Costco's Moat

Client Letter August 2001

I like retail stocks because it is an easy business to understand. It is fiercely competitive business with thin margins, but it is predictable under certain circumstances. Once a company establishes a sustainable competitive advantage it can last for a long time (Wal-Mart in the eighties, Home Depot in the early nineties, Costco and Nebraska Furniture Mart today).

The most recent 10 Q for Costco shows their gross margin (net sales minus merchandise costs) as 10.37%. For me this is a remarkable figure, and is the heart of their competitive advantage. Basically this statistic measures how much the retailer marks up his merchandise before he sells it to the public.

On the surface a low margin would appear to be bad. You would think that the retailer with the lowest margins would make the least money, in fact this simple ratio is a good way to measure a retail moat.

Costco's margin

Store

Gross Margin

Net profits

Return on equity

Wal-Mart 23.0% 3.2% 19.0%
Costco 10.4% 1.7% 14.9%
Dillard's 32.3% 1.7% 4.5%
Best Buy 20.5% 2.6% 21.0%
Home Depot 31.4% 5.6% 17.2%
Albertson's 31.2% 2.4% 15.3%
Bed Bath and Beyond 43.0% 7.3% 20.0%

In other words Costco can show the same profit on 10.4% markup as Dillard's can on a mark up of 32.3%. For a watch that manufactures sells for $100. Dillard's would have to sell it for $132.30 to make the same profit that Costco would make by selling the same piece for $110.40 (this percentage is actually based on a markdown not a markup so the real prices would be higher, but you get the idea.) Wal-Mart is bringing 1.5% more down to the bottom line so they would price the watch at $124.5 ($123 + $1.50).

Or if you want to buy a barbecue grill that the manufacturer sells for $200, you can go to Wal-Mart and pay $249.00 or Home Depot and pay $274.00; or you can buy it at Costco and pay $220.80. Again the math is approximate. Also I suspect that the Home Depot markup varies by product lines and barbecues probably do not get marked up as much as a can of paint.

How can Costco sell the same product cheaper that other big box retailers? Part of the answer is that they are really fussy about turnover. They only stock stuff that they can sell fast. Costco turns their inventory 12.8 times a year whereas Dullard's turn is 5.3, Bed bath and Beyond is 4.7, Home Deport is 6.7, and Wal-Mart is 9.1.

Obviously you do not have to mark merchandise up as much, if you are turning it faster than anyone else. Assuming your other costs are the same as your competitor if your turn is twice as fast you only need half the markup to get to the same bottom line.

Fast turnover has another big advantage; most retailers pay their suppliers in thirty days so if you can turn your inventory 12 times a year your suppliers pay you to carry their product. This keeps expansion cost low because you do not have a big investment when it comes to inventory. You can see on Costco's Balance sheet that their inventory is $2.6 Billion while Receivable are $2.5 Billion. In other words the suppliers pay for their inventory.

Another Way to keep your costs down is to have a big box, if you have a big store and a lot of turns you end up with a lot of volume per store.

Costco's Balance sheet

Store

Total Sales (Billions)

No. of stores

Sales Per Store (Millions)

Inventory (Billions)

Turns

Wal-Mart $191.3 4190 $45.7 $21.4 9.1
Home Depot $45.7 1129 $40.5 $6.6 6.9
Albertson's $36.7 2500 $14.7 $3.3 11.1
Costco $32.1 313 $102.6 $2.6 12.8
Best Buy $15.4 400 $38.5 $1.7 8.5
Dillard's $8.6 337 $25.5 $1.6 5.3
Bed Bath and Beyond $2.9 311 $9.3 $.6 4.7

That's right Costco's per store sales are 2.5 times that of home depot, and 4 times that of Dillard's. Comparing it to Wal-Mart is a bit of Apples Vs Oranges because Wal-Mart's figures include 495 Sam's Clubs and 888 Supercenters. I have read that Sam's volume per store is about half of Costco's. I do not know how reliable these figures are but if anyone has good information on this I would like to hear it.

Table Two above to shows two of the reasons that Costco can sell cheaper than other stores (faster turnover and More sales per store). Another factor is the membership fee. Costco will collect over $600 Million in Member fees this year a figure that is greater than its total net after tax income.

There are many other factors that contribute to Costco's competitive advantage, many of them have been mentioned on this board before. When you add them all up it amounts to a huge Moat. They can sell Computers cheaper than Best Buy, towels and sheets cheaper than Bed Bath and Beyond, power tools cheaper than Home Depot, Bananas cheaper than Albertson's and trash cheaper than Wal-Mart. With this pricing power they have the ability to cherry-pick from any retail category and sell only the highest volume products from across the complete spectrum of retail products.

There are two competitors in their field, but BJ's with $4.9 billion in Sales and 118 stores is only doing about 41.5 million per stores. It is only generating cash flow to build 14 stores this year compared to Costco's 35. Sam's Club's threat is harder to evaluate, but for the last four years Wal-Mart has slowed the expansion of Sam's to a crawl While doubling the number of Supercenters to from 44 to 88. A policy that indicates to me they do not feel competing with Costco is the best use of their capital.

Today Costco reminds me of Home Depot when I first bought into it (1990). At the time HD had about 150 stores, but they had a lower gross margin than their competition, and they already established their dominance in their niche. All they had to do to be a huge winner was to keep doing what they had been doing over an over again for the next ten years. Nothing complicated, no restructuring, no new management, no technical revolutions, Just the same thing day after day year after year. Very boring.

Other than Berkshire, I do not see much today that I feel I can hold for the long haul, but Costco may one exception. I expect Costco will be in our Portfolios for a long time.

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