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An Outstanding Business Model Carves a Narrow Moat for This Warehouse Operator
Posted by: Vanina Egea (IP Logged)
Date: February 17, 2014 10:41PM
Founded in 1983, Costco Wholesale Corporation (COST) has become the largest warehouse club operator in the U.S. The firm also conducts its business in Puerto Rico, Canada, Mexico, the UK, Taiwan, Japan, Korea and Australia. The company caters to its customers with a vast selection of high quality food products, stationeries, appliances, household and lifestyle goods from national brands, as well as private label products. As of January 2013, it counted a total of 648 warehouses, 461 of which are located in the U.S. Despite its comparative smaller store base, Costco is now the third largest food retailer in the U.S.
The Formula for Success
The company runs its warehouses through customer memberships, which account for most of the firm’s profit. On this basis, Costco built a loss-leader business model, selling gasoline and food at zero profit, or even at a loss, in order to attract consumers. This competitive advantage becomes even stronger in an inflationary environment, where household expenses in food and gas sweep a greater share of home budgets. Unsurprisingly, these necessity goods, sold at compelling low prices, have increased market share and are driving strong store traffic. Additionally, it creates more sell-through opportunities for better-margin discretionary products.
Buying Power and Low Capital Expenditures
Low prices efficiently combine with merchandise and sales strategies that result in strong sales volumes and fast inventory turns. Along these lines, the firm concentrates its merchandise purchases on 3,300-3,800 stock keeping units (SKUs) per warehouse, compared to an average of 50,000 to 75,000 SKUs at Wal-Mart (WMT) superstores. If we consider Costco’s $60 billion and Wal-Mart’s $265 billion U.S. sales volume, an average would deliver $16 million in sales per SKU at Costco compared to only $3.5 million to $5 million per SKU at Wal-Mart. Furthermore, the company limits its offering in each product line to fast-selling items, thereby achieving inventory turns in Iess than 30 days.
On the other hand, Costco’s bare warehouse format requires much lower maintenance capital expenditures. And the firm doesn’t advertise, which adds great cost savings.
To further empower its competitive advantages, the company has one of the highest square footage growth in the industry and is expanding its footprint in the domestic and international market. Thus, it opened 26 clubs in fiscal 2013 and plans to open 30 more in fiscal 2014. Geographical diversification logically diminishes the risks that may emerge in specific markets.
A Compelling Value Proposition
Nearly all of Costco’s profit derives from membership fees which has enabled the firm to sell it merchandise at the lowest price points. Consequently, the company has positioned itself as a price leader in the selection of products that it offers. This reflects on the affluence of membership renewal rates, which remain above a healthy 85%. Also, the arrival of new members thanks to more store openings and the strong appeal of its value proposition continue to enlarge its market share. In fact, revenues from membership fees increased over 7% in the first quarter. In addition, comparable warehouse sales increased 3% on a reported basis and 5% on a constant rate. In the U.S. comps increased by 4% (excluding gas) while Wal-Mart and Target Corporation (TGT) showcased a disappointing -03% and -0.9%, respectively.
Costco’s stocks trade at 25.10 its trailing earnings compared to the industry median of 18.80. Its strong competitive advantage, low risks and and sturd growth support the price. The increase of dividends and share repurchases is also appealing, as well as a return on equity of 18.80, which almost doubles its peers' 9.80 average. All in all, although investment guru Ray Dalio (Trades, Portfolio) sold out his holdings, I strongly believe Costco is a solid investment opportunity.
Disclosure: Vanina Egea holds no position in any stocks mentioned.
Stocks Discussed: COST, WMT, TGT,