Boring Portfolio

Boring Portfolio
Thoughts on Chain Stores
From Vice-Chairman Munger

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Oct. 20, 1999) -- I didn't really know what I wanted to do with the last two Bore columns, because I'm not going to get into anything that can't be finished by Friday. I do plan to take a look at Fortune Brands (NYSE: FO) for the last Fool on the Hill I will write for Thursday, which was spurred by last weekend's article in Barron's. As a preview of that, I wasn't too enthused about the company's big-bath accounting, but we'll get to that on Thursday.

One item I did want to include was this thought from Berkshire Hathaway (NYSE: BRK.A) Vice-Chairman and Costco Wholesale (Nasdaq: COST) board member Charlie Munger. This comes from his 1995 lecture at the University of Southern California entitled "A Lesson on Elementary, Worldly Wisdom as it Relates to Investment Management & Business." This text is only available, to my knowledge, in the excellent Outstanding Investors Digest. This is one of the touchstone texts in investing, in my opinion, and I hit upon the following in re-reading the lecture for around the 25th time on Monday:

"On the subject of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power -- which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization. If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of dumb decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying. The reverse is demonstrated by the little store where one guy is doing all the buying. It's like the old story about the little store with salt all over its walls. And a stranger comes in and says to the store owner, 'You must sell a lot of salt.' And he replies, 'No, I don't. But you should see the guy that sells me salt.' So there are huge purchasing advantages...."

All these are excellent points with regard to our investment in Costco Wholesale. As you can see in Costco's Q4 conference call, the above characteristics all play a part in the way the company thinks about its business. No retailer I know of is as fanatical about driving down prices for customers (members, in this case) than Costco:

1. Purchasing power: "The gross margin message sounds like a broken record. We'll continue to drive prices down and we'll only improve gross margins if prices are able to go down. I see no letup in our ability to continue to do that. We have continued improved purchasing power...."

2. Experimentation: Overall, (ancillary) businesses generated $1.797 billion in sales this year, up 36% from last year's $1.325 billion. These are all good, profitable businesses, and the company thinks they help drive renewal rates upward and continually set the company apart from its competitors. "I can assure you that we'll keep coming up with new concepts and new ideas to keep us on top. While we have nothing to announce today, we're working on some other things," said CFO Richard Galanti.

3. Buying intelligence: In asking the company's buyers what they generally think about comps, they've said they don't look at comps -- they just look at sales, how to drive sales, and how to come up with new products. "They're very positive right now. I don't want to assume, though, that we're going to be at 10-11-12%.... We're adding apparel items -- we've just gone crazy with these cashmere sweaters for men and women at $39 and $49. People are coming in and buying 10 and 15 literally at a time for themselves because they're 75% less than at department stores. The deal we did with Microsoft on selling the [Microsoft Network Internet service provider account] at 40% less than they're selling it themselves for. I think there's just a lot of merchandising momentum. There are some of the new things -- expanding fresh foods, and not being complacent there, but every month we're coming out with a new item in the baked goods area.... The fact is we've stayed true to the philosophy of driving prices down.... I think all these things help us."

Over the last two weekends, I was in the Pentagon City store (I would guess this unit is in the top 15 stores, probably doing $150 million per year in net sales). I passed by a stack of (6' x 8', I believe) sheepskin rugs four feet high by about 12 feet long. On the first weekend, the stack looked new. By the second weekend, they had worked through nearly 75% of the inventory. Let's say this pallet held about 50 rugs. Let's say they're gone in three weeks. That's $4,800+ worth of merchandise (at cost) turning at an annualized rate of 17+ times and an annualized rate of sales of a little over $982 per square foot, which is pretty amazing. If I'm underestimating the turnover (which I could be because of the number of datapoints of which I'm making this very unscientific estimate), then the sales/square foot would be higher.

When you consider the turnover versus the margins and put that together with the much higher fixed cost per square foot and higher SG&A as a percentage of revenues for higher-end retailers, I think Costco's attractiveness as an investment (at the right price) is easy to see. Add in the overwhelming customer utility the company creates and I think this is an easy one to understand.

See you Friday.

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