The $60 membership fee was easily justified on my first visit
Costco is a difficult business to understand if you have never visited one of the company’s cavernous warehouses. The massive size and scale of the store footprint and the assortment of products offered to consumers is quite different from the typical retail approach and it is very easy to form mistaken impressions if you are more fixated on numbers in a spreadsheet than roaming the aisles of the warehouse.
It is not always possible for outside observers to get up close and personal with the operations of a business. One can attempt to apply Philip A. Fisher’s “scuttlebutt” approach to investment research, but it is rare for outsiders to be permitted to see how a business truly operates.1 Analysts trying to learn about a company with no consumer facing operations must rely on the company’s investor communications perhaps supplemented by discussions with insiders, suppliers, and competitors.
Retail analysts at least have the opportunity to interact anonymously with a business as a potential customer, but only at the final stage of the distribution channel. If I walk into a typical department store or specialty retailer, I will see the front of the store where individual products are displayed. The back of the store is usually cordoned off and inaccessible to customers.
Costco’s retail approach is very different. When the company calls their stores “warehouses”, they mean it literally. The inside of a typical 146,000 square foot store has very few frills. The floors are concrete, displays are bare-bones, merchandise is stacked high above the shelving, and it is not unusual to see products displayed on shipping pallets. Only a small portion of a Costco warehouse is hidden from view, so we can see much more of how the store operates than in a typical retail location.
I started to analyze Costco in the same way I would look at any business. I downloaded the latest annual report and 10-K and started reading. This was followed by building spreadsheets using many years of annual reports, reading old letters to shareholders, reviewing conference call transcripts, and searching for articles and interviews online. It was only after spending nearly two weeks on the company that it occurred to me that it would be absurd to publish an article on the company without actually walking in the shoes of a member.
I arrived at Costco on a Monday afternoon hoping that it would be relatively quiet. However, I could see from the parking lot that the warehouse was busy. I purchased a basic Gold Star membership for $60 at the member services counter after declining to pay an additional $60 for the Executive membership upgrade.2
The next stop was the food court where I ordered Costco’s famous hot dog combo deal and a slice of cheese pizza for a grand total of $3.84, including tax.
$3.84?!?
Did I travel back in time to the early 1990s? No, the food court is famously cheap. While this is not the type of food I would normally choose, it was undeniably filling. In fact, the quarter pound all beef hot dog alone would have been more than sufficient.
The food court represents a microcosm of the warehouse. It fulfills a common need at extremely low prices and gains efficiencies from a limited set of choices, all of which can be prepared in advance and kept warm without risk of going stale due to the high volume of business. In the short amount of time I spent in the food court, I saw several pizzas deposited in the warmer and served to a constant stream of customers.
After eating, I walked through every aisle in the warehouse. Although my purpose was to better understand the business, I still managed to purchase $240 of merchandise. I didn’t go crazy on impulse buys. These are all products I regularly use.
Costco co-founder Jim Sinegal has often claimed that customers will quickly recover the cost of membership. This was true in my case based on just a few purchases:
With the exception of Peet’s coffee, all of the products shown above are Costco’s Kirkland private label brand and the comparable product is the house brand for Trader Joe’s and Safeway. For the coffee comparison, I used Louisiana based Community Coffee, my regular brand which I believe is on par with Peet’s.
In addition to the items shown, I purchased several additional food items including both packaged and fresh foods and various household supplies. My only impulse purchase was a pair of Puma sweatpants for $20. Obviously, my savings for the trip exceeded the $60 membership cost just on a few items that I regularly purchase.
The obvious question we must ask is how Costco manages to provide such a compelling value proposition for its customers. The short answer is that Costco operates on a gross margin that is significantly lower than its competitors.
Costco’s recent gross margin was 10.5%. The comparable gross margin figure for Wal-Mart is 24.4%. Target operates at an even higher gross margin of 28.3%.3 To take a conservative viewpoint, if Costco’s products have an average price advantage of 15% over Target and Wal-Mart, a customer only has to spend an average of $400 before recouping the $60 annual membership fee. As we can see from my example, it is often possible to recoup the membership fee with an even lower volume of spending.
Costco’s management team is fanatical about driving prices as low as possible. While most retailers might strategize about opportunities to increase gross margin, Costco does the opposite. To earn a profit, management relies on operating efficiencies gained by offering only a limited number of stock keeping units (SKUs) sold in large quantities in a no-frills environment with vendors financing the inventory. One might ask why management does not raise gross margin at least somewhat given that there is clearly a very large advantage. However, this would violate the corporate ethos of viewing Costco as a fiduciary for members as well as a profit-making enterprise.4
At a surface level, Costco’s business model is very simple, but it takes quite a bit of time and effort to come to grips with unintuitive aspects of the business, such as management’s desire to reduce gross margin as much as possible rather than optimizing for short-term profits. The end result is a very high degree of customer trust that manifests itself in membership renewal rates in excess of 90 percent in the United States and Canada.
In order to understand Costco, we must go back to Sol Price who created the concept of membership-based discount warehouses. In many ways, Costco is an intellectual descendant of Sol Price’s FedMart chain. Jim Sinegal, Costco’s co-founder, worked for FedMart from its founding in 1954 until 1977. When Costco opened its first location in 1983, it built upon the FedMart legacy. Sol Price founded Price Club in 1976 which merged with Costco in 1993. Although today’s Costco is not the actual successor of FedMart, its intellectual lineage clearly traces back to Sol Price’s FedMart.
After developing the proper historical context, we will examine Costco’s business model, competitive landscape, operating history, capital allocation, and growth opportunities in more detail. Finally, we conclude with a discussion regarding what the future might hold for Costco within the context of the lofty expectations of market participants. Costco is a remarkable business, but this is hardly a well-kept secret.
For a full analysis of Costco, read the following report published a few week after the initial observations in this article were made:
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- For more on Phil Fisher’s investment approach, please read The Rational Walk’s review of Common Stocks and Uncommon Profits. The book was originally published in 1957 and has become an indispensable investment classic. [↩]
- The different membership levels are covered in detail later in the upcoming business profile. [↩]
- These figures are taken from the latest 10-K report for each company. Costco’s fiscal 2022 ended on 8/28/22. Target’s fiscal 2021 ended on 1/29/22. Wal-Mart’s fiscal 2021 ended on 1/31/22. Wal-Mart’s reported gross margin includes both Sam’s Club, its membership warehouse, and Wal-Mart supercenters. Wal-Mart supercenters are likely to have a gross margin similar to Target’s company-wide gross margin. [↩]
- Sol Price, Jim Sinegal’s mentor, often described his role as a fiduciary for customers. [↩]