Forget Darth Vader and Luke Skywalker. The Star Wars opus is a story about one man, and one man only: Obi-Wan Kenobi, Jedi master and trainer of both Anakin and Luke Skywalker. Unfortunately for Obi-Wan, his training methods worked with only one pupil, so he's only 50% successful as an instructor of padawans. Fortunately for him, his success story saved the galaxy from the evil clutches of the Empire.
After all this talk of Star Wars, you might be asking yourself what this has to do with investing. Well, there is one modern-day Obi-Wan Kenobi, and it's Costco's (Nasdaq: COST ) Jim Sinegal, who will soon be retiring and leaving Craig Jelinek in charge. Hopefully, his teachings and guidance will lead the new CEO down the right path, but regardless of the company, you always have to be wary of the Dark Side.
The Light Side
Fellow Fool John Maxfield thinks Costco can make investors millions. A great first step would be for Jelinek to continue along the same path as his predecessor. Jelinek has been with Costco since 1984, so he is firmly entrenched in the company's policies and procedures, and he should understand that low margins and high volume are the bread and butter of Costco's success. They keep members coming back and paying their annual fee, which is the driver behind Costco's earnings, resulting in lower gross margins than nearly all of its competitors can claim.
In the retail sector, gross margins are an indicator of a company's pricing and brand power. The gross margins at Costco's largest competitors, Wal-Mart and Target (NYSE: TGT ) , dwarf those of Costco. Sears Holdings (Nasdaq: SHLD ) , parent company of both Sears and Kmart, falls between the two. Big-box office suppliers Staples (Nasdaq: SPLS ) , Office Max (NYSE: OMX ) , and Office Depot (NYSE: ODP ) , which use stores with large floor plans similar to Costco, all have margins twice as large. The only one among these stores with a lower gross margin than Costco is BJ's Wholesale Club (NYSE: BJ ) , which, like Costco, derives revenue from the sale of memberships to its giant warehouse stores.
Despite lower margins, Costco has had higher returns than these competitors over the past five years.
Source: Yahoo! Finance.
BJ's is close behind, but it doesn't have the same geographic reach as Costco. BJ's has only 189 stores, all situated east of the Mississippi River. Meanwhile, Costco is the third largest retailer in the United States, with 429 stores in 40 states and Puerto Rico. Wal-Mart is the only other company on the list that has returned anything to investors.
The Dark Side
The path has been laid for Jelinek to easily follow along Sinegal's footsteps. He simply needs to keep margins low and continue to renew 88% of the stores' members every year -- but any reduction in the renewal rate would directly affect Costco's revenue. And the "evil empire" of Wall Street could always come along and tempt Jelinek to make shareholder value more important than customer loyalty.
One complaint Wall Street has long had about Costco is that it's an "expensive" stock, with a P/E ratio higher than many of its competitors. Six of the companies I've mentioned so far have been profitable in the past year, and Costco is indeed, by far, the most "expensive" company as measured by P/E ratio:
One of the easiest ways to lower the P/E ratio, thus making the stock more attractive to investors, would be to increase earnings. One way to do that would be to increase prices, even if it was just by 1% or 2%. Sinegal has long been loath to do so, even keeping the hot dog and soda combo at the same $1.50 price point it had when Costco started selling it 1985. Jelinek could succumb to temptation and raise prices slightly, but doing so could reduce the number of membership renewals each year, this affecting future revenue streams.
What path will he choose?
I'd be willing to bet a lot of Republic Credits that Jelinek will continue down the Light Side. He won't have to vaporize any Death Stars along the way, but he should continue along Sinegal's path and raise shareholder values by putting his customers first. There are a handful of retailers growing revenue despite difficult times for consumers, and Costco is one of them. To read further how it is changing the face of retail, see our exclusive free report.