Costco Wholesale ($COST) — Business Analysis
I. Company Overview
Costco Wholesale (“COST” or the “Company”) is a membership-only big-box retailer of groceries and general merchandise (via physical warehouses and e-commerce). The Company carries both brand-name merchandise and its own private-label brand products, called Kirkland Signature. The latter is generally considered to be equal, if not superior, in quality to national brands, but it’s offered at discounted prices. Its business is divided into two broad verticals: Core Merchandise and Warehouse Ancillary/Other Businesses.
Costco offers three types of memberships: Gold Star, Business, and Executive. Gold Star and Business cards have a $60 annual fee, while the Executive card has a $120 annual fee. Historically, Costco raises its membership fees every 5 years. Despite this, renewal rates are 93% in the U.S. & Canada and 90% worldwide.
These high renewal rates are driven by a higher frequency of auto-renewals and increased penetration of Executive members who, on average, renew at higher rates. The Company reported FY’22 sales of ~$227 billion and as of November 2022 had ~123 million cardholders and ~68 million households within its ecosystem, implying an average annual spend of ~$3,300 per household. BJ’s Wholesale Club averages ~$2,800 per customer.
As the 3rd largest global retailer, Costco operates 850 warehouses across 15 countries — ~81% are in the U.S. & Canada, while ~19% are Rest of World. Warehouses average ~146K sq. ft./warehouse, with new warehouses (especially in foreign markets) being slightly larger than the average existing ones. This implies that, on average, Costco generates revenues of ~$267 million per warehouse and ~$1.6 million per sq. ft., significantly more efficient than competitors such as Sam’s Club who generate revenues of ~$123 million per warehouse and ~$541K per sq. ft. or BJ’s Wholesale Club who generate ~$81 million per warehouse in revenue. This is likely attributable to Costco’s comparatively higher-quality, lower-priced merchandise that allows it to charge pricier membership fees.
Over the last 10 years, comparable sales growth (“comps”) has averaged ~6.8% — it was 14% in FY’22, pulled forward by Covid. Excluding changes in FX and gas prices, comps have averaged ~7.3% over the last 10 years — 11% in FY’22. Notably, Costco has had positive comps for 20+ consecutive years.
Throughout its history, Costco has maintained a strict culture of keeping its product markups below 15%. This results in high sales volume (~$227 billion) and rapid inventory turnover (~13x per year), but also low margins (12.1% gross and 2.6% net). However, this seemingly poor margin profile is deceptive. What Costco loses in near-term profitability, it more than makes up for in customer loyalty, which reinforces the durability of its cash flows and the longevity of its superior returns on capital. In addition, the Company also often sells inventory before it’s required to pay for it. This results in a very efficient cash conversion cycle of ~2 - 3 days.
The business is conservatively debt financed with a considerable cash balance, so net interest costs are negligible. Its interest coverage ratio is 68.5x and its net cash is $4.6 billion.
II. Economic Moat
Scale Economics Shared
Scale economics shared is simply nomenclature used to describe the lollapalooza effects of Costco’s low-cost and scale advantages. Put simply, the idea behind this model is that scale affords structural cost advantages that, when reinvested back into the customer, create a flywheel that lengthens the lifetime of customers and creates substantial barriers to entry. This is how it works:
As Costco grows in size, the scale savings it achieves (described later) are passed on to the customer via lower merchandise prices. In reciprocation of this goodwill (and because it’s the best deal available), the customer buys more products, which provides even further scale to Costco who then passes on the new cost savings as well. This self-reinforcing cycle breeds long-term customer loyalty, resulting in recurring, growing, and durable cash flows.
Source: Business Breakdowns
Another reason this model is so enviable is that sharing scale also protects Costco from entrants attempting to replicate its success. It’s going to take a significant amount of time and capital to achieve the same level of cost savings that afford Costco the ability to offer very low product prices to its customers. And even if an entrant does manage to achieve a similar degree of low-cost operation, they’d then have to worry about dragging customers away from the Costco brand that they’ve grown to love over many years.
Cost Advantages
As mentioned previously, Costco’s scale provides structural cost advantages that allow it to operate profitably at low gross margins. Membership fee revenues are generated at minimal incremental cost, meaning they have high operating leverage and consequently high contribution margins. By harvesting the bulk of profits via this funnel, Costco is able to keep product prices low and pass savings on to the customers.
Costco also benefits from supply-side cost efficiencies that allow it to offer very competitive per-unit prices. The Company sells bulk-sized merchandise to a highly scaled customer base, meaning that when they purchase inventory from suppliers they can negotiate some of the best pricing in the industry, which Costco, again, trickles down to the customer in the form of cost savings.
The bulk-sized nature of its products also provides other benefits. Firstly, it helps Costco maximize cubic space utilization in its stores. Its selling space serves a dual purpose of also acting as storage space, eliminating the costs associated with offsite storage and handling. In addition, it increases basket sizes without making customers feel guilty because they recognize that they’re getting the best per-unit deal. Along with Costco's strict control over entrances and exits, the bulk-sized nature of its merchandise also minimizes shrinkage by making shoplifting more difficult.
Costco operates its warehouses with a very low SKU count (<4,000). Fewer SKUs mean fewer merchants and category managers, less complicated logistics, and fewer negotiations and contracts with suppliers. These benefits give Costco the ability to micromanage its products with greater efficiency and lower expenses.
The low SKU count also induces a sense of “treasure hunting.” Merchandise is rotated out and replaced all the time, so customers are incentivized to visit often to see what deals are available. In addition, to earn its place in the warehouse, each SKU goes through a meticulous due-diligence process and only the fastest-selling models, sizes, and colors make it. So, customers have the assurance that they are treasure hunting in a bargain pool of the highest quality.
On the logistics side, Costco buys merchandise from manufacturers and routes it either directly to warehouses or via depots. This limited-step process creates freight volume and handling efficiencies, which lowers costs associated with traditional multi-step distribution channels.
In effect, Costco’s structural cost advantage engenders strong customer loyalty and accrues pricing power to Costco. The Company then uses its pricing power to periodically raise membership fees with minimal resistance while also continually offering lower product prices and better deals than competitors. It’s a virtuous cycle that has strengthened over many years, and customers love it.
III. Management Evaluation
Jim Sinegal
Costco is the quintessential example of high-quality management — honest, disciplined, long-term focused, and intelligent capital allocators. Jim Sinegal, Co-founder & long-time CEO (though retired since 2011), epitomizes these characteristics, and his commitment to these values has molded the Company’s cultural DNA into that of a scale economics sharer.
When Nick Sleep of the Nomad Investment Partnership met Sinegal for the first time, Sinegal joyfully shared with Sleep a 1967 memo written by Sol Price, Fed-Mart’s founder (and the predecessor to Costco). This is what the memo says:
“Although we are all interested in margin, it must never be done at the expense of our philosophy. Margin must be obtained by better buying, emphasis on selling the kind of goods we want to sell, operating efficiencies, lower markdowns, greater turnover, etc. Increasing the retail prices and justifying it on the basis that we are still “competitive” could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there”.
Price’s emphasis on bringing things as cheaply as possible to the customer is a notion that’s deeply ingrained in Sinegal’s values, and it’s the foundation upon which he’s built Costco. Management was once considering raising the prices on Costco’s famous $1.50 hot dog + soda combo, but Sinegal told them “If you raise the price of the effing hot dog, I will kill you.” Costco benefits from a narrow but deep economic moat, and Sinegal, more than anyone, recognizes that Costco’s low prices are the foundation for this deep moat. Straying away from that would undoubtedly be the catalyst for Costco’s downfall. So by inversion, we should become wary of Costco’s future prospects if it ever deviates from its low-cost approach.
Craig Jelinek
Though it’s obvious that Sinegal was an incredible leader, he unfortunately is no longer the main man at the helm. That honor is now in the hands of Craig Jelinek.
Jelinek has been with the Company for over 35 years and has held various positions before becoming the CEO in 2012. Under Jelinek's leadership, Costco has increased net income by 3.5x, paid dividends of $22.5 billion, bought back over $6.5 billion of stock, achieved average returns on capital of 21%, and ultimately generated shareholder returns of 20% per annum.
In addition to his impressive track record, Jelinek is known for treating employees well, offering industry-leading wages and benefits, and overall fostering a positive work environment that attracts top talent. Building strong customer loyalty starts at the employee level, and Jelinek is well aware of that.
IV. Returns on Capital
Over the last 10 years, Costco has spent ~$28 billion on capex. This goes towards building out new warehouses and maintaining/remodeling existing ones, though a small portion likely goes towards non-store facilities and operations as well.
Presumably, the cost to build a new warehouse accounts for the lion’s share of capex. This could range anywhere from $75 to $100 million per store, inclusive of land, property, equipment, and inventory needed for the store. New warehouses generally start out with low-to-mid $100 million in sales, which gradually ramps up to well over $200 million (newer warehouses start from a higher base). However, each warehouse contributes only around 3% - 4% in operating margin, meaning store-level earnings are ~$8 - $10 million. These unit economics imply returns on capital per store in the low-teens percentages.
Source: Costco 2022 Annual Report
We estimate that Costco has achieved average overall returns on invested capital (“ROIC”) of ~20% over the last decade. However, keep in mind that this is skewed higher as Costco was a Covid beneficiary. The Company carries a substantial net cash balance, of which a large portion is likely considered non-operating, which is a boon for operations and ROIC. Every 5 years or so, Costco will declare a special dividend payment — in 2021, Costco paid ~$4.4 billion in special dividends (1/3 of its cash balance). In addition, Costco has generated 10-year cumulative net operating profits after tax of $34 billion and has invested $13 billion of incremental capital. This implies a reinvestment rate of 37% and a 10-year average return on incremental invested capital of 30%. So, Costco has presumably compounded its intrinsic value at an ~11% annual rate over the last 10 years, excluding the impact of dividends and buybacks (which are not immaterial).
As you might notice, Costco’s overall returns on capital are materially higher than the returns they’re getting on a store-level basis. This is attributable to fantastic management quality. Certain stores will perform better than others, and management has evidently been prudent in investing more aggressively into high-performing stores and paring back on the low performers. In addition, Costco benefits from highly durable, recurring earnings, scale economics, and rapid and increasing inventory turnover which also contributes to enhancing overall returns on capital over time.
V. Reinvestment Opportunities
Over the last 10 years, Costco has increased its store count by ~3% annually. The Company currently has 589 warehouses in the U.S., although there are concerns that it may be approaching domestic market saturation. During Costco’s FY 2019 earnings call, CFO Richard Galanti estimated that Costco can average ~12 U.S. store openings per year over the next decade. We’ve averaged ~15 per year since that statement. However, extrapolating based on 12 - 15 store openings per year, Costco can potentially reach ~680 - 700 stores in the U.S. by 2030.
Source: ScrapeHero
Historically, Costco has opened 20 - 30 stores globally per year. We believe that it can continue this unit growth trajectory for at least the next two decades, though an outsized portion will be international in the latter years given domestic market saturation, meaning Costco will likely trend towards a c. 50/50 mix between Domestic/International. As such, the key reinvestment opportunity for Costco lies in international expansion. Costco expects to have 5 stores in China by YE’23, and we anticipate there is significant room to grow from there.
Source: Costco 2022 Annual Shareholder Meeting Presentation
Given the rigidity of its margins, Costco’s earnings growth is driven primarily by sales volume. Thus, store-level ROICs are likely to be higher in China because of a higher population-per-warehouse and therefore quicker inventory turns and a faster payback period. In addition, international warehouses have higher contribution margins because the base-level of prices are lower and there are fewer competitors to drive it down. Although some inventory does need to be imported which would pose higher costs, this is offset by the fact that labor and input costs are generally cheaper overseas and goods on a per-unit basis are generally more expensive when converted back to USD, meaning that margins for international operations are likely higher.
For example, when Costco entered Iceland, they went in at prices that beat out all of the competition but were still higher than in the U.S. on a constant currency basis. Of course, there’s an argument to be made that margins may be similar and the difference in price is just attributable to higher costs associated with having to import goods. However, we believe that this margin profile will improve over time as Costco scales and obtains a stronger foothold in its international markets. If management can execute well internationally, there is still a strong growth story ahead for Costco.
If you made it this far, we just want to thank you for taking the time to read this, and we hope you’ve learned something new! Please consider subscribing to our free newsletter and sharing it with others. The quality of these write-ups will only improve with a larger audience offering different perspectives. Thank you again for the support!
You can also reach us at:
Twitter: @TheInsightVault
Disclosure
These are opinions only of the author. The contents of this piece do not contain investment advice and the information provided is for educational purposes only and no discussions constitute an offer to sell or the solicitation of an offer to buy any securities of any company. All content is purely subjective and you should do your own due diligence.
The Insight Vault makes no representation, warranty or undertaking, expressly or implied, as to the accuracy, reliability, completeness or reasonableness of the information contained in the piece. Any assumptions, opinions and estimates expressed in the piece constitute judgments of the author as of the date thereof and are subject to change without notice. Any projections contained in the information are based on a number of assumptions as to market conditions and there can be no guarantee that any projected outcomes will be achieved. The Insight Vault does not accept any liability for any direct, consequential or other loss arising from reliance on the contents of this presentation. The Insight Vault is not acting as your financial, legal, accounting, tax or other adviser or in any fiduciary capacity.