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Charlie Munger's Love Affair With Costco

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Berkshire Hathaway (NYSE: BRK-B  ) Vice Chairman Charlie Munger isn't one to mince words, but his recent plug for Costco (Nasdaq: COST  ) had an almost fanatical level of bluntness.

Asked about his favorite company outside of Berkshire, Munger literally interrupted the questioner and answered, "That's easy. It's Costco."

"It's one of the most admirable capitalistic institutions in the world. And its CEO, Jim Sinegal, is one of the most admirable retailers to ever live on this planet," he gushed. "I just can't say enough about my admiration for Costco. More of you should look at Costco. In fact, every time Donald Trump says something and you get discouraged, you should think about Costco."

He wasn't done. "It has a frantic desire to serve customers a little better every year. When other companies find ways to save money, they turn it into profit. Sinegal passes it on to customers. It's almost a religious duty. He's sacrificing short-term profits for long-term success."

This wasn't the first time Munger let his admiration run wild. Last year he said, "Generally speaking, I believe Costco does more for civilization than the Rockefeller Foundation."

What's behind these accolades?

Part of Munger's obsession with Costco is its corporate culture. "It's a total meritocracy," he said. Co-founder and CEO Jim Sinegal earns a few million a year -- a rounding error in the corporate executive world -- answers his own phone, spends 200 days a year visiting stores, and strikes you as a retired middle-class neighbor more than the head of one of the world's largest companies. Costco employees don't wear uniforms. Street clothes and a nametag get the job done -- an idea that saves money while humanizing workers. "Our intention is to try to build an organization that is going to be here long term," Sinegal told The Motley Fool two years ago."And we think you do that by paying attention to some very, very basic things."

Those things, in order, are: Obey the law, take care of your customers, take care of your people, and respect your suppliers.

Shareholders, you'll notice, aren't part of the list. But that hardly means they're forsaken. Costco might be one of the best examples of how happy customers and employees naturally lead to happy shareholders. Sinegal likes to note that Wall Street constantly jeers Costco for being more generous to employees than shareholders, yet its stock consistently trades at one of the highest multiples in the retail industry, well ahead of Home Depot (NYSE: HD  ) or Wal-Mart (NYSE: WMT  ) . Since 1995, Costco has returned 1,000% to shareholders; the S&P 500, less than 200%. Whatever Costco's doing -- deliberately shareholder-centric or not -- works.

The rest of Munger's admiration has to do with Costco's business model.

Retailing is a simple industry. You sell merchandise for a little more than you paid for it. The difference, minus the cost of operating the store, is profit.

Costco is different. It doesn't make much money from retailing. Revenue from retail sales comes precariously close to matching cost of goods sold plus operating overhead:





Retail sales $76.3 billion $70 billion $71 billion
Cost of goods sold $68 billion $62.3 billion $63.5 billion
Selling/administration expenses $7.8 billion $7.3 billion $7 billion
Retail margin 0.55% 0.43% 0.73%

Source: Company filings.

Those margins are so thin they're nearly irrelevant. For comparison, Wal-Mart's margins are almost 6%.

The winners, of course, are Costco's customers. Take a company that prices goods just barely high enough to cover overhead costs, add in the natural savings from selling in bulk, and the odds are overwhelming that Costco customers are getting the lowest prices possible. That, in essence, is the company's goal -- or religious duty, as Munger would say.

The lengths it goes to to uphold that goal are nearly boundless. In 2009, Costco wasn't happy with Coca-Cola's (NYSE: KO  ) prices. Rather than stick customers with higher costs, it simply stopped carrying Coke products altogether. "At this time, Coca-Cola has not provided Costco with competitive pricing so that we may pass along the value our members deserve," read signs over empty store shelves. Most retailers ask how high they can push prices without sacrificing sales. Costco asks how low it can push them while still covering operating expenses.

All the while, the company is still quite profitable. The secret is that essentially all its profits come from membership fees. Total net income in 2010 was $1.3 billion; membership fees that year were $1.7 billion. The year before, total net income came in at $1.1 billion; membership fees, $1.5 billion. That's Costco's deadly weapon: price goods cheaper than any competitor reasonably can, but still reap respectable profits off membership fees.

It's a win-win for members and shareholders. For an average member who spends $1,200 a year at Costco, membership fees -- as low as $50 a year -- aren't much, and well worth it financially. For shareholders, 63 million of those membership fees, with a renewal rate of 88%, equal big, stable profits. And there's a psychological benefit to the membership model: Paying a token fee once a year and enjoying cheap goods year-round feels better than buying average-priced goods all the time.

The question is whether Costco stock deserves your money. "The world has figured Costco out, which is why it trades at 25 times earnings," Munger said. "If you're comfortable with that, Costco is one of the most admirable capitalistic institutions in the world."

Valuation is what has always kept me away from the stock. At some point, however, you have to get comfortable with paying for quality. Costco is a terrific company. Is it worth the price? You tell me in the comments section below.

Fool contributor Morgan Housel owns shares of Berkshire and Wal-Mart. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Costco Wholesale, Berkshire Hathaway, Wal-Mart Stores, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Costco Wholesale, Coca-Cola, Home Depot, and Berkshire Hathaway. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (11) | Recommend This Article (23)

Comments from our Foolish Readers

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  • Report this Comment On July 06, 2011, at 12:59 PM, prginww wrote:

    Yes - it is worth it. My local Costco is ALWAYS busy. I enjoy shopping there. The stock has done great. A wonderful buy and hold. For the doubters I invite you to shop at a Walmart - and while you are at it buy their stock. Tell me in a few months how that's working out for you!

  • Report this Comment On July 06, 2011, at 2:56 PM, prginww wrote:

    I am a big fan of Charlie but I agree with your view that valuation is too generous and I don't think I would buy the stock now and I might actually sell if I had any. If you think about it, they already have 63 million members which is probably close to 63 million households. There are only 115 million households in the US and so I wonder how much room they have to grow domestically (based on their philosophy of near zero margins more revenues doesn't really do much). They have opportunities outside the US and you can ague that they can increase membership fees but I think it can only do so much to justify 25 times earnings.

  • Report this Comment On July 06, 2011, at 4:54 PM, prginww wrote:

    I think that the ratio of members to households is more like 2.5 - 1

    I have 4 memberships in my house.

    Most people I know have 2.

    I realize that the subsequent memberships are at lower cost, but I believe that there is a lot of room for growth in the Costco Membership business.

  • Report this Comment On July 06, 2011, at 4:57 PM, prginww wrote:

    So you expect the stock to be cheaper 5-10 years from now when/if the economy is doing better? Yeah, and Charlie Sheen is a winner...

  • Report this Comment On July 06, 2011, at 6:09 PM, prginww wrote:

    The only reason I would give Costco $50 is to purchase an Optima battery which Costco no longer carries. Unless the great deals and quality of yesteryear reappear, Costco will disappear.

    A month ago, my yuppy half sister bought some parasite ridden salmon from her local Costco.

    Count me out.

  • Report this Comment On July 06, 2011, at 8:35 PM, prginww wrote:

    I like COSTCO meats!! Beef, lamb,pork and poultry. Alone these are worth membership.

    Pharmacy prices are always low. So for cash scrips Costco is the place always. Insured scrips

    are ok anywhere. Booze is another great buy!

  • Report this Comment On July 06, 2011, at 9:11 PM, prginww wrote:

    If Costco is so great, why doesn't Berkshire buy it? It might be a slightly-too-big elephant, but at $37 billion it's in Burlington Northern territory, though Berkshire would have to pay more than that obviously.

    This call just goes to show why Munger is smarter than I am, maybe. Because I just don't get this.

    Say what you will, this company hasn't had a return on equity higher than 14.4 in the last ten years. That's sacrificing near term profitability? -- I guess that's what he means. And that ROE is with financial leverage not a lot lower than WalMart's. Its net margin is less than half of WalMart's -- so I guess that's returning the money to consumers; still, it's clear Costco ain't making back the difference in price on its membership fees -- that would feed into net margin. And its return on assets is less than six. This is all average, or below average, for the S&P. So the goal is to grow revenue and market-share, but at what cost?

    This is a company that bought back a ton of shares in 2006/2007, and dropped that almost to nothing in the year-ending August 2009.

    That said, I get it, I see the top-line revenue growth, I understand the principle of locking in paying members, I get why that is arguably a good long-term business model.

    I'm just wondering what the endgame is. Do they ever raise prices, or are we perpetually looking at a company that has a sub-15 return on equity despite having a level of debt that now approaches 75% of equity?

    And this with a PEG ratio of 1.9.

    Can anyone explain what I am missing? Is the ROE low because it is a growth stock and more equity is required?

  • Report this Comment On July 07, 2011, at 10:09 AM, prginww wrote:

    Costco is a terrific business. The problem is that pretty much the whole world has figured that out and, as Buffett has pointed out, "you pay a high price for a rosy consensus".

    Coscto trades at 25 times earnings. It's intrinsic value can likely grow at 8-9% going forward, but you will probably be disappointed if you expect anything more.

  • Report this Comment On July 07, 2011, at 1:12 PM, prginww wrote:

    When I opened my newborn son's ESA earlier this year, Costco was the first stock I bought for it.

    I'll pay 25X earnings for a solid established company with a decent moat where I'm not getting ripped off by the CEO and board.

  • Report this Comment On July 07, 2011, at 2:53 PM, prginww wrote:

    costco is of course finished and munger along with buffett should have already retired

  • Report this Comment On July 10, 2011, at 7:09 PM, prginww wrote:

    I'd pay 25x earnings for a workhorse like Costco where I know my money is safe.

    Yes, great management & moat blah blah blah.... but $1.50 for a hot dog & drink!! Now that's a company.

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