Operator Thinking

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Buffett:

“We get excited enough to commit a big percentage of [capital] to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.  We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.”

John and I like to focus our study on companies with the first three attributes and wait for the market to provide us with the fourth.  In other words, we want to know what our pitch looks like and be ready, but are happy to wait with the bat on our shoulder indefinitely.

My thoughts on Costco are not revolutionary.  Many have seen and said similar things before.  There is no secret sauce. But, I do think Costco’s business model provides a good pattern recognition example that helps me look for these or similar attributes in other businesses (hopefully smaller and less expensive).

To be clear, I do not think Costco makes an attractive investment at this price (not a bad one, just not attractive enough). However, I would rather spend my time following a good business that is not currently attractive due to price instead of digging around in a lot of cheap, but poor businesses.

The underlying premise of Costco’s value to its investors is that its business model extends the durability of its business, thus making the future cash flow less risky.  Lower profits now equals greater certainty that those profits will exist in the future.   It’s helpful to keep that idea in mind as we discuss what Costco does differently.

There are a number of attributes that are somewhat unique to Costco (and other great businesses).  For this post, I would like to focus on three.

  1. Willingness to accept lower profits to build and preserve future competitive advantages.
  2. Long-Term Thinking Approach
  3. Measured Growth

All three of these attributes are intertwined into Costco’s business decisions.  

Gross Margins:

Let’s start with gross margins.  This is a perfect example of both a willingness to accept lower profits now and Costco’s long-term thinking approach.  Costco’s has a simple business model when it comes to its gross margin profile. Whatever price Costco pays, it will mark it up 14%.  If Costco buys 1m chickens for $5m (unit cost of $5 per chicken), Costco is going to charge $5.70 per chicken.  However, if Costco is able to buy 10m chickens for $40m (unit cost of $4 per chicken), Costco is going to charge $4.56.

This is an important concept to understand.  Costco could potentially charge $5 per chicken, which would be a substantial decrease to its earlier prices, yet provide a huge boost to its gross margin profile.  If Costco were to charge $5 per chicken at their new unit cost of $4, their gross margins would be 20%, and incredible 78% increase in gross margin dollars, while still passing on significant savings to its customers.  

However, this is obviously not what Costco does.  It continues to lower the prices.  And this is a perpetual flywheel.  As Costco opens new stores and gains greater efficiencies, customers are delighted to receive continual discounts.  “These prices keep getting better.”  Not only are these prices better for customers, but they are almost impossible to compete against.  And therein lies the moat–or the attractiveness for investors.  When a stream of future cash flows is more secure, it becomes more valuable.  

The two closest competitors to Costco are probably Kroger and Wal-Mart, on a national scale.  

In this chart, you can easily see the substantial difference in the gross margins between Costco and its main competitors. The difference in gross margins at these retailers represents a continual investment by Costco in extending the durability of its future profits.  Costco could raise its gross margin profile from 12.5% to 17.5% and still be substantially lower than its closest competitor, Wal-Mart at 22%.  This 500 basis point increase in gross margin would immediately add approximately $5.8B in operating profits.  On the other hand, this dramatic increase in price would certainly allow for Costco’s competitors to make a stronger push for Costco’s lucrative customer base.  Costco is literally investing in its customers by “sharing the profits.”  Some companies invest in advertising, but I believe Costco’s deliberate low prices is their preferred method of attracting and keeping customers.

screenshot-2016-10-13-23-27-26

Employee Investment:

Costco’s second investment area is its employees. Many employers pay lip service to the idea that their employees make their business great.  However, Costco puts its money on the line whereas other companies only put out press releases. Costco is consistently ranked among the top employers to work for, even when going head to head against the Silicon Valley employers, whose perks are legendary.  See this 2014 Glassdoor ranking, where Costco beats out Facebook, Salesforce, Microsoft and many more.  In 2015, Costco came in third in a similar survey.  Or you can ask the employees at the stores, which I do often.  Almost universally, they will mention upward mobility in the company and health benefits as the top reasons for employment.  Health benefits, in particular, are not cheap.  Costco has made a consistent investment in retaining its employees by providing them with generous health benefits.  The associated costs with Costco’s investment in its employees lower its current profits, but maintains its ability to provide a high level of service to its customers.  Additionally, this represents Costco’s long-term thinking insofar as Costco sees its current and potential employees as assets to invest in, instead of a “current year expense” line item.   

Real Estate Investments:

Another aspect of thinking long-term and measured growth is Costco’s real estate and growth strategy.  First, Costco owns rather than leases its locations.  This is relatively rare in our current market.  Typically, a retailer like Bed, Bath and Beyond, for example will lease all of its locations.  The rationale is that a retailer’s capital is better devoted to opening more stores at a faster pace.  Additionally, the lease structure theoretically provides the retailer the flexibility to move on if the current location becomes less attractive.  I am not a die hard believer in one model or the other, but Costco’s approach is typical of its approach to its business.  Costco would rather commit to a location long-term and does not see the rationale of providing a landlord with a return when Costco has the cash to invest.  Coupled with this long-term approach to real estate is a measured growth strategy.  Costco is a highly sophisticated organization that could potentially open up many more stores each year, yet Costco approaches growth with an idea of good growth is better than growth at any cost.  Most retailers or “store unit” based businesses will set out on an ambitious plan to grow their footprint by 20-30% per year only to later realize that cannibalization of its older stores by its newer stores is defeating the purpose of its growth.

Wall Street loves growth and margin expansion.  Costco’s measured growth and consistent investment in preserving the durability of its profits for the long-term make neither of these possible in the short-term.  

Customer First Mentality:

Another aspect of long-term thinking is Costco’s continual focus on getting the customer the best deal.  The recent American Express contract negotiation was a great example.  American Express expressed frustration at losing the contract, but noted that the terms Costco was negotiating were uneconomic for American Express.  Hearing these comments from American Express, you might believe that Costco would be pocketing the upside of a new deal, but that’s just not Costco’s approach.  Another example is so-called slotting fees.  Most retailers accept “slotting fees” for placement on their shelves or even higher payments for better placements, i.e. end cap or on the outside of an aisle.  However, Costco does not accept those payments, but instead requires the manufacturer to present its best prices, thus implicitly passing along this “slotting fee” to the customer through lower manufacturer pricing, which Costco in turn only marks up its standard 14%.  

Brand Power or Mindshare:

Buffett and Munger both talk frequently about the power of a brand or its “mindshare.”  Costco certainly has the mindshare of its customers.  Costco is the reason people shop at Costco.  This may not make sense at first.  However, when you need Diet Coke, you can go to Kroger, Albertson’s, Wal-Mart, but you go to Costco because of Costco itself. This mindshare is incredibly powerful and Costco continually works to improve this by adding more and more features (pharmacy, eye care, car sales, etc.).  Another power of the brand is evident in Costco’s growing Kirkland sales. Kirkland is Costco’s generic brand that makes up about 25% of Costco sales (and growing).  Customers trust the Kirkland brand because they trust Costco.    

“Bad Things”

I would be remiss if I did not point out a few of the very real “bad things” when it comes to thinking about Costco as an investment.

Competition–It’s Brutal Out There

Retail is brutal.  There is no other way to say it.  Your competitors are watching your every move and the customer is not as sticky as most investors would like to imagine.  What have you done for me lately is the mantra of the retail customer and any businesses needing to please a customer each and everyday might not make the best investment.  Even Buffett has had a hard time investing in retail (Tesco, Hochschild Kohn), choosing to avoid it, instead of trying to pick tomorrow’s winners from today’s brutally competitive landscape.  If someone said Costco was in the too hard bucket because it was in retail, I could understand that reasoning.  

Costco is winning at the game it is currently playing.  I have full confidence that Costco has significant advantages on its current playing field.  However, and this is a more general lesson, if the playing field itself changes, I worry that Costco could lose very quickly.  For example, Microsoft did not lose its dominance in PC computing because Linux’s operating system was a better mousetrap, but instead the world shifted the playing field to mobile devices, a field on which Microsoft no longer competed well.  I have a hard time seeing (or believing) how the game will shift, but I think the biggest threat to Costco is that Amazon (or another competitor) significantly shifts the playing field.  Convenience of online shopping and delivery if executed at even a slight premium to the cost of a Costco trip could be a potential game-changer.  I have no idea how this would work, but a shift from going to a store to receiving a delivery of items would dramatically shift the game in a way that I am not sure Costco would be “as competitive.”  

Financials

Although Costco is a great business, the current valuation is not attractive.  John and I both like to think about buying the business as a whole to see what type of return we would get.  Costco’s currently enterprise value, both equity and long-term debt is around $70B (we use approximate math).  

  • Current Enterprise Value: $70B
  • Average Operating Cash Flow (past 5 years): $3.5B
  • Maintenance Capex: $500m (current depreciation is around $1.2B, so my number is probably low)
  • Free Cash Flow: $3B
  • Roughly 23x free cash flow or around 4% return on investment.

This is not a tech bubble figure, but you can certainly see that this valuations incorporates both some growth and a long lasting durability in Costco’s business.  

I am not 100% convinced on the durability of its business, and I am not in favor or paying up for growth.  Additionally, if we look back at Costco’s ability to reinvest in its business, we can see in the table below that Costco’s ability to plow a significant amount of capital into its business is almost certainly lower than it once was.  For example, the capital invested grew over $4B from 2000-2005, however from 2010-2015, capital employed only grew $2.4B.

Incremental Capital Employed (Billions)
1990-1995 1,437
1995-2000 2,406
2000-2005 4,480
2005-2010 3,431
2010-2015 2,459

Costco may not be the best investment at its current size or price.  However, one day the market could provide us a better price and we will be ready.  Additionally, I think it is helpful to understand how a fairly commoditized business can be approached differently.  In other words, how Costco thinks differently about its business and how to recognize the long-term owner mentality in other businesses.  A quote from Munger seems apt when studying Costco:

“I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you. Nothing has served me better in my long life than continuous learning.”  

Even if we don’t invest in Costco, I hope we are a little smarter each time we look at Costco.

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Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at matt@thesoavgroup.com.

 

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