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

http://www.fool.com/investing/general/2014/01/24/why-less-choice-means-more-profits-for-these-wareh.aspx

Mark Lin
January 24, 2014

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 powe