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Why Less Choice Means More Profits for These Warehouse-Club Operators

Wal-Mart  (NYSE: WMT  ) is the world's largest retailer, but it isn't necessarily the most profitable. In fiscal 2013, Wal-Mart delivered an impressive return on invested capital of 12.1%, but its profitability was still inferior to that of its warehouse-club operator peers. Costco Wholesale  (NASDAQ: COST  ) and its Latin American counterpart PriceSmart (NASDAQ: PSMT  ) achieved 2013 ROIC of 13.3% and 15.5%, respectively. PriceSmart was founded in 1996 by Sol and Robert Price, the pioneers of the warehouse-store concept.

Inverse relationship between profitability and SKUs
To understand the reasons for the difference in profitability, it is worthwhile referring to Charlie Munger's quote on the subject: "In business we often find that the winning system goes almost ridiculously far in maximizing and or minimizing one or a few variables -- like the discount warehouses of Costco." As Munger correctly pointed out, the success of the warehouse-club operating model lies in the minimization of SKUs (stock keeping units) to maximize profits.

Costco carries an average of about 3,700 SKUs per warehouse, while PriceSmart carries approximately 2,200 SKUs. Given that PriceSmart's warehouse clubs are smaller in size to their U.S. counterparts, the average number of SKUs per square foot is comparable. In contrast, an average Wal-Mart supercenter boasts more than 20 times the number of SKUs that warehouse-club operators carry.

High inventory turnover
There are two key components to a high ROIC -- profit margins and asset turnover. Given that Wal-Mart, Costco, and PriceSmart sell low-margin general merchandise and groceries, there is a natural limit to how much margin expansion can be achieved through a better product mix. Instead, retailers compete to sell the most goods in the shortest time possible i.e., maximizing inventory turnover. In fiscal 2013, Costco and PriceSmart held their inventories for 29.8 days and 39.6 days, respectively. In comparison, inventories stayed in Wal-Mart's stores or warehouses for an average of 43.8 days.

High inventory turnover has several benefits. Firstly, the faster you turn over your existing inventories, the more shelf space available for new trending products. While Wal-Mart clears the old stuff on its shelves, Costco and PriceSmart keep their assortment fresh with what consumers are demanding right now. Secondly, high inventory turnover increases sales per SKU over the year, resulting in stronger bargaining power over suppliers. When Costco and PriceSmart purchase more products from a single supplier, they get more bulk discounts and become a more significant customer for that supplier.

Choice can be demotivating
When you try to pick up milk at your favorite retailer, you are typically confronted with an array of choices ranging from healthier choices to exotic flavors. At times, you may even give up on buying altogether...if you simply can't decide. Experts agree that less is more for both consumers and retailers.

Two professors published a research article in the Journal of Personality and Social Psychology titled "When Choice is Demotivating" in 2000, which claimed that consumers are more likely to purchase gourmet jams or chocolates when offered fewer choices. Separately, a 2007 study by Bain showed that SKU minimization can increase retailers' sales by as much as 40%.

Where did Wal-Mart go wrong?
If SKU rationalization is the cure-all for retail profitability, it seems sensible that any company can adopt similar practices. Wal-Mart proves otherwise. In 2011, Wal-Mart had to put more than 8,500 products back on its shelves after its SKU rationalization efforts alienated its customer base, resulting in quarters of same- store sales declines.

There were two key reasons for this. Firstly, positioning was an issue, as Wal-Mart was known to its customers for its 'Every Day Low Prices' and having the widest assortment of products in the industry. Customers switched to competitors when they couldn't find the exclusive products they loved at Wal-Mart anymore. Secondly, SKU rationalization is as much an art as it is a science. Dropping the wrong SKUs will lead to customers voting with their feet. Furthermore, the right assortment needs to be optimized on a store-by-store basis to cater to local differences.

Foolish final thoughts
The financial numbers for Costco and PriceSmart speak to the success of the warehouse-club model and the benefits of SKU rationalization. However, only those who  truly understand their customers' needs and prune the products that customers don't require will reap the profits.

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Mark Lin

Mark is a private value investor and is the author of website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.

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