Costco. An aspirational business model?
Advocates for higher employee compensation continuously reference Costco Wholesale (COST) as the model for other corporations to emulate. COST is a profitable company that pays well above minimum wage while also providing good employee benefits.
Last week low-income restaurant and retail trade workers staged a one-day nationwide strike. Their demand? $15 per hour; almost double what some of them were currently making.
Do companies exist to serve those who invest their money, time and efforts in starting and running the business? Or… are corporations merely a tool to provide employees with wages and benefits? If you subscribe to the latter theory it might be difficult to get entrepreneurs interested in risking capital to create new businesses and the jobs that come with them.
Can higher wages and benefits really co-exist with attractive profit margins? The answer is unequivocally, ‘No’.
Costco has never had good net profit margins.
Paying generous wages and benefits to rank and file employees has limited Costco’s average net margins to less than half those of retailing rivals Target and Wal-Mart. During the past decade, the much vilified McDonald’s (MCD) sported average net profit margins more than nine times greater than Costco’s.
How much money a business earns is determined with a simple formula.
Corporate Profits = Gross Sales x Net Profit Margins
More profits over time creates greater shareholder value. Here are fiscal 2012 numbers to illustrate that point.
McDonalds had by far the best margins of this group. Royalties from franchisees cover a large slice of the parent’s corporate overhead. Wal-Mart had the largest total profit due to their enormous sales volume. Target sold 26% less merchandise than Costco but earned almost 67% more dollars for shareholders.
From an owner’s viewpoint Costco was the worst performer of the four.
Costco’s business model is unusual. Costco charges its customers for the privilege of shopping with them, online, at their gasoline pumps or in their stores. The company’s $55 and $110 per year membership fees incur only trivial overhead. They drop, almost 100%, right to Costco’s bottom line.
Those annual fees accounted for more than 100% of COST’s actual net profits during each of the past five years. (See chart below).
Paying employees high wages meant Costco’s $97 billion in FY 2012 sales merely served as a money-losing promotion aimed at ensuring an ever-growing stream of recurring membership fees.
Other companies would not want to copy Costco’s business model. If they did, it would not be likely to work for them anyway. Customer demographics are a key consideration. Costco caters to a much more affluent clientele than WMT, TGT and MCD while also sporting a much higher average transaction amount. Sam’s Club and BJ’s use a membership format but do not duplicate Costco’s employee compensation scales.
McDonald’s outstanding 10-year shareholder total return numbers reflect its attention to profitability. The weaker long-term shareholder return for WMT and TGT were mainly attributable to multiple compression. Wal-Mart’s was priced at a very expensive (35x) P/E 10-years ago. Target commanded 21 times its FY 2003 EPS.
Costco’s fine 10-year stock return benefited from the tailwind of a substantial P/E multiple expansion from 18.3x to 25.0x. That is unlikely to be repeatable. The only other time in the last decade that COST hit greater than a 25 P/E was in early 2008. The shares proceeded to plunge from $75.20 to $38.20 in less than one year.
Costco management is willing to sacrifice profits to keep prices low and employee compensation high. That does no favors for shareholders.
Franchise owners of McDonald’s and many other restaurant chains show much lower profits that the public imagines. Increasing wages would force them to raise prices significantly. Trying to absorb higher pay packages for workers would torpedo profits at the local level. That might prove to be both a job killer for current employees and a huge disincentive towards opening new units.
What is the proper hourly rate for an entry level job that requires little skill and no experience? That is an open question best left to the marketplace to decide. Employees that feel underpaid are free to quit, allowing them to accept better paid positions elsewhere.
If no better pay packages are available, perhaps those workers should be happy they are not part of the unemployment statistics we all wait to see each week.
Are any of the stocks mentioned good buys now? Here is a quick cheat sheet summary of my evaluations. All four appear to have only modest upside potential over the next 12-months. My projections do not include dividend yields which would make total return potentials a bit better.
None currently trades at a discount to their own previous 5-years’ normalized multiples. The Fed’s ZIRP policies might support slight P/E expansions if rates do not ratchet up too much.
The verdict. All these are OK to hold. None offers exciting upside. These reasonably conservative, decent yielding stocks are best suited for those merely wishing to outperform cash, treasury bonds or bank CDs.
Disclosure: No position in any stocks mentioned
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