Costco Stock Analysis

Today we have an excellent post by Brad Ferris of Triaging My Way To Financial Success. After a mentorship and five years of self-study, Brad began investing as a DIY investor in late 2005. He invests using a holistic approach that utilizes key value and dividend-growth principles in three portfolios (Value, DivG & RSP).

Brad’s investing discipline is guided by a set of Value Rules and lessons learned on Enduring Value. He has extensive knowledge of the healthcare industry in pharmaceutical and medical device/supply companies and incorporates those insights into his portfolios when possible.

This is an extremely long analysis but one that covers all aspects of business and value fundamentals. Do stick it out to the end.

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In a previous post I presented as part of my short-term investing strategy a long held Value Rule that a company never compete on price.

In the comments of the post the moneygardener asked the following question:

“I’m curious about your thoughts on Costco. Do they compete on price? Why are they successful?”

Costco (COST) is a company that I know quite well both as a consumer and prospective investor. I shop at Costco as a long time member and have always found the business model and strategy fascinating.

The simple answer to MG’s question is that Costco does not compete on price and what makes them successful is multifaceted. The company is brilliantly managed, knows its core customers well and has all the hallmarks of enduring value that I enjoy in my investments.

Readers might be scratching their heads and asking “how does Costco not compete on price when everything there is cheap?” but remember that this is all about strategic management. You never compete on price because it slashes your margins and that directly impairs your ability to make money. Margins are how you make money in business. An investor shouldn’t confuse low prices with low margins without first seeking to understand the business model and basic principles of economies of scale.

What you need to do is put a business in perspective and to objectively examine not just the obvious, but what goes on behind closed doors; what makes a company tick, work well and stay competitive in a retail space that is dominated by giants? What allows Costco to be successful is that they know their niche and have both the business strategy and operational capacity that allows them to perform remarkably well in passing along savings to their customers.

I want readers to maintain an open perspective and keep in mind the following reasons of why Costco doesn’t compete directly on price:

1. They don’t sacrifice their margins in order to spur demand
2. Their business plan creates savings
3. Their discounting incentives are never perpetual
4. Their customers are not motivated by price alone

Some Background:

Costco has its roots in San Diego, California when in 1976 Sol & Robert Price opened the first exclusive business club for shoppers in a remodelled airplane hanger that served as their first warehouse. By 1980 the Price Company offered public stock and a few years later another warehouse business, Costco opened for business in Seattle, Washington. As each business grew more warehouse stores were opened and their businesses expanded into new product offerings.

By 1989 Costco had 46 warehouses in operation and both corporations were aggressively growing their businesses. In 1993 shareholders of both companies approved the merger of Costco and Price Company to form PriceCostco (later Costco Companies). In 1997 the business streamlined operations by selling off non-core assets and today has operations in the US, Puerto Rico, Canada, UK, Korea, Taiwan, Japan and Mexico.

When examining Costco as a business I first want to address their business model. Specifically:

• Do I understand the business
• Is the business sustainable
• What does the business do and do they do that best
• Is management able to execute over long periods of time
• Are there substantial competitive threats
• Does a competitive advantage exist

From Costco’s 2007 Annual Report:

Costco operates “…membership warehouses based on the concept that offering our members very low prices on a limited selection of nationally branded and selected private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover. This rapid inventory turnover, when combined with the operating efficiencies achieved by volume purchasing, efficient distribution and reduced handling of merchandise in no-frills, self-service warehouse facilities, enables us to operate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets and supercenters.”

If you’re maintaining a SWOT on Costco there are a few key items you want to make sure you write down:

• Membership structure encourages customer loyalty
• Diversification of merchandise (both private & brand name)
• High inventory turn-over

Whether you place those three items under strengths, weaknesses, opportunities or threats is your choice. Throughout my analysis I want to focus, target and investigate some key flags from that 2007 message and determine any threats when management uses the phrases “low prices” & “significantly lower gross margins”.

Analysis:

The business plan for Costco is very simple. The company buys directly from manufacturers and routes purchases directly to a consolidation point (hub) or individual warehouses in less than 24 hours. What this allows the company to do in their distribution system is not keep inventory idle or held up so that products can be purchased by customers as quickly as possible. Their in-warehouse inventory system knows when each item is sold and when product levels are reaching their targeted threshold for a reorder. A purchase order can be generated to the manufacturer for more products and shipped directly to the warehouse to be placed directly in storage for restocking.

High sales volume and rapid inventory turnover are very important and an investor shouldn’t overlook this point. When Costco puts in a purchase order with a manufacturer it will likely need to pay in full within 30-60 days for that purchase. When any company can receive product directly, sell it to a consumer and receive cash in hand before needing to pay for the original merchandise from the manufacturer this results in a very high operating cashflow for the business. Why is cashflow important?

Cash allows a company to pay its employees, bills and invest in the business without having to use expensive uses of debt. When the time comes for Costco to pay a manufacturer for products purchased it can often take advantage of discounts (2/10 net 30) and further reduce its cost of purchase. This operating principle improves Costco’s working capital and allows them to operate much more efficiently. Instead of having to pay the full cost of products from manufacturers and then wait for a sale to receive cash Costco can benefit from being the short-term intermediary between the core manufacturer and end customer.

The operating warehouses for Costco average 140,000 square feet of selling space. This space is used both horizontally and vertically to improve efficiencies. Inventory is sold directly at the floor level to customers and extra product stored vertically above the floor. This eliminates the need for holding excess inventory in non-customer areas that requires a large space and more financial resources can instead be focused on the customer.

Costco employs a very innovative warehouse design for multiple reasons and the design of their stores is something I’ve always appreciated since I concentrate on the strategic management of businesses and consumer behaviour.

Have you ever asked yourself the question, “How can I come into Costco for just milk & walk out spending $65?” Milk never costs $65 and in fact is likely the lowest margin item sold in Costco. The reason you walk out of Costco spending more than your intended $4 is because of how strategic management is utilized and the business’ ability to understand customer behavior.

Say you go to Costco for a bag of milk on your way home from work. At every Costco there is only ever one entrance and one exit for all customers. You are greeted by one or more employees on the way in and at least one on the way out. Immediately as you enter the warehouse you’re required to display your exclusive membership card and are immediately handed a coupon pamphlet of various discounted products. You then have to navigate the same landscape that is duplicated hundreds of times at every other Costco warehouse in North America. In order to get to the milk (located at the far back corner) you have to navigate your way through consumer electronics, home appliances, clothing, automotive, books, games and home accessories.

These are all high-margin items; the percentage markup from the manufacturer cost is higher than other products. Located at the rear and far side of the warehouse are food and household perishables which are lower margin and generally more frequently purchased items. These lower margin items are placed strategically opposite the entrance & exit because Costco wants you to browse, investigate, sample and spend more time in their stores in the hopes you’ll find something you want, need or decide to try. You then navigate the rest of the store back towards the checkout and are advertised to for supplementary business such as credit cards, small business loans, auto & home insurance, business telephone, check printing & real estate/mortgage services along your exit.

Costco boasts one of the lowest percentage inventory losses in the retail industry. This is primarily due to membership control and ensuring only one primary entry & exit in each warehouse. Less than 0.2% of total inventory is lost to theft in any given year. To put this into context US retailing giant Wal-Mart often reports inventory losses due to theft at 1.6% of total inventory; eight times higher than Costco.

Costco maintains an average of only 4,000 SKU’s (stockkeeping units) per warehouse in comparison to over 40,000 that are often found in a supermarket. This allows Costco to generate a much higher focus on the product needs of customers and not carry inventory that is not in high demand. Their product mix is also diversified and proportioned equally among six key units. Additional supplementary services include sales from pharmacy, photo, hearing-aid & optical centers, travel, gas and print/copy services. If a unit isn’t profitable at a specific warehouse than that service is not offered or discontinued.

Costco also provides select private label brand merchandise under the Kirkland® brand name. This enables manufacturers such as Proctor & Gamble and Kimberly Clark to sell generic versions of their Tide & Huggies products to Costco customers under the Kirkland brand name. Those companies still sell their premium brand products beside the generic versions at a higher margin and still benefit from a sale when customers choose either the generic or brand name product.

Marketing and promotional activities are very limited for Costco. Through either direct marketing initiatives (mailings to your home via Costco Magazine) or individual manufacturer coupon mailers Costco does not aggressively discount their products in order to spur demand. This is a very important when we examine their gross margins. From time to time Costco will rotate discounts through key high demand items, but after a promotion of 7-14 days the prices are adjusted back.

What they don’t do is sacrifice their gross margins in order to generate demand or higher sales over a long period of time. Competing on price is something I believe a company should never do. But there is a significant difference between a company offering a rotating weekly discount on less than 3% of their inventory to customers versus slashing margins across the board by 25-30% in order to secure a higher market share.

Because Costco is so efficient at managing its inventory it can afford to offer promotional discounts each week on select products or services, but they are never permanent or sustained. A 1kg box of cereal might be $2.00 off one week and then it immediately returns to its regular price of $7.99 once the promotion is complete. Often Costco isn’t even the primary source for these discounts and they are initiated my primary manufacturers in order to sell old inventory so that new product can be released for sale in future months. Costco adds a volume incentive for to manufacturers who understand that their customers make regular and repeated purchases of their favourite items. When and where you know exactly your end user will be is a massive benefit for many manufacturers who use Costco to sell their products.

In a city of 300,000 Kellogg’s may sell their products among as many as 500 different locations to consumers, but almost 20% of that entire volume may come from one or two Costco locations. This relationship with sales is contributing factor in the close relationships that Costco enjoys with key manufacturers.

The consumer is also vitally important to Costco. As much as consumers are motivated by price they enjoy the shopping experience at Costco. They recognize that discounts will be offered from time to time, but never permanently sustained. Costco does sell items at a lower price than their competitors, but remember that they can because of their ability to pass along the discounts from their operating efficiencies in supply chain management and cashflow. Costco also adds something unique to customers by offering products not found anywhere with their generic Kirkland brands and sells items in bulk that otherwise aren’t sold in smaller quantities. To many Costco customers Kirkland isn’t even considered a generic brand because of the tangible quality that exists.

Numbers:

It’s now time to examine the quantitative numbers of the business to determine how margins are affected by the operations of the business and the business model via management.

(click to see the google spreadsheet) Edit: Dead link

This is simplified version of a spreadsheet I maintain on most companies on both current and historical data for my situational analyses. My intent is to compile information easily and look for trends that might give caution for investing in a company.

The first thing I’ll draw attention to is the gross margin data. You’ll see that for each year (1994-2007) I’ve listed the gross margin as a percent of sales. This is one of the first quantitative set of data I will collect if I suspect a company of competing on price. A sudden change, sharp decline or any trend downwards in the absence of a significant rise in inventory cost usually indicates to me that management is dropping the ball. In the case of Motorola a few years ago you would see a massive drop in gross margins from the historical trend.

Costco has maintained their gross margins within a very tight range over the last ten years. You’ll see a low of 10.10% in 1997 and a high 10.72% in 2004. The historical change averages out to 1% to the upside, so I’m very confident that Costco management is very focused on maintaining their margins and not competing on price by heavily discounting their margins. Even during difficult economic periods such as 2000-2002 you can see steady margins that indicate to me a very good grasp of management ensuring profitability.

Sales have increased just over 11% on average each year with warehouse growth at 6.11%. Long-term debt to equity has remained very low, Book value per share (BVPS) has been more than adequate and there’s been an aggressive commitment by management of the company to buy back common shares. Also notice the very strong growth in memberships of both businesses and individual Gold Star members.

One item I will point out that caught my attention some time ago is putting growth into proper perspective. I’ve spoken about the importance of assessing management in a company, but often I get the question of how an investor determines this. With each company it will be slightly different because they likely operate in different industries under much different conditions. So we know that the business is growing at a conservative pace, that margins are not being sacrificed and debt to equity hasn’t ballooned as in the case of a business being heavy leveraged.

There’s a section in the spreadsheet titled, “SGAE as % of net sales”. In any annual report you’ll find lots of numbers and putting them into context can be difficult. Costco supplies a graph with the title “Selling, General and Administrative Expenses” or SGAE as I’ve called it in my spreadsheet. If I want to evaluate management I want to know how well they manage the business on a variety of criteria and this is one of them. An investor wants to ask the question: Can Management Control Spending? Not just expenses of raw materials and labour, but what everyone spends on all expenses not related to the cost of inventory and overhead.

SGAE as a percentage of net sales has been maintained in a very tight range. As a business grows it’s very easy for management to lose focus and get lazy in their spending. When I add together the low D/E ratio, solid margin control and tight range of SGAE I get a very clear view of just how good the management of this company is. Remember that my #1 criteria for any group of management is the requirement that they have the pulse of the business and never stop taking that pulse. The numbers for Costco are always consistently within a very low variance year-over-year or from the historical average which gives me the impression that management is on top of operating this company in a smooth and efficient manner. They are growing the business within their means with no considerable effect to margins, warehouse growth and general expenses.

The main issue, as with any business, is when you get to the competitive analysis.

Costco operates in a highly competitive retail environment. Costco benefits from a base of niche customers via their membership program with those same customers able to purchase products from a wide variety of competing companies such as grocery stores and large scale retail operations. Competitors include Lowe’s, Wal-Mart, Target, Kohl’s, Home Depot, Office Depot, PetSmart, Staples, Trader Joe’s, Whole Foods, Best Buy and Barnes & Noble.

The company competes for leasable land for new warehouses with other box stores and their warehouse locations are often located further away from highly residential areas such as city cores and older suburban areas. Customers tend to have to drive further to shop at Costco than a local grocer, but Costco combats this with a much better customer environment, larger discounts on bulk purchases and various incentives through their membership programs.

The company is exclusively dependent on US & Canadian operations for revenue and profits and directly affected by how consumers behave. In any tough economic environment Costco has historically shown a resilience to persevere and continue growing their business. While I trust the management to continue doing what it does without diversifying into non-core operations any significant decrease to consumer spending has to be considered as a threat.The Bottom Line:
Sales growth for Costco has been consistent as warehouse growth for the company on an annual basis has been conservative and membership growth has continued on track. As Costco grows its membership base it enjoys a higher amount of traffic and continues to focus on growing its average transaction through various means. The company is well managed and benefits from a unique business plan that focuses on operational efficiencies. The company conclusively in my mind does not compete on price and I have no issues providing this company with my label of Enduring Value.

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