Costco - Relentless Focus On The One Thing
Costco - Relentless Focus On The One Thing
Costco - Relentless Focus On The One Thing
Introduction
Patrick: [00:01:53] Today we will be diving into Costco. Costco is a favorite business story and model for
many operators and investors. It was founded in 1983 in Seattle, and it has grown into a juggernaut with over
$169 billion in sales and almost 60 million members globally. To me, Costco is the best example of doing one
thing for customers and getting better at it constantly for decades. To help me break down Costco, I talked to
both Zack Fuss and Chris Bloomstran. Zack is an investor at Continental Grain, a 200-year-old family-owned
business that is focused on investing and operating businesses throughout the food and agriculture
ecosystem with assets across the US, Latin America, and Asia. Chris is the President and Chief Investment
Officer of Semper Augustus Investments Group and a long-time shareholder of Costco. In this Breakdown,
we'll start with Zack by diving into the Costco business model, examining the relentless focus on efficiency
that separates Costco from its peers, and exploring the secrets behind its private-label Kirkland. I'll then talk
to Chris about the growing international opportunities for Costco and the lessons that operators and
investors can take away from studying the business and founder James Sinegal. I hope you enjoyed this
Breakdown of Costco.
Zack: [00:03:18] Costco is an interesting one because on the surface it's a retail business, but the primary
differentiator or the economic moat of Costco is really the combination of its brand, its company culture, its systems,
and its supply-side economies of scale. So the business at its core, it's a network of 800 warehouses across 12
countries, does about $180 billion in sales. It's the second-largest retailer in the US behind Walmart at $550 billion.
But it's recognized for being maniacally obsessed with its customers, its members, and providing them with the lowest
prices possible, which results in a highly loyal customer base and the operating philosophy is simple. It's keep costs
down and pass the savings on to the members.
Patrick: [00:04:02] The shared scale economies piece of this has become, I think Costco is the symbol of that
concept. That actually what you're trying to do is actually get your margins as low as possible, not as high as
possible. Can you just talk through that dynamic where, unlike most retailers that are making money on the
sales of the products, Costco is instead making money through its membership and that inverts the typical
goal?
Zack: [00:04:25] So in many ways, Costco is the original consumer subscription business. So before cohort analysis
and CAC to LTV equations where common speak in investor parlance, the founder, James Sinegal, and his team
were reaping the benefits of a contractually recurring fee stream, which is their subscription. So as subscriptions have
become more broadly adopted by a wide range of consumer-focused businesses, it's become more commonplace,
but it was allegedly the original inspiration for Amazon Prime.
So Costco has 55 million members who pay $60 a year for the privilege to shop the warehouses. It's a retailer in the
traditional sense, but the reality is it doesn't take much margin on its product sales as you referenced. And you can
kind of think about it as analogous to a group purchasing organization where the 55 million paying members pool
their capital and buying power together, and they extract the best deals from their vendors, customers literally pay for
the right to shop their stores and Costco then negotiates on behalf of its members and is able to offer them really the
Private Label
Patrick: [00:12:27] Can you say a bit more about private label and maybe we could talk about this as its own
section here. They're obviously not the only company to have private label. Tell me a little bit about what
you've learned about that concept. What makes it go? You've talked already about why do it. Cheaper price,
higher margin. But what makes it work well? Where does it fail? Kirkland's an incredible story. Say a bit more
about the private label as a strategy.
And so what the retailers started to realize is that they can get that trade spend for the highly marketed branded
items, but in the shoulders of the aisle put their private label brands. And if you look at a store brand Oreo, as an
example, relative to that of a Nabisco Oreo, it's probably somewhere from half to two-thirds of the cost of retail, but
the margin that they're realizing on that is so much higher. That's really compelling for retailers to lean into private
label. The other thing about private label is it tends to be counter-cyclical. So in times of economic distress or
uncertainty, people are likely to drift towards lower ticket items. And so they do really well and over time search costs
have been really important and people used to only go for the brands that they recognize, but more and more store
brands themselves are standing out. And so the Whole Foods brand means something and they have their 365 brand
and Costco Kirkland means something and they stand behind that. And because Costco has such high brand equity
and Kirkland in particular, consumers are willing to trial the Kirkland product and in many cases will choose it over a
branded peer, knowing that they're getting an equivalent or a better product. And I think a lot of that has to do with the
price transparency of the internet and quality assurance standards have been implemented over time. And so if you
think about back to 75 years ago, when people were dealing with retailers, the brands themselves were what made
sure that the items they were getting were fresh, that they were made in hygienic backgrounds and environments that
were safe. Now the stores themselves stand behind their products and so they're in a very advantageous position to
lean into their private label brands. And if you take it a step further, especially in grocery, you have concepts like
Trader Joe's or Aldi or Lidl that have flipped the script and instead of being 20% private label, 80% branded, it's the
opposite. Costco is still at the 25% to 30% private label mix, but it's growing over time and the brand is so important
to their success because people tend to gravitate towards it.
Zack: [00:15:52] The key differences as we have spoken to is the membership model itself and the limited sku count.
And so the reason that the membership model is so important is because of that negative working capital benefit that
you get from that. 75% of the operating income that Costco generates is from its membership model. People pay $60
a year, 50 million paid members that make up 100 million store members. Retention rates are in the 90% range.
These are super loyal customers. The shopping experience and event is unique. You consider that in relation to
Walmart, they have the concept of everyday low prices, but the reality is at a 25% to 35% gross margin that's
common in consumer discretionary retail. Costco at 10% already has an inherent competitive advantage because, by
definition, their prices are going to be lower. Beyond that, because they have bulk size packaging, and so if you
consider at Kraft Heinz Ketchup likely you're buying it in both packaging of five. So you're paying less per unit, but a
higher ticket and a way more attractive margin to the customer. And so the feedback loop associated with that
continues to provide a ton of value to the customer itself.
The size of the stores, Walmart has back of house, which probably comprises about 30% of the entire store footprint
whereas when you walk into a Costco warehouse, the entire warehouse is a store.There's no incremental inventory
and so not a single square foot is wasted. Because the items are bigger, they have less theft. With less theft means
The key differences as we have spoken to is the membership model itself and the limited
sku count. And so the reason that the membership model is so important is because of that
negative working capital benefit that you get from that. 75% of the operating income that
Costco generates is from its membership model. People pay $60 a year, 50 million paid
members that make up 100 million store members. Retention rates are in the 90% range.
These are super loyal customers. The shopping experience and event is unique.
Patrick: [00:18:19] Can you talk a bit about this concept of, I think they call it open source retailing, and this
is really a supplier relation story. I was with a friend the other day who used to be a huge supplier to Costco,
ran a company that produced healthy chips and Costco was 30% to 50% of his sales typically. And even
though he made a 30% instead of 38% margin, they were by far his favorite supplier because the people were
the best to deal with. But one interesting thing that he brought out was if he had a new product, sometimes it
would only be like three months to get a meeting with Costco, and then often if they like it, it would be like
six months until it was literally on the floor as a trial whereas with any other retailer, it would take way, way
longer. Can you talk about Costco and the way that it uniquely treats its suppliers?
Zack: [00:19:05] If you consider the size and scale of Costco, which I think some people are surprised by it's the
second-largest brick and mortar retailer in the US behind Walmart, and as a function of that, they are the largest
customer to a number of their vendors. And so the way that Walmart does that is they try to extract as much value
from their vendor as possible whereas Costco has always viewed their relationship with their vendor partners as a
true partnership, realizing that if they can provide them with visibility into what they want, how much they want it, and
where they want it, that they can both create more value than they capture, but also deliver a disproportionate
amount of that value back into their store shopping experience.
So for instance, for every product vertical, they have a dedicated merchandiser who was responsible for maintaining
their relationships with the brands, with the vendors, trialing new products and once a year they're going to have a
show where new vendors can come and sample their products. So for instance, during holidays, the toy buyer may
be responsible to meet with a long tail of 50 to 100 different producers of toys. And then they'll choose the 10 to 20
hottest items that they think that they want in their stores. And they can present a purchase order that day for a
number that will be probably 30% to 40% to 50% of what that vendor is going to sell. And to your point, have it on the
shelves ready for the holiday in the next four to six months. And it's the certainty with which they work with their
vendors. It's so important.And if you compare that to some of the largest multinational retailers they compete with,
many of those actually fine their vendors if the items don't arrive at the store within a certain time window, so they can
get the things from the back of house to the shelves. Because Costco has customized packaging and pallets to
straight to the store floor, they can work in a more flexible manner with their vendors and making sure that the
expectations are set for everyone while ahead of time and there are no last-minute changes and because they only
have 800 warehouses as opposed to the thousands of stores that their competitors have, it just makes it way easier
for everyone to manage the supply chain and both the vendors, the customers, Costco and its employees benefit
from that directly.
Zack: [00:21:40] I mean, it really is remarkable. When I started analyzing the business, I think that sales per square
foot were likely in the $800 to $1,000 range and they're closer to $1,500 today. Which relative to Walmart, I think is
still 2.5 to 3 times as high of square foot productivity. A lot of it is attributable to that feedback loop. I mean, this is a
business that comes positively just about every year in and year out. And it's because they're providing more and
more value to their customer. And if you consider the percentage share of wallet they continue to go after, there are
markets where 2/3 to 75% of the local demographic has a Costco membership. And so a lot of it is attributable to
traffic. A lot of it is attributable to volume. And so that means that people are coming more often and they're building
their basket sizes bigger.And then on top of that, Costco's starting to compliment their stores with value-added
services like travel or auto insurance or home insurance. They have so many items that they continue to complement
to build the basket. And as the fixed leverage in the stores helps to fund new investments, they can provide their
members with better and better products. So a TV that may normally retail for $3,000 at a call it 50% margin, Costco
is happy to send to their customers at $1,500, which is close to break-even. And it's those types of offerings that they
continue to build on that help them to further the square foot productivity in such an exceptional way. And I think for
all those reasons, there's no reason that that won't continue over time as they move up the value chain of value-
added services, and then just better value propositions on their core consumables for their customers.
Patrick: [00:23:21] Can we talk about the warehouses and individual unit basis a little bit because you and I
have talked before about the concept of cost to build a warehouse or a store or whatever it is a Domino's, a
Dollar General and the payback period on those build-outs and how long it takes the per store ramp to
happen from entry to full saturation in a given market. And I think Costco is very different from some of the
other ones that you and I have talked about in the past on a per warehouse spaces. Can you walk us through
the life cycle of a warehouse and how it's unique?
Zack: [00:23:52] What they lose in cash on cash returns they make up for in scale. And the reason I mentioned that
is if you consider a restaurant concept, for instance, you may be putting $1.5 million in the ground and receiving it
back in two years, but you have to do it so many times for the economics to be strong. And then you, on the other
side of the spectrum, think about something like a Costco, right? Where a new store costs them anywhere from $75
to $100 million to build including the land, the property, and equipment needed and the inventory for that store. And
then it ramps up over time from that low $100 to $125 to $150 million level to well over $200 million in sales, but each
store only contributes a 3%-ish margin. And so you're looking at best case scenario anywhere from $8 to $10 million
in free cash flow per store on a per-year basis.And so on an $80 to $100 million investment, you're getting $10 million
in cash flow per store, which is a return on capital in that low teens percentage, which is attractive, but not as
astronomical as some other unit-based concepts we think of. But what's so important is the duration of those cash
flows. And referring it back to your last question, the ability to continue to build your basket and build your same-store
sales comps that drive really attractive return on equity.And because they have this recurring revenue stream, this is
a business that hypothetically could support a fair amount of debt although they've chosen to maintain a very
conservative balance sheet. And the way they continue to improve the model is by just getting their inventory to
return quicker. By building the store's basket over time, they're hoping that inventory turnover of 12 to 15 times a year
goes to higher and higher numbers, which means that returns on capital for that particular store are going to continue
to get better.
Conservative Nature
Zack: [00:26:17] Frankly, these are pretty conservative guys. Charlie Munger has been on the board of this business
forever. So they have that Berkshire ethos connected to the business. There's something about Seattle-based
businesses and leverage. Look at the balance sheet of Microsoft, look at the balance sheet of Amazon, recognizing
that they're tech businesses. They're conservative and the reality is that when this business was started 20, 25 years
ago, the debt cost of capital was in a markedly different environment than it is today. And they're happy to self-fund
their growth.They, every couple of years take a price increase on their membership. When the cash builds on their
balance sheet, they pay out a special dividend. They're just starting to open stores in China and so to the extent that
they ever want to borrow capital to do something strategic, I think they like the optionality of that cash. But it's not too
dissimilar from a Berkshire balance sheet in that if you consider the diversity of businesses that they're in and the
cashflow durability of their business, they also maintain a rather conservative balance sheet and I think that Costco is
the same.
Even if you want a stress test the business, look back to the great financial crisis. Look at the more recent pandemic,
the business grows in just about any environment. And so it could support a very robust capital structure if they so
chose to, but they are formulaic in what they do. They know they're going to open 20 to 30 stores a year. They know
the cost needs of that capital spend and they have a pretty high degree of certainty know what their membership
retention is going to be and what that membership fee stream is going to look like, and they're happy to return that
cash to their shareholders via special dividends, but they don't see any reason to put the business at risk in any way,
shape or form because their vision is to continue to grow the business for decades. But I think that by any typical
financial analysis, you could definitely support a fair amount of leverage on this business.
Patrick: [00:28:02] You mentioned perhaps the legend is that Bezos learned from Sinegal, and this is the
inspiration for the Amazon Prime model. And I love that with Bezos just stepping down, they still own
relentless.com. It seems like almost Costco should own relentless.com as much as Amazon does. And if I
think about the business, the major lesson I take away is this idea of The One Thing or keep the main thing,
the main thing. That they've been doing the same thing forever, and just constantly getting better at it. Are
there other lessons beyond that major one, this relentless focus on the member, that you think are most
interesting to take away from your time studying Costco and apply to other businesses?
Zack: [00:28:40] So I think at its core. Costco is a best-in-class business. It's maniacally focused on keeping costs
low and passing those savings onto the customer and improving the shopping experience to drive membership
growth and retention. And if we consider retail in the US, the best-in-class retailers, whether it be a Home Depot, a TJ
Maxx, an O'Reilly Auto Parts, they all have that maniacal focus on the customer. And I think what we've started to
realize is that retail in many ways, lost its way over the course of the last 10 to 15 years as it faced competition from
online players. And now we're shifting back to a place where retailers are focused on customer service above all else.
I think we talked about it briefly, but the way that they take care of their employees, if you have happy employees and
they're willing to take care of the customers, that's going to drive the customers to spend more in the store and to rely
on their Costco or their Walmart or their Target.
I think that we can now apply that broader to a number of different store concepts where consider the evolution of
something Best Buy and the Geek Squad. In stores where the merchandise itself is somewhat commoditized, it's
really the service and the store experience and the customer experience that's going to help to strengthen the
economic moat of that business. And so that's clean stores, low prices, and happy customers and I think being
concerned with all stakeholders is a function of that. And taking care of your employees is part of that feedback loop
And I think what we've started to realize is that retail in many ways, lost its way over the
course of the last 10 to 15 years as it faced competition from online players. And now we're
shifting back to a place where retailers are focused on customer service above all else. I
think we talked about it briefly, but the way that they take care of their employees, if you
have happy employees and they're willing to take care of the customers, that's going to
drive the customers to spend more in the store and to rely on their Costco or their Walmart
or their Target.
Chris: [00:30:51] Well, they've been growing outside the United States and so of their 800 stores, something like 550
are US, there are another 100 Canadian stores, but they've been growing in 11 or 12 global markets. They're in the
UK with a pretty big presence. They've got some Spain stores and they've got one in France, but then in Asia, they've
got a big presence in South Korea, they've got a big presence in Japan. They just launched in China, in Shanghai.
Lines around the store. People were camping out overnight.
But four years ago they opened a store and I'm not sure many people know this, but they opened a store in Iceland in
Reykjavik. And so I thought, how in the hell are you going to make that work? I mean, how are you going to make that
$1.50 hot dog and soda work in Reykjavik? It's Hawaii at some level.It's an island and so the grocery stores can't sell
things for the same prices. If they've got to be shipped in on container ships or they've got to be flown in. So you just
run on a higher price scale. How in the world is Costco going to go in and sell things at the prices at which they sell
them and win? So they opened the store and the whole population of Iceland is 350,000 people. And if you do the
economics of how many stores a Costco can have in St. Louis, and you do the population of St. Louis, two million
people, they have three stores and you get a certain density, you get a certain number of the population that signs up
as members and you make it work. You think, "Well, you got to get every damn family in Iceland to sign up as a
member." And why would they do that? And then you realize, "Oh my God, they're not going to sell the hot dog for
$1.50. They're not going to sell at the same price points at which they would sell in a warehouse in the United
States."All they have to do is beat the three or four grocery stores in Iceland. All they have to do is beat the company
selling gasoline, the convenience store on price. And so when they came in at the price points at which they came in,
goods on a per unit basis, when you convert the local króna currency to the dollar are a hell of a lot more expensive
in Reykjavik, suburbs of Reykjavik, where there are one store and they are. Everybody in the country has signed up
and it's destroyed the rest of retail because they've taken the scale. If you think about how did they distribute? They
took a pallet, ship it in, however they ship it and drop it on the floor.So all of the same blocking and tackling that they
go through, except those goods are obviously not going through the depots, the pseudo distribution centers. They're
having to put pallets on a plane, a lot of it being brought in direct ship from the suppliers, but they're getting it to
Iceland and they're selling it at a price point that kills the rest of the competition. And so for that, the whole concept
lends itself to international growth. And I think that's why when you're selling something in whatever market you're in
Chris: [00:34:06] Jim Sinegal in my mind is maybe the best CEO that I've ever seen. He's the best business leader.
And what he really understood was culture. I mean, he understood that the culture of the place will feed on itself and
it drives into the flywheel. I mean, he understood that happy employees would be permanent employees. That happy
customers would come back and renew. And I think the lesson is instead of this rat race that public companies find
themselves in, which is the quarterly earnings hurdle, which is the compensation hurdle for how they get rich.The
average CEO works in that position for four or five years, and they tend to be heavily compensated with stock options
and restricted shares and with all kinds of ridiculous metrics to where they often have to drive the stock price up for
them to get rich because so much of their comp is awarded that way. Well, if James Sinegal founded Costco with Jeff
Brotman, and Sinegal was the only CEO, Brotman was the chairman and they paid themselves identically. They paid
themselves reasonably. They had a bonus structure that was tied to growth in sales and growth in pre-tax profit, but
they were paid reasonably. I think at the highest, Sinegal probably made $6 million bucks a year. And for the last 10
years he worked, he never raised his salary. He was making like a $350,000 salary and they never bothered
themselves with short-term profitability with beating the number.
They created this private company mindset where we're going to drive the profitability way up. I mean, we don't even
get into this business. You wouldn't even open your first Costco store as a public company unless you had this very
long-term mindset. If you think about the economics at the store level, those stores don't mature for 8 to 10 years. A
new store in today's dollars, the class of 2020 stores will do $130 million in revenues. A mature store that's been in
the system for 10 years will do over $200 million. When you think about it, you have to sign up members. You don't
go to full subscription on day one unless you're opening a store in Reykjavik. It takes time for the throughput of the
store to get up to scale and to drive those sales per square foot to north of the $1,400 on the mature stores.And so
when I first understood the business, I think in the first 10 years they were public, they got a knock from Wall Street
for taking care of the shareholder. You looked at the thing and go, "This thing doesn't make enough return on equity."
But they don't use any debt in the capital structure. Who would put all the money into the land and buildings when you
can borrow it? Who would open a store that's not going to reach full profitability for us for 10 years, for 8 years? And if
you peeled the layers of the onion back, you realized that if they have 350 stores in 2004, they've always opened 20
to 25 stores a year. They're methodical. They've never figured out a way to open anymore. They've never needed
open anymore. They do better on real estate than anybody.
And so the return on capital was being masked by the half of their stores in the system at the time, more than half of
the stores that weren't mature, that were under-earning on their potential returns on capital. So when I paid 20 times
earnings for it, I really wasn't paying 20 times when you assumed that the business would season. It's that long-term
perspective that a guy like Sinegal had that was so unique in the world of public companies that allowed them to
scale up and they've opened no more than 20-25 stores a year. So now they've got 800. It's a far more mature
concept than it was. So when I was buying, if you run that growth in store count and growth in square footage, they
were going to grow square footage at 6.5%, 7% a year, 7.5%.Today they're growing at 2.5%. So it's a system that
because of these efficiencies and changing the sku's and keeping things fresh and working with suppliers that allow
them historically to grow same-store sales at a way higher rate than all the retail competitors. I mean, they're still
growing same-store sales at 6%, 7%. I bake in that they're at least going to grow at 2% or 3% over the inflation rate,
And so here's Sinegal. I mean, he gets it. He got rich, they award restricted shares. They've never really used stock
options to incentivize management. They don't want managers to have the downside of the stock going down for
some period of time, but they want their managers to have skin in the game. So anybody that works in corporate
management, inside a public company that is being groomed to be the CEO of a business or top executive or
anybody that's taking on a board role at a publicly traded company ought to study, Jim Sinegal. The profound long-
term ability to think about what really matters in a business and it ain't quarterly profits. It is not getting rich in a
hurry.It's getting rich long-term side-by-side with your shareholders, letting the entire universe that surrounds you win.
Let your employees win, let your customers win, let your suppliers win to a point. And for that, I think the guy ought to
be studied. And if you ask the average business leader, if you ask the average director of a public company, who's
Jim Sinegal, very few have heard of him. He ought to be studied. There ought to be books and books written on the
guy and there's not.
The profound long-term ability to think about what really matters in a business and it ain't
quarterly profits. It is not getting rich in a hurry.It's getting rich long-term side-by-side with
your shareholders, letting the entire universe that surrounds you win. Let your employees
win, let your customers win, let your suppliers win to a point. And for that, I think the guy
ought to be studied.
Patrick: [00:40:08] I think it's a great place to end. My favorite quote of his, which sums up a lot of what
you've talked about is "retail is detail". And I think he really lived that philosophy through the way he built the
business and the stores are run. And thanks, Chris, for sharing so many interesting lessons on Costco. I
think hard to replicate model, but it highlights the importance of operations of keeping the main thing the
main thing as people say, and I appreciate you breaking down Costco with me today. I hope you've enjoyed
this Breakdown of Costco with Zack and Chris. After talking with them, it makes me realize how important it
is for businesses to relentlessly focus on their one key thing and that a decades long pursuit of optimizing
that one thing can yield incredible results.