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Costco (COST) Stock | NASDAQ: COST

Doing One Thing Great

The leading warehouse club, Costco has stores worldwide, with most sales derived in the United States and Canada.

It sells memberships that allow customers to shop in its warehouses, which feature low prices on a limited product assortment.

Costco mainly caters to individual shoppers, but roughly 20% of paid members carry business memberships. Costco's warehouses average around 146,000 square feet; over 75% of its locations offer fuel.

Growth

36

Valuation

85

Quality

78
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Where Are We Now

Updated on: 11/7/2021

Conviction Score

9

In our humble opinion, Costco is the best brick-and-mortar retailer on the planet. Talk about “value” – we think Costco’s bargaining power and network effect coming from its membership model is envied by other retailers and consistently drives economies of scale and lower prices for member shoppers.

  • Today, Costco has almost 112 million global membership holders across 815 warehouses worldwide. What’s more is the company is expanding in South America, Europe, and Asia, where Costco warehouses today are scarce.

  • Costco does not grow like a traditional retailer. It grows like a tech company – revenues and profits are both growing around 20% per year. With this, we think Costco is still not expensive and has room to run over the long run.

Investment Thesis

  1. Costco has an obsession with giving members the lowest price for products through their supplier relations and negotiating/pricing power. The business is optimized for low retail gross margins, a unique model when compared to other retailers.

  2. Costco’s membership model creates a network effect and feedback loop as more members means better economies of scale and lower prices for members.

  3. Private label brand, Kirkland Signature, exemplifies Costco’s commitment to excellence and quality. With Kirkland, Costco is able to replicate or beat the quality of the best-known brand in the category while collecting higher margins.

  4. Costco’s selective and capped Stock Kept Units (SKUs) are to ensure floor products are chosen with intention and purpose. The business is obsessed with store optimization and increased basket sizes to achieve same store sales growth and industry leading revenue per square foot.

  5. Costco has seen tremendous success expanding into international markets. Their entry into markets like China, South Korea, Japan, Taiwan and even Iceland have shown the global appetite for Costco’s Wholesale model. The business will be able to continue to open new warehouses and take advantage of these global opportunities.

The Basics

Costco is a retail warehouse club that gives members access to purchase wholesale goods. They have locations all over the world, primarily in the United States, Canada and Mexico. Through its vast membership base, Costco can leverage economies of scale to achieve lower prices from suppliers. Store locations, referred to as warehouses, contain skids of products which are placed for members to pick and purchase from. This warehouse model has product handling advantages as customers select products directly from the warehouse floor.

Their revenue is generated through products sold in store, but their profitability is generated primarily from their membership cards. To gain access to these low prices, consumers are required to pay an annual membership fee to enter the store and buy items.

Costco has a heavy emphasis on keeping low prices for consumers, which is why they have one of the lowest retail gross margins.

This is by design and what makes Costco a unique value proposition for Members.

Costco Revenue Breakdown (Q4 2021)

Source: Costco Investor Relations

Costco has a heavy emphasis on keeping low prices for consumers, which is why they have one of the lowest retail gross margins.

This is by design and what makes Costco a unique value proposition for Members.

Costco’s Roots

Sol Price and his son Robert were known as the creators of the retail warehouse club. They popularized the idea of a business in which paying a membership fee gave you access to shop at large warehouses for wholesale items.

In 1976, the duo opened up a warehouse called the Price Club, out of an old airplane hangar.

Then along came Jim Sinegal and Jeffrey Brotman who took that same idea of a retail warehouse club and started their own company called Costco. Their first location was based out of a Seattle warehouse in 1983.

Sinegal had some experience with warehouse clubs, as he previously used to work for Price Club under Sol Price.

In 1993, Price Club decided to merge with Costco as both companies had very similar values and business models. They took on the name of PriceCostco and memberships between both stores were universal. A member from Costco could use their card to enter Price Club and vice versa.

This merger boosted sales significantly, opening up 206 new locations and generating $16 billion in annual sales.

By 1994, executives of Price Club left the company and decided to start a new company called PriceSmart, which was another type of warehouse club business centered around Central America and the Caribbean.

Jim Sinegal and his Costco executives decided to change the name from PriceCostco to simply Costco.

Costco grew into newer continents, starting with a Chinese location in Shanghai. The Shanghai location brought in 200,0000 cardholders upon opening. That location now has over 400,000 cardholders well above the average across the company.

An Obsession for Excellence

Costco has seen consistent growth every year, even though their primary source of profitability comes from their memberships. What allows this business to perform so well?

- It is in their obsession for excellence.

Consumers keep wanting to come back to shop at Costco because of the low prices that the business has to offer. Unit prices for products are significantly lower than any of the competition allowing Costco to always be to go to for retail shopping.

They make the conscious decision to keep their gross margins lower than other big box competitors.

Instead of maximizing profit, Costco is obsessed with making sure their members are getting the best prices in the market.

Costco has a unique approach to treating stakeholders.

They believe that if employees and customers succeed - shareholders will too.

The most popular item that Costco has to offer is its infamous hot dog combo. Since 1985, Costco has been selling this same combo for $1.50, never changing the price once.

Back in 2018, when the current CEO of Costco, Walter Jelinek was the COO, he told ex-CEO Jim Sinegal that they should raise the price of the combo, even if by a quarter, because of how much money they were losing. Sinegal told Jelinek if he raised the prices, he would "f***** kill him". That is how adamant he was on keeping prices low for Costco members.

Jelinek then went on to switch Costco’s supplier of hotdogs and opted to use their own company brand, Kirkland Signature, to produce the hot dogs. The demand for hot dogs has been so high, Costco has two manufacturing plants in Chicago and Los Angeles purely for these products.

Costco’s obsession with keeping prices low not only helps to grow the consumer base every year, but also keeps membership rates consistent. Costco holds a near 90% renewal rate with its members.

Costco Number of Cardholders (M)

Source: Costco Investor Relations

The Positive Feedback Loop

Costco is always putting their customers first, striving to keep prices as low as possible. This dedication has brought in a growing number of members every year, while also retaining their current ones.

For Costco, it ends up becoming a positive feedback loop, as more members not only benefits the business’ top line revenue, but also benefits the members themselves.

Costco's Business Model/Positive Feedback Loop

What Costco does well behind the scenes, that members don’t see, is negotiate for lower prices with suppliers. Buying an outstanding number of products from a manufacturer allows them to have pricing power and get the best price per unit possible. 

Now this kind of negotiating power is only possible if Costco has a substantial number of members. As Costco’s membership base increases, they have better economies of scale and negotiating power with their suppliers. They use this leverage to strike even cheaper prices. Tie this in with Costco’s obsession with putting their members first and they end up passing on savings back to members. The more memberships bought creates a network effect as it not only benefits the business, but it also comes back to the consumer in the form of cheaper prices.

What Costco loses on cash-to-cash sales; they are able to make it up through the economy of scale as more memberships help every part of the business.

The Kirkland Signature Brand

Costco also offers their private label in warehouses called Kirkland Signature. This brand covers a vast range of items ranging from food and home items to supplies and self-care products.

Kirkland Signature's LogoSource: Costco.com

Kirkland Signature holds a lot of brand power as consumers are very familiar with Costco and the values it entails. They believe the same things translate into the brand as it holds a certain standard of quality and excellence, just like its business.

Costco is able to use this brand power to their advantage as they alleviate some reliance on suppliers to buy products, when they can manufacture it themselves. In addition, they are able to generate higher margins on their own products.

Store Layout Optimization

Of all retail stores, Costco is known to have one of the largest sales per square foot figure, sitting at just over $1,300 in sales per square foot.

Costco strategically places all of their products in the warehouses to ensure efficiency while also changing the layout of the store every month. Both of these ensure that Costco is able to generate the most sales per square foot as products are placed methodically, while also encouraging a larger basket size from members.

Inventory Strategy

Costco caps their Stock Kept Units (SKUs) at 4,000, meaning they only carry 4,000 items in their stores. This is compared to the typical retail store such as Walmart, who carry 40,000 SKUs.

They selectively pick their items based on quality, price and brand to give customers the most value, while also ensuring Costco has a high inventory turnover ratio. Currently they sit at a turnover ratio of 12, meaning they are able to sell and replenish their stock once a month.

Costco Revenue ($M) (Q4 2021)

To keep operating costs low, the company puts their products on the floor with wholesale packaging on skids.

This eliminates the need for workers to stock products and instead just need to place the skids in their correct position.

Sample of Costco's WarehouseSource: The Toronto Star

A Look at ROIC

Costco is constantly looking to expand its business by opening up new warehouses across North America and other countries. Typically, they open up 20-30 locations per year.

It takes a few years for each warehouse to ramp up as they get their initial membership base.

Costco is able to grow at its current rate because of how its locations are set up to be long term investments. At first ROIC is low as the warehouse builds its membership base.

Long term, you see consistent ROIC and ROE readings around 20% across the business.

Each store has a long runway for growth before it reaches membership saturation.

It is a long-term investment that pays off as Costco continues to scale as a business.

Risks

Competition

In the US, there are a handful of competitors who stand against Costco, such as Walmart’s Sam’s Club and BJ’s Wholesale Club. Both competitors hold a similar focus to Costco, providing memberships to gain access to wholesale items.

In Sam’s Club’s case, their main advantage against Costco is their membership fees being 25% cheaper. This difference in price may the defining factor for many customers as both businesses have very similar structures.

To combat this competition issue, investors should be looking at how Costco looks to expand their business into other countries. Currently, there is a heavy reliance on their American stores for the business, as they account for 70% of stores worldwide, while Canadian stores only account for just over 10%.

As the retail warehouse scene in Canada is not as competitive, Costco should be looking at new opportunities to stay ahead of the competition.

International Expansion

As Costco continually looks to expand its business into other countries, the risks arise if these stores do not have the same uptake as North American locations. People around the world support different values and the same success strategy in one part of the world may not always translate to another part.

If Costco does have a location that is not successful in a certain country, it may affect Costco’s plans for international expansion.

However, as of right now, we see no significant risk in these expansions as Costco has a proven track record of success in countries such as China, Iceland, Japan, and South Korea.

International expansion is certainly part of the growth opportunity for the business.

Bottom Line

Costco has been in the retail warehouse club business for half a century. They have had relentless focus and obsession with providing an incredible value proposition for their members.

Jim Sinegal and the Costco team were able to do one thing and do it great. That was to provide the best possible products to their members at the lowest prices possible. The story of the hot dog combo was a true testament to how committed Sinegal was to keeping customers happy and loyal.

Costco’s gross margins are notably lower than competitors, but it is intentional to retain a strong and growing membership base.

Costco has substantial negotiating power with their suppliers as they buy a copious volume of products. With any savings from products they buy, Costco loops them back to customers in the form of lower prices.

Their private label Kirkland Signature continues to flex its brand power as members look to these products for quality and excellence.  Costco is also able to use this high demand to increase margins on every product.

A focus on optimization and inventory are subtle moves that Costco does well. Holding only 4,000 Stock Kept Units (SKUs) compared to the typical 40,000, shows Costco cares about the products they give to their consumers, meticulously selecting them based on quality, brand, and price.

These ideas are the cornerstones of what makes Costco a great business. Their emphasis doing one thing great has allowed them to grow their membership base so quickly while also increasing their top line revenues.

The business has tremendous opportunity for international expansion, continued same store sales growth and widening their competitive advantages.

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