Dueling Fools Below Costco
The Bull Argument

By Chris Rugaber (TMF RFK)
March 8, 2000

I am both a customer of and a shareholder of Costco, and I can't decide which I like more. Costco is popular among many other Fools as well. Foolish scribe Yi-Hsin Chang sang the company's praises in a recent "Stocks Fools Love" special, and former Fool Dale Wettlaufer bought shares of the company for the Boring Portfolio. I'm afraid Rick has his work cut out for him, especially after last week's second-quarter report. Fool News writer Richard McCaffery summed up the quarter well in his aptly titled story, "Costco's Sales Astound."

To save you a click, let's quickly look at some of the numbers. In the company's fiscal second quarter, which ended February 13 of this year, Costco recorded sales growth of 17%, net income growth of 19% to $0.39 per share, and comparable-warehouse sales growth of 14% -- up from a decent year-ago figure of 10% (comparable-warehouse figures are for stores open for more than a year). This isn't just one good quarter for Costco, either. In the past four years, Costco has clocked in with 10.8% compound annual revenue growth, 26.7% annual net income growth, and 23.3% yearly EPS growth.

Costco is a nearly flawless retail machine, and has methodically increased sales, earnings, and market share, while branching out into new product lines and expanding geographically. Over the years, sales per store have increased, sales per customer have increased, the number of units has profitably increased, and the company has successfully expanded abroad. Costco also has an online unit that may be profitable by next year.

Costco's story has been told in recent years by Fortune, Forbes, and several Fools, especially Dale in the Bore Port. Nevertheless, let's go over it here in a nutshell: Costco excels at offering its customers value, which is a combination of quality and price. Rather than just dumping cheap stuff out on the floor for customers to pick through, Costco offers upscale items at excellent prices, as well as basics such as toilet paper (its top-selling item) at a discount. Costco is easily one of the most customer-centric companies in the world, regardless of what Jeff Bezos says. As Jim Sinegal, Costco's CEO, states:

"Costco is able to offer lower prices and better values by eliminating virtually all the frills and costs historically associated with conventional wholesalers and retailers, including salespeople, fancy buildings, delivery, billing and accounts receivable. We run a tight operation with extremely low overhead which enables us to pass on dramatic savings to our members."

In fact, as Fortune reported last year, the company's computers "are rigged to alert management when a price on an item exceeds its cost by 14% or more." I've found computer software cheaper at Costco than at Best Buy, VCRs at a better price than at electronics stores, and even the Nokia cell phone I bought direct from AT&T turned up cheaper at Costco a few months later. As CEO Sinegal has stated, the company simply won't sell something if it can't save the customer money.

Nevertheless, it sells quite a few things. As its website notes, Costco sells groceries, candy, appliances, television and video equipment, automotive supplies, tires, toys, hardware, sporting goods, jewelry, watches, cameras, books, housewares, apparel, health and beauty aids, tobacco, furniture, office supplies, and office equipment. Many Costco stores also provide a variety of what it calls "ancillary" services, which include pharmacies, optical centers, one-hour photo development, hearing aid centers, and gas stations. These are frequently higher-profit businesses, which helps offset the razor-thin margins the company maintains on its "core" businesses.

Yet, despite the wide range of goods, what's interesting about Costco is they actually stock fewer individual products in their cavernous warehouses than you would think. As Forbes points out, Costco has mastered the art of a buyer's club, which is to do much of the comparison shopping on behalf of the customer, and then stock the one or two brands that provide the best value. As a result, Costco stocks maybe 4,000 different products, while a Wal-Mart Supercenter or Target may have up to 100,000 different items. This ensures that the company stocks products that sell and enables Costco to manage inventory efficiently.

The company's low prices result in low profit margins, but this is part of Costco's success, rather than a handicap (though the company works to increase margins, slowly, over time). While higher margins are great for software companies or high value-added manufacturers such as Intel, a retailer that can maintain low prices will attract and keep more customers than its competitors, especially when it is also selling quality products. Costco maintains lower margins than practically anyone in the retail business.

So how does the company make money? By turning its inventories at high speed, Costco sells enough product to make plenty of profit. As Rob Landley wrote in the Rule Maker portfolio when discussing what the portfolio calls Merchant Kings: "A distributor with faster inventory turnover can thrive with a lower profit margin because they make their profit more often and compound their earnings much more rapidly. Simple math says that a 30% profit compounded four times gives 2.86 times the original amount [1.3 x 1.3 x 1.3 x 1.3 = 2.86]. A 15% profit compounded eight times is 3.06 times as much. Strange as it seems, a company that makes half the profit twice as often comes out ahead in terms of sheer cash."

In essence, this is what Costco does, and it's among the best in the business at it. We can see how well Costco does by comparing its efficient asset and inventory management to the king of retailers, Wal-Mart.

                           Costco     Wal-Mart
Gross Margin                 10.3%     21.82%
Net Margin                   1.86%      3.21%
Days In Inventory            39.8      63.71
Days Sales Outstanding     2.33       3.58
Days Payables Outstanding   35.06       40.1
Cash Conversion Cycle        7.07      27.19
SG&A as % of Sales           8.59%     16.89%
Asset Turns*                3.989       2.64
Feb Comp Sales               13.0%       6.1%
(Figures for calendar Q3 1999; * asset turnover for trailing 12 months as of calendar Q2 1999. Data from SEC filings and Motley Fool data. SG&A = sales, general and administrative.)

Costco's ability to turn inventory and assets rapidly, especially compared to Wal-Mart's, is clear and impressive. Certainly, Wal-Mart's Sam's Clubs are Costco's closest competitors, but Wal-Mart doesn't provide much data for that division. Costco's other warehouse competitor, BJ's Wholesale Clubs, is much smaller (less than $4 billion in sales in the last 12 months) and, like Sam's and Wal-Mart as a whole, has slower sales growth than Costco. While its margins and expenses are comparable to Costco's, its inventory management is not as impressive.

Costco is at the top of its form, and that is somewhat reflected in its stock, which has done well in recent years. Rick presumably will have to argue that the stock's price is too high.

Suffice it to say, you pay a high price for a great company, but there is still plenty of room for Costco to grow. I'll get more into that in my rebuttal.

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