September 11, 1998

An Investment Opinion
by Dale Wettlaufer

Shopping Costco, Part 2

Continuing with my look at Costco (Nasdaq: COST), I should say right off the bat that one of the most informative articles on the company that I have read was Forbes' August 11, 1997 cover story on the company. Reading this article, one can't help but be reminded of Wal-Mart (NYSE: WMT). Having recently read Sam Walton's Made in America: My Story, the Forbes article reminded me very much of the growth story of Wal-Mart and the single-minded devotion to creating value for customers that both of these companies share.

To wit, California lawyer and businessman Charlie Munger, Vice-Chairman of Berkshire Hathaway, effuses with praise for Costco. Telling Forbes that he broke his rules about sitting on outside boards of directors, Munger said, "It's hard to think of people who've done more in my lifetime to change the world of retailing for good, for added human happiness for the customer." "Including Sam Walton," the magazine asked. "Munger nods." In an article in Discount Store News earlier this year, Costco Chief Financial Officer Richard Galanti summed it up pretty neatly: "If we can't save customers money, we're not going to sell an item."

Saving people money -- big money over the course of a year -- isn't the entire part of a value equation. Value is the intersection between product satisfaction (which includes the service component of selling) and utility and price. You can sell junk to someone at a rock-bottom price or you can sell exclusivity at at a needless markup. Getting the highest quality to the customer at the lowest price has been something that Wal-Mart built its business on, but it appears to this casual observer that Costco is going that about ten steps better.

According to BT Alex. Brown retail analyst Barbara Miller, Costco's average store has about 3,500 stock keeping units (SKUs) in a 120,000 square foot store, "...miniscule relative to, for example, a supercenter in the same size box [store].... COST's merchandising is a key thing responsible for its success," Miller said. "Clubs are item merchants, hence each selection is important." Forbes focuses on this thread, as well: "By stocking only a few branded goods in each product category, Costco is in essence doing the customer's comparison shopping and demanding the best terms from the vendor." In other words, when you walk into a Costco, you're not faced with random piles of stuff you don't need or cheap knockoffs of stuff you do need. For those shoppers that aren't looking for an adventure in cheap, unknown substitute brands, they can feel comfortable walking into a Costco.

When it is the company's private mark, Kirkland Signature, the company is very serious about the brand equity it is building. Barbara Miller agrees, "Even its private label products, Kirkland Signature, compare themselves to the best (e.g. the luggage is compared feature by feature with Tumi) -- the chicken breasts are co-branded with Tyson." Forbes relays an interesting story on this point: "[Costco CEO Jim] Sinegal is careful not to abuse his customers' trust by using the signature label on something second-rate. Because Procter & Gamble came up with a superior paper towel, Costco won't sell it towel line as Kirkland, choosing instead a lesser private label. No easy hits on the customer -- that's the rule."

Some market forecasters think there's a ceiling on where this is going. I disagree that the market ceiling on this is only $10 billion in sales over where the warehouse club industry was in 1997. And I also disagree with Charlie Munger on this being "an absolute revolution." From the beginning of commerce, the merchant that has been able to deliver the best value -- remember, that's the intersection between price and quality -- has done well. That's a common element in the successful retail concepts of the century -- Sears, Roebuck; Montgomery Ward; Wanamakers; Larkin; Woolworth's; Hannaford Brothers; Kmart; Wal-Mart; and $24 million retailer Costco. The revolution is in form, not function.

Some investors might not believe a brand with staying power can operate on margins of less than 2%. Going on the idea that brand is about delivering value to a customer, whether it's Coke selling its product at a premium to no-names or Costco operating at about half the gross margin of a Wal-Mart, we have to orient ourselves to the concept that brand is about good returns on capital. In the capital management department, Costco's asset activity ratios are formidable, blowing away Wal-Mart:

Company                         WMT       COST 
 Inventory Turnover             5.79      11.71 
 Capital Turnover               4.14       6.41 
 Cash Conversion Cycle         32.18       7.93 
 Year/Year Inv. Cap. Growth    15.26%     13.67% 
 Invested Capital Turnover      4.14       6.41 
 Gross Margin                  21.75%     11.84% 
 Operating Margin               5.52%      3.17% 
 SG&A/Sales                    16.24%      8.54% 
 Net Margin                     2.99%      1.82% 
 Asset Turnover                 2.88       4.15 
 Assets/Equity                  2.40       2.20 
 PP&E Turnover                  5.56       7.33 
 ROA                            8.63%      7.54% 
 ROE                           20.68%     16.61% 
 Net Cash from Operations  $6,698.00    $732.61 
 NCFO/Reported Earnings       180.93%    171.68%
Overall, this is the sort of company that I look for as an investor. It has a clear-headed approach to its business model and pursues the model like a hellhound. The headroom on the growth is not limited anytime within the next ten years, in my opinion, if one understands that the revolution here is not about a big box (store) but about delivering the absolute best value to a customer. As such, this is the sort of company that can invest capital in the business at double-digit yearly growth rates without diluting shareholders or unduly leveraging the business. In the growth phase, the company will earn its cost of capital and probably not get to the point where it absolutely crushes its cost of capital until a good part of its stores have reached a more mature phase. The model so far indicates that the economics of individual units improve as they age and take share away from traditional retailers.

At the current quote, the company is priced where it should be, in my opinion. Barring no big changes in interest rates, the company's annual return will follow its capital growth rate and then improve as return on capital improves with maturity. In all, this means a forward-looking growth rate from the current quote of perhaps 13% per year. It's too bad, actually, that the market didn't take down Costco that far in the last action.
Company                   WMT     COST 
 EV/Revenues             1.24      0.55 
 EV/Invested Capital     4.7       3.32 
 EV/Assets               3.32      2.14 
 Price/Book Value        7.32      4.26 
 PSR                     1.11      0.51 
 EPS                    $1.64     $1.84 
 P/E                    37.20     28.22 
 EV/Operating           22.39     17.42 
 EV/Net Income          41.29     30.38 
 EV/FCF                 68.49     47.26 
 EV/NCFO                22.82     17.70