Many (web) pages have been filled about the concept of untapped pricing power but companies that have it are like unicorns. Everyone knows what they look like, and some people claim they once saw one. But there seems to be no opportunity to observe one at your leisure.
This has bothered me for some time and this week, I decided to fire up my keyboard and do something about it. Being lazy, I don’t want to be hunting unicorns on a daily basis, so I might as well point one out that is likely to stick around for a decade or two.
Measuring retail cost
Retail is about acquiring goods from suppliers in large volumes and providing those goods to a large group of consumers in much smaller volumes. The supplier benefits because it can adjust its operation to the agreed-upon volumes, and consumers benefit because they can get what they want, where they want it and in the volume they need. The retailer covers its costs by charging the consumer a higher per-unit price than what it paid the supplier. That’s the gross margin, also known as markup.
It follows that the retailer that is able to get goods from the supplier to the consumer at the lowest cost has superior earnings power. To find that company, we divide the costs of some competing retailers by their revenue. We do that by subtracting net margin from gross margin and dividing the result by revenue.
This is a phenomenal group of retailers, and Costco (COST, Financial) wins by a clear margin. PriceSmart (PSMT, Financial) has the second-best cost structure but still spends 6 cents more than Costco per dollar of revenue.
By raising its prices by 5%, Costco could still undercut PriceSmart. This would boost Costco's net margin from 2% to approximately 6%. In other words, Costco's earnings power is three times higher than its reported earnings under generally accepted accounting principles (GAAP). Costco doesn't raise its prices though. It passes on its lower costs to consumers. At Costco, they're called members. Unsurprisingly, Costco has a growing number of loyal members.
Is it real?
GAAP is almost as bad as statistics when it comes to revealing the truth. The nice thing about retail is that it is simple to check what's really going on by walking the floor. Being lazy, I’ll use my web browser instead.
Costco’s per-dollar cost advantage is less obvious with high-volume, low-margin groceries (tangerines). Conversely, the advantage is magnified by slower-moving, high-margin items such as cameras, handbags and watches, so we’ll check out these departments.
As of today (May 23, 2019), the Fujifilm XP140 at Costco.com is the first camera that shows up on my web browser when I sort by price. The price is not listed online for non-members, but it sells for $149 at the warehouse. At Walmart, it sells for $199 and at Amazon, it sells for $179 (new).
For handbags, the first (non-Kirkland) bag you’ll find is the Riviera crochet tote by The Sak. At Costco you can buy them by the dozen for $35. At Amazon, the cheapest one sells for $39. I'm unable to find that particular bag at Sam’s Club but at Walmart, the cheapest The Sak tote sells for $54. For watches, the first men’s watch that comes up is the Invicta Pro Diver Stainless Steel with a blue dial. That’s $40 at Costco, $50 at Amazon and $55 at Walmart.
With patience, it is possible to find better deals at Amazon. That’s because retailers often have to liquidate their unsold inventory, allowing consumers to pick up small numbers of merchandise at low prices.
But on any given day, the chances of finding Costco merchandise selling for less anywhere else are remote. If you do find an item selling for less, then that’s probably a distressed retailer liquidating some inventory.
So that’s it: a company with untapped pricing power that you can observe at your leisure.
Most readers on this forum will be aware that Charlie Munger (Trades, Portfolio) sits on the board of Costco. He often explains that he prefers to buy quality, and it is even better to buy quality at a discount. That idea sums up Costco.
Disclosure: This is not a recommendation to buy or sell anything. This is an expression of my views about Costco with the intent of engaging in intelligent discussion about the company and its stock. At the time of writing, I had no position in any of the stocks mentioned.
Further reading:
My thoughts on the root cause of Costco's cost advantage: https://www.measuringthemoat.com/post/costco-wholesale-untapped-pricing-power
Data from someone who does walk the floors: http://www.clubintelligencecenter.com/hhc/documents/wcf_501_20180629.pdf
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