Learnings From Costco

Disclosure: In no way am I recommending Costco as a stock. Although I might imply that the stock is “affordable” or “reasonably priced” in my material, that is done with the benefit of hindsight and is not worth a tinker’s dam.

Note: Please refer to this Google Sheet Link to access a full historical financial model of Costco from 1997-2019 that I collated from my readings. I did not make financial projections because there are no lessons to learn from that activity. Pardon my grammar, random commentary, and my sloppy rounding of figures in the sheet. I write random stuff when I read the filings that may be inaccurate and opinionated; take those with a grain of salt. Accounting is adjusted manually for visibility so some figures will differ from their reports.

I started off with a commentary. Skip to the lessons here.

To start off, one might wonder why in the age of Amazon am I picking Costco to learn from. There are three reasons.

First, Costco is a successful capital compounder which is a strict requirement. Over the past 23 years, Costco grew its operating income and its cash flow from operations (two important metrics given economics of scale plays a huge role in reducing their capital requirements) by 10-11% annualized. With discipline and intelligent capital allocation, Costco was able to help its long-term shareholders to an annualized rate of 14.1% while the S&P 500 returned 8.5% over the same period with dividends reinvested. For scale, a dollar invested in Costco in 1997 at a high PE ratio of 31x is today worth $21 versus $6.5 for the S&P 500. There is already a lesson here: although price paid is crucial, picking the right business is equally so.

Second, the business is basic and understandable. There is nothing technologically superior about its product or business model which makes it an even more interesting study. Think about it: Say we have a pair of twins, one gifted at birth and one average at best. Over time they are fed the same food, taught the same lessons, provided the same resources, and both turned out to be the top in the world in their respective careers. If you are given the choice to read only one of their biographies, would you rather read the story and learn the lessons of the gifted child or his average-at-best sibling?

Third, Costco represents the best of capitalism; they pay good wages, take great care of their stakeholders, and their service actually adds a tremendous amount of value to the world. There is much to learn that could not only be applied in investing or business but in our personal lives. As you will read later on, I believe this to be their greatest competitive advantage. It may sound easy to replicate, but good luck doing so in the capital markets.

What is Costco?

The introduction would be brief because one could simply read the annual report to understand quite clearly the business. The key lessons will follow.

Costco runs a membership warehouse model. The difference between a warehouse store and a typical grocer is the layout. Unlike a grocer, a warehouse is taller and goods are sold in bulk, allowing it to stack its inventory in pallets vertically above the display isles where the customers shop. This offers a few key benefits:

• elimination of a backroom or a separate warehouse for inventory storage and thus a reduction in unused square footage and transport cost.
• reduced frequency of inventory handling by employees which reduces “fingerprint” cost.
• ability to make large purchases and take advantage of discounts due to huge storage capacity (a higher vertical space per square foot exponentially increases volume).

All these lead to lower landed costs, allowing warehouse stores to price products at a discount while still maintaining a positive but razor thin margin. The way to do well in this business with such economics is by achieving high inventory turnover to leverage fixed operating expenses in order to maximize returns on capital.

Costco does so in multiple ways, but mainly using their membership model where members pay annually for an unlimited entry ticket to Costco’s 750+ warehouses around the world. The membership model is crucial to the warehouse’s discount model for a few reasons. One key benefit is that because every dollar of membership revenue flows directly to the bottom line, membership warehouses can keep prices low while still maintaining their profits. This is extremely powerful because price leadership itself is a natural marketing tool. Customers love a good deal.

The idea of paying to enter a store only to spend more money sounds counterintuitive at first. This is done on purpose as the membership weeds out customers who understand the value of buying in bulk from those that do not. This is crucial, as bulk buyers empty the shelves faster, leading to lower inventory shrinkage and larger turnover, whereas picky buyers who enter stores five times a week only to buy a handful of goods leads to excess inventory sitting on the shelves, not to mention the congestion they would cause at an already crowded Costco. Remember, the longer the inventory kept on shelves, the greater the opportunity costs.

The membership model sieves out the wrong customers while keeping the leftovers around for a year. This pool of long-term customer attention is great, because now Costco can work to keep them around to (1) shop more frequently and (2) shop at Costco forever. Point (1) is satisfied via ancillary business offerings such as their famous food courts, gas stations, pharmacy, hearing aid and optical booths, all of which sell products at an extreme price discount compared to traditional alternatives. They are able to sell at a huge discount because they couldn’t care less about the margins on those offerings as long as it keeps customers visiting their stores and emptying the shelves. Remember, the key to do well here is inventory turnover. If you haven’t noticed, point (2) is similarly satisfied once customers live within the Costco “ecosystem”. A typical Costco member gets gas at Costco’s discount gas stations, fills their prescriptions at Costco’s low cost pharmacies, gets their eyes checked at Costco’s optical centers, and shops for everything they need at Costco’s warehouses. As long as they keep their products the cheapest and of the greatest quality, their customers will stay and pay their membership fees. The best comparison isn’t Walmart’s Sam’s Club, BJs or Home Depot. It’s Apple’s closed ecosystem of products.

In summary: the more the right customers shop, the greater their scale economics. This results in greater pricing discounts as Costco “shares” their scale economics via keeping prices low instead of hoarding the benefits to only its shareholders. In addition, their increasing scale allows them to leverage vendor payment terms to fund working capital, resulting in lower capital required to open new warehouses. As long as Costco keeps their people happy, they will continue to generate excess returns to shareholders for every dollar of capital deployed into expanding their warehouse base.

What is Costco's secret sauce?

Costco’s competitive advantage is not so much its slew of ancillary services that serves as customer magnets, its widespread network of depots or its top class supply chain infrastructure that keeps its cost leadership status, but rather its business philosophy–to treat its customers and employees well. Shocker, isn’t it? Quite often companies do well because they take simple but highly probable truths to the extreme.

Ancillary services, cheap prices and supply chain prowess might be hard to set up to compete with Costco, but what's harder is sustaining a public corporation whose strategy seems to put customers first, employees and suppliers second, and shareholders third. At first, that might seem to go against the shareholder primacy model–that the purpose of a public corporation is to serve the dollars of its owners. But if you peel away the layers you will find that customers who shop at Costco love it not just because of the great deals they are getting, but they feel good supporting an enterprise that actually takes good care of their employees and suppliers. In the consumer’s mind, Costco is good capitalism. Happy employees in turn do a fantastic job at delighting their customers and keep employee turnover rates low.

In my opinion, the strategy of putting their customers and employees over their shareholders does not violate the shareholder primacy model. Instead, I believe it to be a necessary condition in order to serve its shareholders for the long-term. Happy customers and happy employees keep the membership dollars tap running, ultimately benefiting the shareholders. I believe this to be Costco’s management’s greatest achievement and their greatest source of sustainable competitive advantage simply because of how difficult it is to build a corporation that eschews short-termism in today’s world¹. Costco’s long-term strategic moves have over time compounded to build a strong brand–the face of good capitalism–that many, even Walmart and Amazon, find it hard to compete with.

Costco’s entire corporate structure is built to prevent vultures from ransacking the business and to provide a long enough runway for the company’s efforts to bear fruit. The founders understood the crucial importance of long term shareholders in order for the business to thrive and to sustain its glory once it succeeds, and thus put in place ancient corporate structures that are now deemed “poor” corporate governance practices², such as classified boards, supermajority votings, and a board of directors that served for decades. Although these structures seem to make it hard to remove poor performing directors, one must not forget that it is equally hard to elect a short-term corporate vulture. This structure is required to keep a board that supports management’s long-term efforts such as sustaining Costco’s merchandise pricing investments and salaries during inflationary periods³.

Learnings from Costco

1. Where is the value-added?

   “What value does the business bring to its customers?” is a basic yet fundamental question that is often forgotten by investors. When Bill Ackman listed his 4 lessons from his disastrous Valeant investment, he mentioned one which I thought illustrates the importance of this basic question; a management with brilliant capital allocation does not translate to value-added for a business.

   When studying one of Valeant’s many shenanigans, one of its strategies stood out as a perfect example to why this question is crucial to any investment process. Michael Pearson, Valeant’s then highly rated CEO, carried out a financially brilliant strategy of acquiring drugs and raising its prices. It made a lot of financial sense, because by eventually raising the acquired drugs’ prices by double digit multiples, they are able to pay a large purchase price for any drug or pharmaceutical company and still be able to wring out a high return on their investment. This high acquisition price keeps the deals and the drugs coming. The problem is that this strategy makes no business sense at all. By definition, a business is meant to serve its customers, and by serving its customers well its owners get rewarded. Yet, the order has not just been flipped, their customers were being decimated. If investors could care to ask where Valeant is adding value to its customer, they could have avoided participating in its customer’s massacre.

   Costco on the other hand took this basic concept to the extreme. Every move that Costco took was to benefit not just their customers but their employees and their suppliers. Their annual reports are full of clues that hint at their enthusiasm in serving their customers; a stark contrast to other companies where annual reports are fashioned to please the eyes of stock analysts with fancy colors, graphs, and rationalisation for touting non-GAAP figures. When management is madly in love with their customers and their service/product, the risk of financial mismanagement is reduced.

2. Good companies are disciplined and find it easy to sustain the deployment of capital at a high rate of return.

   For Costco, it is straightforward–simply copy their warehouse concept from one location to the next in a disciplined and controlled manner, making a move only when the outcome is obvious. The result of their disciplined capital allocation can be seen in the way they reported warehouse figures–they have never once closed a warehouse due to poor performance. The only time they did is to relocate to a bigger warehouse due to under capacity. In contrast, Sam’s Club and BJ’s have been downsizing.

   One reason that made it so straightforward for Costco is their long-term laser-like focus into building a strong positive association in the consumer’s mind. This is evident across the globe even in nations that have never had a Costco:

   

   Costco’s first warehouse in China had a massive overcrowding issue on their opening day. You would think that a highly advanced country whose citizens shop online for everything would opt to shop for groceries online too, but this is simply not the case. This shows that e-commerce itself might not be efficient enough to beat Costco's model.

3. Good companies are disciplined in returning capital to shareholders.

   This is an obvious point. In Costco’s case, their new warehouses grow sales quickly and generate cash faster than management can allocate it. Costco’s warehouses take years to mature, usually around a decade or more to reach normalized returns on capital. Over time as more warehouses mature, Costco’s banks get flooded with cash at a rate much quicker than their ability to open more warehouses. This “critical mass” status was achieved in the early-to-mid 2000s and can be seen via Costco’s capital allocation over time:

   

   Note that although growth CAPEX as a percentage of net income fell, their net income grew, and their CAPEX have consistently been increasing YoY.

   Costco is also very disciplined in the way they returned capital to owners:

   

   Note that share repurchases are made at a reasonable price. Also worthy to note is that dips in repurchases coincides with a spike in P/E. When shares are expensive, opt for dividends instead.

4. Great leaders are candid about their mistakes and seek to solve them. Oftentimes, they are not motivated by money or prestige, but are in love with what they do.

   Costco’s management have personally offered to leave compensation bonuses on the table (even when they met their targets) simply because they made mistakes. This not just shows the seriousness in which they take their jobs, or that they are doing it for more than just the economic benefits, but it also shows the intrinsic values the management has–one of responsibility, honesty and integrity–that is likely to permeate throughout the organisation.

   This particular detail happened more than once and can be found in the compensation report of the 2014 and 2018 proxy statements, so it isn’t like they bragged about their nobility. This goes to show that it is important to not just read reports for the facts, but also to look out for the underlying intent behind the reporting style.

5. Never underestimate the value of highly competent directors who have large stakes in the business and have been around for a long time.

   In the well-studied area of corporate governance, it is generally a bad idea to have long serving directors, especially those who hold large stakes in the enterprise, as they are deemed not independent and/or might have built a close relationship with the management, and as such, his/her value to common shareholders as a director is impaired. In my opinion, if the director is a good human being, a decent capital allocator, and is highly intelligent and rational, this rule does not apply. I believe their long service is a sign of their ability to understand the workings of the business, and their large stakes as a sign of confidence. You always want stewards of your capital eating their own cooking.

   Costco’s board of directors are highly qualified and experienced individuals, some of which have massive stakes in the business and have served for decades. Notable ones include Charlie Munger (since 1997) from Berkshire Hathaway as head of the audit committee and a member of the compensation committee (he probably played a huge role in their excellent financial reporting quality), Hamilton E. James (since 1988) from Blackstone as the lead independent director, Susan Decker (since 2004) who is also a Berkshire Hathaway director and a respected investment professional and technologist, a couple of long serving executive directors, and until recently, the founders of both Costco and The Price Club.

6. Long-term pay/compensation structures that are reasonable and not excessive and are detached from stock market returns, instead relying on real operating metrics.

   Costco’s compensation is a painful one for executives looking for a quick and high payout in a short duration of time. The compensation’s main structure is built on performance based RSUs with a proportional 5 year vesting period (20% vested per year) and avoid stock options due to the difficulty in accounting for long-term ones. RSUs have an accelerated vesting period for long-term service. At 35 years of service, RSUs vest at 100% on grant date. Such a structure would be a pain for an externally-hired MBA-decorated executive to make a windfall at Costco. Critics might say that their compensation structure will not attract the best CEOs, but Costco mainly relies on internal hires simply because they understand the business so much better. For instance, Craig Jelinek, the current CEO, started at Costco way back in 1984.

   Their compensation is also based on metrics that are basic to the nature of Costco’s business. For the CEO, it is simply sales and pre-tax profits (scale economics and cost efficiency, key duties of the chief). For the other executives, metrics are based on true business factors and tied to individual areas of responsibility such as inventory shrinkage on a per-area basis. What you would not see is any talk about stock returns or any artificial financial metrics such as “adjusted” EBITDA or “total shareholder returns”.

   In contrast, Kroger’s “committed to investors an 8-11% Total Shareholder Return (TSR) target” as part of their compensation plan. Along with the typical business metrics that goes into a compensation calculation, there is now a “total shareholder return modifier”. Promising an 8-11% gain for an industry that grows at 3-4% in the Amazon era creates a perfect environment to breed misconduct.

Closing

Although what I talked about above might be obvious and basic, I believe them to be big contributors to Costco’s compounding success. Besides, it is often the obvious and basic ideas that are easily forgotten.

During my study of Costco, I was constantly reminded of Ockham's Razor, an ancient principle (much older than Ockham himself) that states that the simplest objective hypothesis is more likely to be true. In Costco’s case, perhaps behind everything that they did right, the biggest contributor to their success is simply that the business is run by competent managers who happen to also be good human beings.