September 8, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Shopping Costco, Part 1

In writing about Costco Companies (Nasdaq: COST) in our recent series on return on equity, I discovered a pretty interesting company. While the point of looking at Costco was to examine the relationship between return on assets and return on equity, the brief look I took at the company made me want to look closer.

One of the best ways to start a new research project is to head on over to Excite's excellent Transium website at http://excite.transium.com/. The site aggregates content from a number of different trade magazines and more general publications, but it's really the trade magazines that give you the best introduction to the issues at hand in a particular industry. The Excite Transium website is particularly useful for researching consumer goods and retail companies.

In the case of Costco, entering in the ticker symbol or the name of the company yielded 42 articles from Discount Store News, the leading trade magazine on the industry. Thirty-two of those articles are from DSN's Supercenter & Club Business journal. Other trade magazine articles were available from MMR, Supermarket News, Chain Drug Review, Crain's, and Home Improvement Market. In other words, not the sort of stuff that you see on most people's coffee tables, but invaluable for conducting investment research.

What did we find out about Costco, then? First, most encouraging was an item from MMR dated 5/18/98 and titled "There's Still Room for Clubs to Grow." In the article, we find a number of useful items:

-- "Management Ventures Inc. (MVI), a consulting firm, predicts that the warehouse club industry in the United States and Canada will generate sales of about $50 billion this year, up from an estimated $47.9 billion in 1997. The gain will come mainly from the addition of about 30 outlets by the major players, bringing the total number of stores in the two countries to about 825."

OK, that's helpful. Costco reported in its second quarter 10-Q that it had opened twelve warehouses in the U.S., two in Canada, and one in the UK. Just through the first half of the year, Costco already accounted for nearly half the industry's estimated 1998 expansion and was planning on adding another two to three locations through the end of the year. The company also consolidated a number of California distribution facilities, which should help working capital management and possibly add marginally to operating earnings.

-- Another piece of information from the article: "Costco's outlets in the U.S. and Canada generate estimated annual volume per unit of $77 million to $80 million, while Sam's outlets are believed to average about $46 million. Industry observers attribute the disparity to Costco's ability to inspire increased shopping frequency and higher per basket rings. The retailer's net margins are estimated to be less than half of Sam's, keeping prices down and boosting sales, yet the company generates strong profits by maintaining strict cost controls and using its capital effectively. Costco is also seen as an innovator on the merchandising side of the business. A strong focus on such departments as meat and produce, for example, has helped broaden the appeal of its outlets."

Excellent. Any company that can beat Wal-Mart in merchandising and in sales per square foot knows what it's doing. Wal-Mart is the innovator at these things.

-- On gross margin, MMR reports that "...the company has had success with its own Kirkland label products, which have helped spur growth in the chain's gross profits."

Checking into gross margin, merchandising costs as a percentage of net sales decreased from 90.275% to 89.901%. In most industries, this would be a rounding error not worthy of much attention, but on $21.48 billion in sales, that's $80.3 million in gross profit, contributing 16 percentage points to a year-over-year operating income (before asset impairment provisions and warehouse closing costs) increase of 31%. In all, Costco raised operating margin (before impairment charges) to 2.998% of revenues, up from 1996's margin of 2.559%, a formidable achievement that would be difficult to duplicate.

Nevertheless, the company did increase operating margin (again, before any impairment charges) to 3.213% of revenues for the first six months of 1998, up from 2.941% in 1997. Merchandising costs as a percentage of net sales also dropped again, below last year's level. At 89.753% of net sales, merchandising costs as a percentage of net sales are down from 89.958% through six months of 1997. Again, For many companies carrying the number three places to the right of the decimal for many companies would be a hairsplitting excercise, but this is a company where margins and inventory control are both extremely important. And these percentages aren't random either. Keeping controllable expenses such as inventory shrinkage (disappearance and destruction) down and increasing sales through merchandising and maintaining customer satisfaction and repeat visits all decide what happens on the left side of the decimal.

We'll continue our look at Costco on Friday.

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