The most searched-for stock on GuruFocus Monday, the day Amazon announced its $13.7 billion bid for Whole Foods (WFM, Financial), was not Amazon (AMZN, Financial) or Whole Foods – it was a competitor, Costco (COST, Financial), that could be vulnerable to disruption.
Costco stock shed almost 9% since Monday, versus a 2.5% drop in the S&P 500 Retail Select Index and 0.53% decline in the S&P 500. Fear of Amazon’s move into brick-and-mortar rippled through the retail industry, with Target (TGT, Financial), another rival, sliding 0.45%. Walmart (WMT, Financial), widely seen as having the strongest position against Amazon, with Moody’s writing in a research note Wednesday that Amazon had “no discernible edge” over the company, gained 2.52%.
"Costco's drop is connected to the overall sector's plummet following the Amazon-Whole Foods announcement,” Krista Fabregas, ecommerce and retail analyst at FitSmallBusiness.com, said. “But like Amazon, Costco has perfected operating on thin margins, so it's positioned to weather the storm better than others, which is why many experts are long on the stock.”
As a low-cost, warehouse-style retailer of selected goods, Costco operates on some of the lowest margins in the business. In 2016, the company reported gross margins of 13.32% and net margins of 1.98%.
Wal-Mart and Whole-Foods price their goods up higher. Wal-Mart posted 25.65% gross and 2.81% net margins in 2016. Whole Foods, known for its pricey merchandise, had 34.41% gross and 3.22% net.
The storm that threatens the space is heavily related to Amazon’s history of disruption, having started as a business that shook up the book industry. What exactly Amazon has planned is up for debate, and Ryan Farnung, planning researcher at GPS Financial in Pittsford, New York, said that the negative market sentiment surrounding the industry will hurt Costco’s stock as well.
“It's likely that the real reason behind Costco's plummet has less to do with their business directly and more to do with the fact that the Whole Foods acquisition proves that Amazon is getting serious about their involvement in retailing groceries. The thought process is that Amazon is going to do something to revolutionize the way that we buy groceries (in the way that they have done with so many other products), and that is going to harm the more traditional grocery retailers.”
Costco’s business model and agility have helped it in the past. In its first-quarter report, the company said that it had succeeded against competition through means such as “adjustments to our pricing and our merchandise mix, including increasing the penetration of our private label items.”
In addition to a membership model designed to drive loyalty, the company’s business strategy is centered on competitive pricing. Rather than focusing on the short term, Costco seeks primarily to become synonymous with “pricing authority” to its customers, which affects its margins.
“Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases, instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales (gross margin percentage),” it said in its quarterly report to the SEC.
Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)’s friend and business partner, is also a holder of Costco. What he will do with the stock remains to be seen. It is one of just three of his holdings, along with Berkshire Hathaway (BRK.A)(BRK.B) and investor Li Lu’s fund. Prior to the Whole Foods acquisition, the last time he mentioned it publicly was at his 2017 Daily Journal meeting in response to a question about his unusually concentrated portfolio, where he expressed confidence.
“And is three stocks enough,” he said. “What are the chances that Costco’s going to fail? What are the chances that Berkshire Hathaway’s going to fail? What are the chances that Li Lu’s portfolio in China is going to fail? The chances that any one of those things happening is almost zero. And the chances that all three of them are going to fail?”
Over the years, Costco has produced sustained growth with a conservative balance sheet. Its revenue has increased each year since 2008, and has turned a profit annually for the past decade. In 206, it recorded revenue of $118.92 billion, risen from $116.2 billion the previous year. Net income was $2.35 billion, compared to $2.38 billion. Costco also ended the first quarter with $4.54 billion in cash and $2.82 billion in long-term debt.
If Amazon continues with a disruption of the retail sector, it likely will not do it through further acquisitions of attractive grocery stores including Costco, Farnung said.
“I don't think it would make sense for Amazon to acquire Costco. They only need to figure out how to apply their systems to groceries once, and they can do that with Whole Foods,” he said. “There wouldn't be a reason to continue purchasing other grocery retailers if they believe that they can do it better, because if the market agrees then many of the competitors will disappear naturally.”
See Costco's 15-year financials here.
